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., C. P. A.
PROFESSOR OF ACCOUNTING, SCHOOL OF BUSINESS,
COLUMBIA UNIVERSITY
VOLUME II
(SECOND YEAR)
[Illustration]
_Twelfth Printing_
NEW YORK
THE RONALD PRESS COMPANY
1922
Copyright, 1918, by
THE RONALD PRESS COMPANY
To Nancy
AS A TRIBUTE OF LOVE AND TENDER
MEMORY TO HER MOTHER
PREFACE
A knowledge of the subject matter of Volume I is a prerequisite to the
profitable study of the present work. Therefore, it may be well to
review briefly the contents of the latter as an introduction to this
book. In Volume I the attempt was made to formulate and illustrate
the basic principles upon which the practice of accounting is
founded. The principles of debit and credit were developed and their
application explained—as related ultimately to the balance sheet and
statement of profit and loss. The chief books of original entry (the
voucher register excepted) and the various ledgers were described and
illustrated. Columnar books, controlling accounts, methods and devices
for preventing and detecting errors, methods for the proper handling
of purchases, sales, cash, and trade discounts, and some phases of
proportion and interest were discussed in detail.
Some special applications of accounting principles, as viewed in
relation to the accounting problems involved therein, were also
explained and illustrated under such heads as: notes receivable
discounted and dishonored; consignments and approval sales; single and
joint venture accounts; accounts current, their reconciliation and
adjustment; instalment sales; sales for future delivery; single entry,
its methods and the results attainable under it; etc.
From the standpoint of business organization, the accounting problems
peculiar to the single proprietorship and the partnership were given
full treatment. The advantages and disadvantages of the various types
of organization, the rights and duties of owners among themselves
and to outsiders, the accounting procedure necessary under different
conditions for changing from one form of organization to another, and
other like items were set forth. Underlying the entire treatment of
the subject was the guiding principle that accounting is never an end
in itself, that its right to existence depends solely on the service
it can render from the standpoint of administrative and financial
management.
In content, the present volume is primarily a study of the corporation,
its accounting and financial problems, although most of the material,
in so far as it consists of a statement of general principles, is
equally applicable to other types of organization. The emphasis of the
volume is laid upon the problem of valuation as met in the commercial
balance sheet. Chapters IV to XXVII inclusive comprise this portion of
the subject matter. The other chapters treat miscellaneous matters, a
knowledge of which is essential to the student of accounting. These
latter form parts of the work of the second year as mapped out in the
author’s scheme of instruction, whereby the whole field of accounting
is covered by a well-graded three-year course of study. In this scheme
cost accounting should be studied concurrently and as a parallel course
with the work of this second volume. Only a bare outline of some of the
problems and methods of cost accounting is presented in this volume.
As to the division of the text and its use in the general scheme, it is
suggested that the first twenty-seven chapters should comprise the text
material for the first semester, leaving the remainder for the second
semester in which the chief emphasis should be placed on the solution
of problems rather than on the formal classroom lecture. Hence the text
material is lessened for this semester’s work, and the student’s main
effort is directed towards the application to the problems of business
of the principles already established.
Instead of following the plan of the first volume in placing the
practice work for the student at the end of each chapter of text, this
material is presented separately in three appendices. It is believed
that this will be found a more convenient arrangement.
The author desires to emphasize the need of ample practice work and at
the same time to take a stand against the method of teaching accounting
exclusively by the so-called laboratory or case method. A happy
combination of text containing a statement of principles and showing
methods of application, together with practice material intelligently
made up so as to require a knowledge of principles before solution,
is the desideratum in any course of instruction. Principles, theory,
without application are barren and soon slip away, even if seemingly
understood at the time. Practice without a thorough grounding in
fundamental theory can never be sure of itself. An equitable division
of the student’s time between theory and practice portions should
be aimed at. In the present volume, while the time required for the
practice assignments may at times seem heavy, an attempt has been made
to keep it to the minimum deemed essential for adequate training either
for general or professional use. It cannot be too emphatically stated
that accounting as a profession ranks as to subject matter and the need
for its services with the other professions. If it is to enjoy equal
honor, dignity, and professional standing, teachers and practitioners
must condemn without qualification the idea prevalent among many that
a few months’ training suffices to turn out a finished product. Too
often has such a course given point to the witticism that an accountant
is a bookkeeper without a job. As stated in the preface of Volume I,
a course of at least three years’ _professional_ study is now quite
generally recognized as essential. Accounting is so broad in its many
ramifications that less than that gives inadequate training.
The reception accorded the first volume and the report of results
achieved in the classroom, through its use leads the author to hope
that this second volume may have a courteous hearing and trial.
Criticisms and suggestions will be much appreciated. The author
hopes to be able to offer in the not too remote future the third and
concluding volume in this series on general accounting.
The author is indebted for much assistance and counsel. Acknowledgment
is due Miss Nina Miller of the Columbia staff and Eric Bodine for help
in gathering and preparing much of the material for Chapters XXVIII to
XXXIII; to H. A. Inghram of the University of Georgia, for preparation
of a large part of Appendix D; to Leo Greendlinger and David E. Boyce
for the use of problems prepared by them; and to his good friend,
Joseph Gill, for help in reading the proof. To S. B. Koopman and James
F. Hughes of the Columbia staff in second year accounting, the author
is under special obligation for many suggestions. Mr. Koopman has
furnished most of the problems for Appendix B, and has collected those
for Appendix C.
As with Volume I, so in shaping the content of the present volume the
author has had the good counsel and ever ready help of his chief,
Robert H. Montgomery, and desires again to offer goodly acknowledgment,
for his debt is large.
R. B. KESTER.
Columbia University,
New York City, August 5, 1918.
CONTENTS
CHAPTER PAGE
I THE CORPORATION 1
The Corporation
Classification and Definitions
Method of Ownership
Working Organization
Different Classes of Stock
Common Stock
Preferred Stock
Guaranteed Stock
Founders’ Stock
Debenture Stock
Stock of No Par Value
Watered Stock
Treasury Stock
Forfeited Stock
Bonus Stocks or Bonds
ACCOUNTING FOR STOCKS
Discount on Stock
Premium on Stock
Property Exchanged for Stock
Treasury Stock Donated
Bonus Stock
Treasury Stock Purchased
Redemption of Preferred Stock
Forfeited Stock
Stock of No Par Value
Distinctive Records
Stock Ledger
Minute Book
Conclusion
II THE VOUCHER SYSTEM 26
Purchasing for the Manufacturing Business
Expansion of the Purchase Journal
Development of Voucher System
Definition and Description of Voucher
Operation of Voucher System
Voucher Check
Form of Voucher Register
Distribution of Vouchers
Posting of Summary Totals
Effect on Cash Book and Bank Account
Payment of Vouchers
Voucher Index of Creditors
Control of Vouchers Payable
Introduction of System
Purchase Returns and Allowances
Partial Payments
Handling of Notes Payable
Cash Discount on Purchases
Modifications of System
Summary of Operation and Advantages
III FACTORY COSTS 49
Difference Between Factory and Financial Accounting
Definitions of Terms
Special Purposes of Cost Records
Nature of Raw Materials and Supplies
Accounting for Material Cost
Direct and Indirect Labor
Time-Keeping Records
Pay-Roll
Safeguarding the Pay-Roll
Distribution of Labor Charges
Expense
Summary of Manufacturing Cost
IV THE BALANCE SHEET 60
Business Methods under the Microscope
The Reading of the Balance Sheet
Definition
Relation Between Balance Sheet and Trial Balance
Form of Balance Sheet
Purpose and Uses
Types of Balance Sheet
Origin of English Form of Balance Sheet
Variation of English Form
Balance Sheet Titles
Grouping and Classification
Arrangement of Groups
Report and Account Forms
Valuation Accounts
Statutory Requirements as to Frequency of
Balance Sheets
Condensation of Information in the Balance Sheet
Use of Supporting Schedules
V GENERAL PRINCIPLES OF VALUATION 81
Content of the Balance Sheet
Valuations for Rate Regulation
Valuation for Sale and Purchase
Other Kinds of Valuations
Going Concern Valuation
Kinds of Value
Source of Data as to Values
Cost Value the Usual Basis
Definition of Capital and Revenue Expenditures
Organization Expenses
Definition of Replacements, Renewals,
Maintenance, etc.
Treatment of Renewal of Parts
Treatment of Cost-Cutting Changes
Asset Subject to Depreciation a Deferred Charge
to Operations
Authorization of Booking Capital Expenditures
Repairs on Second-Hand Plant
Construction Costs
Distinction Between Capital and Revenue Expenditures
Often Based on Opinion
Main Groups of Asset Items
Valuation of Liability Items
Over- and Under-Valuation
The Balance Sheet an Expression of Opinion
VI DEPRECIATION—ASPECTS AND DEFINITIONS OF TERMS 99
Aspects of Depreciation
Definitions
Authoritative Opinions
Why the Depreciation Factor Arises
Actual or Absolute Depreciation
Theoretical Depreciation
Comparison of Actual and Theoretical Depreciation
“Accounting” and “Fair” Depreciation
Complete and Incomplete Depreciation
Individual and Composite Depreciation
Physical and Functional Depreciation
Deferred Maintenance and Accrued Depreciation
Attitude of the Law
Decision of Supreme Court
Recognition of the Depreciation Factor
Distinction Between Repairs and Renewals
Depreciation and Plant Efficiency
Unit Efficiency
Depreciation and Fluctuations in Market Value
Distinction Between Depreciation and Depletion
Effect on Different Kinds of Business
VII DEPRECIATION—ITS CAUSES 120
Analysis of Causes
Age as a Cause of Depreciation
Wear and Tear of Use
Functional Depreciation
Inadequacy as a Factor
Inadequacy Through Change of Policy
Inadequacy Through Motives of Economy
Inadequacy Due to Unforeseen Development
Inadequacy Imposed from Without
Obsolescence as a Cause
Treatment of Obsolescence
Contingent Depreciation
Terminable Rights
Effective Depreciation
VIII DEPRECIATION—FACTORS OF RATE DETERMINATION 136
Fundamental Purpose of Depreciation
Depreciation a Cost of Operation
Complication of Short Fiscal Periods
The Factor of Idle Time
Depreciation a Means of Financing
Danger of the Financing Viewpoint
The Standardization of Depreciation Rates
Effect of Local Conditions
Factors in Determining Depreciation Rate
Bases of Normal Rate
Policies as to Repairs
Depreciation Rate an Engineering Problem
Attitude of Regulatory Bodies
Methods of Handling Repairs
IX DEPRECIATION—METHODS OF CALCULATING 150
Methods of Calculation
Factors of Calculation
Symbols to be Used
1. PROPORTIONAL METHODS
(a) Straight Line Method
(b) Working Hours Method
(c) Composite Life Method
(d) Service Output Method
2. VARIABLE PERCENTAGE METHODS
(a) Fixed Percentage of Diminishing Value Method
(b) Changing Percentage of Cost Less Scrap Method
(c, d) Arbitrary Methods
3. COMPOUND INTEREST METHODS
(a) Sinking Fund Method
(b) Annuity Method
(c) Unit Cost Method
4. MISCELLANEOUS METHODS
(a) Maintenance Method
(b) Replacement Method
(c) The Fifty Per Cent Method
(d) Appraisal Method
(e) Insurance Method
(f) Gross Earnings Method
Condition Per Cent
X DEPRECIATION—APPRAISEMENT OF THE VARIOUS METHODS 173
General Considerations
Ideal Basis for Distribution of Depreciation Charge
1. PROPORTIONAL METHODS
(a) Straight Line Method
(b) Working Hours Method
(c) Composite Life Method
(d) Service Output Method
2. VARIABLE PERCENTAGE METHODS
(a) Fixed Per Cent of Diminishing Value Method
(b) Sum of Expected Life-Periods Method
(c, d) Arbitrary Methods
3. COMPOUND INTEREST METHODS
General Considerations
(a) Sinking Fund Method
(b) Annuity Method
(c) Unit Cost Method
4. MISCELLANEOUS METHODS
(a) Maintenance Method
(b) Replacement Method
(c) Fifty Per Cent Method
(d) Appraisal Method
(e) Insurance Method
(f) Percentage of Gross Earnings Method
Effect on Return on Investment
XI RECORDING DEPRECIATION ON THE BOOKS 187
Methods Commonly Employed
Renewals and Replacements
Subsidiary Records
Grouping and Classification of Plant Assets
Form of Plant Ledger
Asset Record
Periodic Revision of Rates
Frequency of Revision of Rates
Test of Condition Per Cent
Composite and Group Rates
The Reserve as an Index of Financial Condition
The Reserve in Relation to Expanding Plant
Reserve as Related to Efficiency
Reserve Not Based on Cost of Replacement
The Financing of Replacements
Secret Reserve
Insufficient Charge
Appreciation as an Offset to Depreciation
Appreciation Due to Physical Changes
Appreciation Due to Adaptation to Use
Unearned Increment
Depreciation Policy and Stockholders
XII CASH AND MERCANTILE CREDITS 210
Introduction
What Cash Includes
Stamps Remitted as Cash
Temporary Cash Disbursements
Disposition of Cash Funds
Cash Held Abroad
Accounts and Notes Receivable
Objection to the Title, Accounts Receivable
Risk for Credit Losses
Risk and Length of Credit Period
Analysis of Customers’ Accounts as the Basis
for Estimate of Bad Debts
Basis of Estimate of Bad Debts
Discounts and Collection Costs
Valuation of Other Receivable Items on Open Account
Loss on Notes Receivable
Interest on Notes Receivable
Balance Sheet Titles for Notes Receivable
XIII MERCHANDISE STOCK-IN-TRADE 225
Definition and Scope of Term
Valuation at Market or Cost Price
Objections to Valuation at Less than Cost
Anticipation of Profits or Losses Undesirable
Method of Treatment and Summary
Depreciation of Stock-in-Trade
Full Costs of Stock-in-Trade
The Distribution of Costs Over Stock-in-Trade
The Pricing of the Inventory
Valuation of Manufacturing Inventory
Contracts and Length of Cost Period
Valuation of Scrap
Inventory-Taking
Perpetual Inventory
XIV TEMPORARY INVESTMENTS; ACCRUED AND DEFERRED ITEMS 241
TEMPORARY INVESTMENTS
Nature of Temporary Investments
Valuation of Temporary Investments
Reserve for Investment Fluctuations
“Stock Rights” on Investments
Cost of Investments
Valuation of Bonds
Valuation of Unissued Stock
Valuation of Treasury Stock
Summary of Valuation Formula
ACCRUED AND DEFERRED ITEMS
Nature of Accrued Income
Inadequacy of Cash Method of Handling Accruals
Correct Method of Handling Accruals
Showing of Accrued Items on Balance Sheet
Valuation of Accrued Items
Accounting for Accrued Income
Illustration of Different Methods of Recording
Accrued Items
Prepaid Items—Definitions and Kinds
Valuation of Prepaid Items
Danger of Overvaluation
Accounting for Deferred Debit and Other Items
XV PERMANENT INVESTMENTS 258
Nature of Permanent Investments
Permanent Investments as an Aid to Operation
Valuation of Permanent Investments
Holding Company and Subsidiary Enterprises
Controlling Investments
Advances to Subsidiary Concerns
Rules for Valuation
Investments in Partial Holdings
Investments Producing No Income
Bond Values and Market Interest Rates
Nature of Bond Discount or Premium
Record of Bond Investments
Amortization of Bond Discount and Premium
Formulas for Compound Interest
Formulas for Annuities
Formulas for Bond Valuation
Valuation of Sinking Funds
Valuation of Investments in Land
XVI MACHINERY AND TOOLS, FURNITURE AND FIXTURES,
AND OTHER EQUIPMENT 279
General Considerations
Distinction between Personalty and Real Property
Machinery and Tools
Accounting Records
Operation of Machine Accounts
Valuation of Machinery and Tools
Estimate of Depreciation
History of Machine
Standards of Operation
Abnormal Operation
Map of Machine Location
Methods of Application of Depreciation
Basis of Valuation
Scrap Material
Accounting for Tools
Depreciation on Hand Tools
Valuation of Home-Made Machinery and Tools
Expenditure for Rearrangement of Machinery
Definition of Furniture and Fixtures
Valuation of Furniture and Fixtures
Delivery Equipment—Definition and Valuation
Carriers and Containers—Valuation
Patterns, Molds, etc.—Valuation
Disposal of Assets
XVII BUILDINGS, LAND, AND WASTING ASSETS 297
Definition of Real Property
Cost of Buildings
Valuation of Buildings
Betterments on Leased Buildings
Application of Depreciation
Accounting for Land
Valuation of Land
Depreciation or Appreciation of Land
Appreciation of Land Values
Depreciation in Land Values
Valuation of Land Investments
Mortgages on Land
Donated Land
Land as Stock-in-Trade
Wasting Assets—Definition and Characteristics
Dividends May Include Return of Capital
Basis of Depletion Charge
Application of Income Tax to Wasting Assets
Depreciation on Buildings and Machinery of a
Wasting Asset
Unusual Risks
Water Rights
Leaseholds
XVIII INTANGIBLE ASSETS—PATENTS, FRANCHISES, GOOD-WILL 316
General Considerations
Patents a Monopoly Grant
Purchase of Patents
Patents Developed Within the Plant
Patents Purchased and Not Used
Elements of Depreciation on Patents
Service Life of Patents
Booking Depreciation on Patents
Accounting Classification of Depreciation on Patents
Royalties
Relation of Depreciation Rate to Cost of Manufacture
Sale Price of Patents
Copyrights
Trade Secrets
Trade-Marks
Franchises—Definition and Kinds
Depreciation on Franchises
Organization Expenses
Good-Will—Definition and Nature
Local and Personal Character of Good-Will
Difficulty of Valuing Good-Will
Creation of Good-Will by Advertising
Valuation of Good-Will Based on Normal Profits
Valuation of Good-Will Based on Excess Profits
Valuation of Good-Will Based on Capitalization of Profits
False Good-Will to Cover Capital Deficiency
Periodic Revaluation of Good-Will
XIX LIABILITIES ON THE BALANCE SHEET; CURRENT AND
CONTINGENT LIABILITIES 339
Form and Valuation
Arrangement on Balance Sheet
Items Within Groups
Cancellation of Liabilities Against Assets
Inventory of Liabilities
Contingent Liabilities
CURRENT LIABILITIES
Loans from Bank
General Classification of Notes
Accounts Payable
Accrued Expenses
Booking of Accrued Expenses
Deferred Credits
NATURE OF CONTINGENT LIABILITIES
Statement of Contingent Liabilities
Notes and Drafts Transferred
Guarantees as a Contingent Liability
Long-Term Leases
Purchases for Future Delivery
Pending Lawsuits
Stock Not Fully Paid
Accumulated Dividends on Preferred Stock
Signature to Surety Bond
XX FIXED LIABILITIES—BONDS AND MORTGAGES 356
Nature of Fixed Liabilities
Purpose of Fixed Liabilities
Corporation Bonds
Nature of Bonds
Difference Between Bond and Real Estate Mortgages
Kinds of Corporation Bonds
Authority for the Issue of Bonds
Financial Considerations Involved in Issue
Bonds versus Stock Issues
Accounting for Bond Issue
Entry of Issue on Books
Entry of Premium or Discount on Books
Entry of Interest Payments on Books
Relation of Bond Interest to Premium or Discount
Example of True Interest Cost
Presentation on Balance Sheet
Other Fixed Liabilities
XXI CAPITAL STOCK AND ITS VALUATION 372
Problems in Valuation
Kinds of Stock
Par, Real, and Market Values
Value Dependent upon Earning Capacity
Increase of Book Capitalization
Capitalization on Cost
The Law and Stock Issues
Treatment of Discount or Premium
Valuation of Stock Issued for Property
Valuation of Treasury Stock
Redemption and Reduction of Capital Stock
Dividend Stock
Stock Issued as a Bonus
Unissued and Treasury Stock on the Balance Sheet
Preferred Stock Covered by Redemption Contract
XXII PROFITS 387
Difficulty of Determining Profits
Economic Definition
Legal Definition
Accounting Definition
Methods of Determining Profits
The Problem a Question of Valuation
Effect of Asset Losses on Future Profits
Legal Decisions as to Asset Losses
Loss Charged Against Current Profits
Loss Treated as Deferred Expense Charge
Loss Charged to Capital
Profit on Work in Progress
Goods Made for Stock but Not Sold
Goods Made to Order
Profits on Long-Term Contracts
Profit on Goods Awaiting Delivery
Interdepartment Profits
Profits Due to Appreciation of Assets
Capital Profits
XXIII SURPLUS AND RESERVES 407
Definition
Creation of Margin
Disposition of Profits
Reserves
Different Meanings of Reserves
Reserve for Bad Debts
Under- and Over-Estimate of Reserves
Depletion Reserves
Operating Reserves for Accrued Costs
Collection Costs Not under Contract
Sales Discounts on the Balance Sheet
Distinction Between Reserves and Accrued Items
Contingent Reserves
Deferred Income—Misuse of Term
Proprietorship Reserves
Secret Reserves
Argument for Secret Reserve
Argument Against Secret Reserve
Earmarking of Reserves
Continuity of Reserve Policy
Covered Reserves
Classification of Reserves
Legitimate Use of Surplus Account
Statement of Surplus
XXIV DIVIDENDS 428
Introduction
Disposition of Corporation Profits
Shareholders’ Rights as to Profits
Directors’ Control over Profits
Provisos as to Declaration of Dividends
Stockholders’ Rights to Dividends
Declaration of Dividends
Liability of Director
Revocation of Dividends
Payment of Dividends
Dividends Paid as Salaries
Methods of Paying Dividends
Borrowing to Pay Dividends
Dividends Paid in Property, or by Borrowing
on Property
Bond and Scrip Dividends
Stock Dividends
Dividends Proportional to Holdings
To Whom Payable
Accounting Record
Relation of Capital Losses to Dividends
Liquidating Dividends
XXV THE SINKING FUND 447
Origin and Use
Definitions
Mathematical Principles on which Based
Accumulation Based on Agreement
Effect of Settlement of Debt
Relation of Fund to Profits
Accounting for Sinking Fund
The Sinking Fund on the Balance Sheet
Entries to Sinking Fund
Booking the Trustee’s Report
Treatment of Income and Expense
Final Disposition of Fund
Treatment of Sinking Fund Reserve
Relation Between Depreciation and Sinking Fund
XXVI PROBLEMS IN CONNECTION WITH THE PROFIT AND
LOSS SUMMARY 466
Interrelation of Profit and Loss and Balance Sheet
Periodic Adjustments
Interest as a Cost of Manufacture
Arguments Against the Inclusion of Interest
Problem of Charging Interest on Books
Unrealized Profits
Corporation Dividends
Discount on Bonds
Sinking Funds
Working Capital
The Correction of Closing Errors
XXVII THE PROFIT AND LOSS SUMMARY—FORM AND CONTENT 477
Standardization of Form
Synonymous Terms
Cost of Goods Sold—Manufacturing Concern
Cost of Goods Sold—Trading Concern
Further Differentiation of Terms
Desirability of Uniformity in Terms Used
Profit and Method of Showing
Form of Presentation—Account Form
Non-Technical or Report Form
Examples of Forms of Presentation
Form for Manufacturers and Merchants
Content and Manner of Showing
Supporting Schedules
Adjustment of Inventories
Selling Expense and Administrative Schedules
Schedules for Special Needs
XXVIII LIQUIDATION OF A CORPORATION 493
Reasons for Liquidating—Partial and Complete
Liquidation
Current Assets Transferred into Fixed Assets
Tying up Cash in Stocks of Material
Unwise Use of Cash for Paying Dividends
Inability to Secure Cash for Refunding Operations
Excessive Borrowing on Short-Term Securities
Losses in Conducting the Business
Loss Through Fraud, Theft, or Unavoidable Causes
Methods of Liquidation
Liquidation under Bankruptcy
Liquidation under Voluntary Dissolution
Liquidation under Receivership
Status of Creditors in Liquidation
Accounting for Liquidation
XXIX COMBINATIONS AND CONSOLIDATIONS 507
Reason for Combination
Types of Consolidation
Accounting for the Holding Company
Distinction between Consolidation and Merger
Formation of Consolidation and Merger
Principles of Valuation of the Constituent Companies
Fundamental Principle of Equalization of Conditions
Valuation of Partnership
Earning Capacity
Good-Will
Capitalization of a Consolidation or a Merger
Payment of Amalgamated Interests
Closing the Books of the Merged Concerns
Opening the Books of the Merger
XXX BRANCH HOUSE ACCOUNTING 521
Advantages of Branch and Agency System
Agency and Branch Differentiated
Degree of Control Desired
Factors of Successful Management
Main Principles of Branch Accounting
Agency Accounts
Branch Accounting Records
Illustration of Simple Branch Accounts
Illustration of More Complex Branch Accounts
Purchases
Sales
Adjustments on Branch and Head Office Books
Example of Adjusting Entries
Reports from the Branch
Examples of Reports
XXXI BRANCH HOUSE ACCOUNTING (Continued) 542
Foreign Exchange
The Accounting Problem of the Foreign Branch
Accounts Opened on Books
Handling Fluctuations in Foreign Exchange
Conversion of Branch Results
Illustrative Bookkeeping Problems
Local Supervision of the Foreign Branch
The Foreign Sales Agency
Method of Conversion of Results
The Foreign Purchasing Agency
XXXII SUSPENSE ACCOUNTS; NUMBERED ACCOUNTS; ADJUSTMENT
OF FIRE LOSSES 556
SUSPENSE ACCOUNTS
Definition of Suspense Accounts—General Purpose
Reserve for Doubtful Accounts as a Suspense Account
Use of Suspense Ledger
Accounts Receivable Hypothecated
Accounting for Accounts Receivable Discounted
NUMBERED ACCOUNTS
Allotment of Numbers to Accounts
ADJUSTMENT OF FIRE LOSSES
The Insurance Contract
Requirements in Case of Loss
Determination of Value of Loss
Adjustment of Differences
Effect of Coinsurance Clause
Method of Record-Keeping to Facilitate
Ready Adjustment
Adjusting Entries for Fire Losses
XXXIII STATISTICS IN BUSINESS; PRIVATE BOOKS; JOURNAL
VOUCHERS; BUILDING EXPENSES AND INCOME 581
STATISTICS IN BUSINESS
Value of Business Statistics
Railroad Statistics
Manufacturing Statistics
Mercantile Statistics
Use of Graphs in the Presentation of Statistics
Advantages of the Use of Graphs
Principles of Graph Construction
PRIVATE BOOKS
Purpose and Content
Operation of Private Books
JOURNAL VOUCHERS
Need for the Journal Voucher
Index to Journal Vouchers
Content of Voucher
Other Methods of Authorizing Entries
BUILDING EXPENSES AND INCOME
Allocation of Building Expense
XXXIV THE CONSOLIDATED BALANCE SHEET AND PROFIT
AND LOSS SUMMARY 600
Purpose and Function
Problem of Partial Ownership
Conditions under which Used
The Setting Up of the Consolidated Balance Sheet
Showing of Intercompany Accounts
Showing of Notes Discounted
Reconcilement of Current Accounts
Valuation of Inventory
Reserve for Intercompany Profits
Valuation of Inventory—Minority Interests
Valuation of Liabilities
Showing of Capital Stock
Showing of Surplus
Showing of Deficit
Showing of Profit and Loss Summary
The Consolidated Profit and Loss Summary
Illustration of Consolidated Balance Sheet
XXXV ACCOUNTS AND REPORTS OF RECEIVERS AND TRUSTEES 620
Appointment of Assignee or Receiver
Appointment of Trustee
Accounts and Reports of a Receiver in Equity
Reports to the Court
ACCOUNTS AND REPORTS IN BANKRUPTCY PROCEEDINGS
Initial Statements Presented to the Court
Reports and Accounts of Receiver or Trustee
Liquidating Dividends
Relative Standing of the Creditors
Statement of Affairs
Basis of Valuations in Statement of Affairs
Deficiency Account
Illustration of Statement of Affairs and
Deficiency Account
REALIZATION AND LIQUIDATION ACCOUNT
Evolution of the Realization and Liquidation Account
Supporting Schedules
The Question of Cash
The Handling of Valuation Reserves
Illustration of Realization and Liquidation Statement
Uses to which Realization and Liquidation Statement
May be Put
LIQUIDATION OF A PARTNERSHIP BY INSTALMENTS
Nature of the Problem
Illustration of Liquidation by Instalments
APPENDIX A—PRACTICE WORK FOR STUDENT—FIRST HALF-YEAR 655
B—PRACTICE WORK FOR STUDENT—SECOND HALF-YEAR 694
C—MISCELLANEOUS PROBLEMS FOR SUPPLEMENTARY WORK 727
D—REVIEW QUESTIONS 755
FORMS AND CHARTS
PAGE
Stock Book or Stock Ledger 22
Stock Book to be Kept by Brokers
(New York Form Prescribed by Comptroller) 23
Stock Book to be Kept by Corporations and Transfer Agents
(New York Form Prescribed by Comptroller) 23
Voucher 30, 31
Voucher Check—Double 33
Voucher Check—Single 34
Voucher Register 35
Chart Showing Actual and Theoretical Depreciation 105
Chart Showing Progress of Uniform Depreciation and
of Diminishing Efficiency 115
Graphic Chart—Straight Line Method 153
Graphic Chart—Working Hours Method 155
Graphic Chart—Fixed Percentage of Diminishing Value Method 158
Graphic Chart—Sinking Fund Method 162
Graphic Chart—Annuity Method 166
Plant Ledger 193
Branch Report to Head Office 541
Head Office Ledger Account—Summary of Branch Expenses 541
Chart Showing Comparison of Sales with Cost of Advertising 585
Chart Showing Comparison of Sales with Gross Profits 586
Chart Showing Comparison of Sales, Purchases,
and Sales Salaries 587
Chart Showing Comparison of Sales with Cost of Sales 588
Journal Voucher 593
Card Index for Journal Vouchers 594, 595
Accounting—Theory and Practice
CHAPTER I
THE CORPORATION
The Corporation
In Volume I, Chapters XLVIII and XLIX, the fundamental characteristics
of the corporation were explained and discussed briefly and some of
its peculiar accounting features were set forth. Here these matters
will be gone into more fully and additional aspects of this type of
organization will be treated. In Volume I were explained the advantages
and disadvantages of the corporate form, the procedure incident
to the formation of a corporation, its charter, officers, working
organization and management, the records peculiar to a corporation, the
showing of proprietorship, opening the corporation’s books, booking
premium and discount on stock, change from partnership to corporation,
the distribution of profits, dividends, etc. Only so much of the
information already presented will now be repeated as may be necessary
to make the treatment here complete.
Classification and Definitions
As instruments for the transaction of business, corporations may
be classified in a number of ways. First, all corporations are
either public or private. Public corporations are the governmental
organizations set up to transact the collective business of a city, a
county, a township, or school district.
Private corporations are divided into two subclasses, stock and
non-stock. Under stock corporations are included all those organized
to carry on business for a profit. Under non-stock corporations are
included all those organized to carry on non-profit-making enterprises,
such as libraries, hospitals, religious organizations, eleemosynary
undertakings, etc.
Under the head of stock corporations we may have the following
subclasses: (a) industrial or manufacturing, (b) commercial or trading,
(c) public utility or quasi-public, and (d) financial, i.e., banks,
trust companies, insurance companies, etc.
From the standpoint of the sovereignty to which allegiance is due,
corporations are either domestic or foreign. A corporation is domestic
in the state in which it is organized; foreign in any other state or
country. Thus corporations chartered in New York are domestic in New
York and foreign in New Jersey and Canada. A foreign corporation may
be at a distinct disadvantage with a domestic corporation. To obviate
this, one occasionally sees a separate incorporation in every state in
which a concern intends to do business. Very infrequently is a domestic
corporation subject to more stringent supervision and regulation than a
foreign.
From the standpoint of the fact of incorporation, corporations may be
classed as (1) de jure and (2) de facto, the former comprising those
which have met fully all legal requirements for incorporation, the
latter comprising those which have not met fully all legal requirements
but are to all intents and purposes corporations in fact.
Method of Ownership
Business corporations are sometimes spoken of as “open” or “close.” An
open corporation is one in which ownership of the stock is not held
closely but is being passed about, traded in, or transferred from one
owner to a new. A close corporation is one in which the stock is held
very closely in order to retain control and keep profits and trade
secrets within a small compass of ownership. Thus some corporations are
strictly family affairs; others are held by a few families or a small
group.
What is known as a corporation “sole,” while little known now,
virtually exists in some close corporations, as where one man holds all
but two shares of stock. The incorporation of a single individual is
not legally possible in this country.
The corporation, because of its peculiar advantages over other forms
of business organization, has become the accepted form for most large
enterprises. The gathering together of large capital funds, the
ease and efficiency of management and control, continuous life, the
facility of transfer of ownership, and the limited liability of the
stockholders, make the corporate form attractive to the investor and
absolutely necessary to the large businesses carried on today. In some
states encouragement is given the small business to incorporate; in the
State of New York, for example, the minimum limit of capitalization is
only $500. In a few other states the old-time fear of the corporate
form is still expressed in their general corporation laws in which the
minimum limit for corporate capitalization is set as high as $10,000.
Working Organization
The peculiar features of the stock corporation are the method of
ownership and working organization. This latter is effected through
a board of directors who are responsible directly to the owners at
periodic intervals. Within the board are its officers and committees to
whom duties are assigned by by-laws, custom, common consent or action
of the board. Under these official heads are the rank and file of
the organization—department heads, clerks, employees, etc. It is not
necessary to treat here this phase of the organization further.
Different Classes of Stock
The collective capital of a corporation is divided into shares of equal
value. Ownership of a share or shares in a corporation is evidenced
by formal certificates of stock. Each share carries with it the same
privileges, powers, and duties of ownership as every other share of
the same class. It represents a pro rata share of the total interest
of its class. There may be several different kinds or classes of
ownership within the corporation, these classes will have different
privileges, and there may be other points of differentiation. The
reason for setting up these different classes is almost always to
secure additional capital from outside sources by making the investment
as attractive as possible. Upon a reorganization, an adjustment of
the various interests concerned may require a grading of ownership, a
differentiation by classes in order equitably to satisfy the claims of
all interested parties. These various classes of stock ownership will
be discussed under the following heads:
1. Common
2. Preferred
3. Guaranteed
4. Founders’
5. Debenture
Common Stock
Common or ordinary stock is that which is evidence of ordinary
ownership in the corporation. The share of ownership of the original
organizers of the corporation is usually in the common stock. The
common stockholder is a sort of remainderman, a residuary legatee. Upon
dissolution, after the special claims and privileges of the other
classes of owners have been satisfied, the common stockholders come
in for their share. After the satisfaction of the claims of preferred
owners, the common stockholders have a right to all that is left, their
rights being simply residuary. They are subsequent to those of the
other classes and to that extent inferior to them, though they may be
more valuable.
Preferred Stock
Preferred stock has some kind of preference over the common. Such
stocks differ among themselves, there being no standardized features
applicable in every way to all kinds of preferred stocks. The basic
purpose of the various preferences is to make the stock attractive from
an investment standpoint. Common to all preferred stocks, however,
is a preference as to dividends. Whenever profits have been made and
have been set aside for dividend purposes, the preferred stockholders
receive their dividends ahead of the common stockholders. If only
sufficient profits are available to meet the requirements of the
preferred stockholders and are appropriated for that purpose, the
common owners receive nothing. Stock may be preferred as to assets as
well as to profits. By this is meant that in case of dissolution the
net assets remaining after payment of all outside claims are applied
first to satisfy the interests of the owners of preferred stock and any
remainder then goes to the common stockholders.
_Cumulative and Non-Cumulative._ Preferred stock carries with it a
definitely stated minimum rate of dividend. The preferred claim to
the profits may be cumulative or non-cumulative. In the one case, if
profits are insufficient at any time to meet the preferred dividend
requirements or are not appropriated for that purpose, the claims of
the preferred owners _accumulate_ from period to period until satisfied
in full. This satisfaction must take place before the ordinary owners
can have any share in the profits. The rate of accumulation is the
specified minimum and usually interest on unpaid dividends is allowed
when the company finally settles these preferred claims. Of course,
since dividends can be declared only out of profits, no claim for
preferred dividends or any other kind can exist unless sufficient
profits have been made. Non-cumulative stock is stock on which the
dividend claim does not, if unsatisfied at any time, accumulate from
period to period. Preferred stock is cumulative unless otherwise
specified.
Dividends on cumulative stock do not have to be paid just because
sufficient profits have been made. Declaration of dividends rests
entirely with the board of directors who may see fit to appropriate
profits to other purposes. A holder of non-cumulative stock may be very
unjustly discriminated against in favor of the common stockholder by
the withholding of all profits for a number of periods until a large
amount has been accumulated. This is then disbursed as a dividend to
the common owners after the deduction of as much as may be necessary to
satisfy the preferred owner for the _current period_. On this account a
non-cumulative stock is not attractive to investors.
_Participating and Non-Participating._ Preferred stock may be
participating or non-participating. It is said to be participating
when the terms under which it is issued provide that it shall share
in any dividend in excess of its own specified minimum. Thus, if it
is 6% preferred, after the preferred receives its 6% the common stock
receives a like dividend, and then the preferred and common may share
alike or in any agreed ratio in any further dividends declared in
that year. Both participating and non-participating stock is either
cumulative or non-cumulative. Preferred stock is non-participating when
it is limited to the rate of dividend specified in the terms of its
issue.
_Redeemable and Convertible._ Other features met in some preferred
stocks are redeemability and convertibility. Preferred stock may be
issued under a contract to redeem it, after a certain length of time,
at a named figure—frequently par plus one year’s dividend. Redemption
may be either at the option of the holder or the company. Redemption
may be serial, i.e., a certain amount called at stated intervals for
redemption. Preferred stock is convertible when under the contract
in the terms of its issue it may be converted into some other form
of ownership or obligation. Thus, provision may be made that after a
certain time has elapsed, preferred shares may be converted into common
according to specified rates of conversion; or conversion into bonds of
the company is sometimes provided for. Many nice adjustments may become
necessary from an accounting viewpoint, when redemption or conversion
take place at any ratio other than book values.
Guaranteed Stock
Stock which is issued under a guarantee to pay a specified dividend
is said to be guaranteed stock. Inasmuch as dividends can be declared
only out of profits, a company cannot guarantee its own stock—or rather
a guarantee on the company’s own issue must always be dependent or
contingent upon the earning of profits sufficient for that purpose.
Stock issued by one company and guaranteed by another may with
strict propriety be called guaranteed stock. Thus, a large company
may enter into a contract of lease with a smaller concern whereby
the compensation shall be, let us say, an 8% dividend guaranteed to
all holders of the stock of the smaller concern. Such a guarantee is
not contingent but becomes a lien or claim on the guarantor company,
regardless of the amount of its earnings.
Founders’ Stock
In England there is issued what is known as “founders’” stock, a stock
preferred as to its _share_ of dividends. Thus, a comparatively small
portion of the common stock authorized might be set aside as founders’
or promoters’ shares with the stipulation that these founders’ shares
shall receive a dividend out of proportion to the ratio which they bear
to the total common stock. The provision might be that these shares
shall receive one-half or one-third—or any other specified share—more
dividends than shall be given to the common owners. Instead of being
preferred stock with specified dividend rate, it is preferred over
the rest of the shares of the group from which it was originally set
aside but its share of dividends is dependent upon the dividends given
the rest of the shares. The par value of the founders’ shares might
represent only one-twentieth of the value of the rest of the group,
while their share of the dividends would be, say, one-fourth as much as
that of the other shares. This preference as to amount of dividends may
give founders’ shares a much higher market value than the other shares.
Provision is sometimes made for their redemption, as usually there is
such a marked difference between their amount ratio and their dividend
ratio as compared with the other shares, that dissatisfaction among
the owners results. Outstanding founders’ shares may then interfere
seriously with the marketability of the other shares.
Debenture Stock
The term debenture stock is applied to a class of liabilities rather
than to proprietorship items. In England debentures of various kinds
are frequently used. A recent book[1] thus describes them: “In Great
Britain the term ‘debenture stock’ is used to designate an unsecured
loan issued in _irregular_ amounts. If the amounts were fixed
and equal, the issue would be called ‘debenture bonds’ or simply
‘debentures.’ Debenture stock is a debt of the corporation and does
not resemble stock as used in this country.” Debenture stock has
not proven popular in this country, although used to some extent in
Canada. The Public Service Commission of the State of New York defines
debenture stocks as “those issued under contract to pay absolutely
thereon at specified intervals a specified return.” These stocks,
while usually of limited life like bonds, are sometimes “perpetual and
give the holders no right to demand the repayment of their capital,
and the company no right to repay it.”[2] When issued as perpetual,
they somewhat resemble capital stock, as the term stock is used in
this country. Because of the fixed and absolute charge for interest—or
dividends as it is sometimes called—which these stocks carry, they
are much more of the nature of bonds than of a stock indicating
_proprietorship_. Debenture stocks are therefore to be classed as
liabilities.
[1] “Business Finance” by Lough.
[2] “Stocks and Shares” by Hartley Withers.
Stock of No Par Value
A characteristic of most stock is that it bears a specified par value
which must be uniform for all the shares within a class. The par
value of the different classes may differ, however. In most states no
regulation is made of the amount of par value. A par value of $100 is
customary for industrial and commercial concerns, and of $1 for mining
companies. Between those limits, and even beyond them, one finds stocks
of almost any par value.
In the State of New York the issuance of stock of no par value is
allowed. Both preferred and common classes may be issued without par
value, but if the preferred shares have preference as to assets, the
certificates for preferred shares shall state “the amount which the
holders of each of such preferred shares shall be entitled to receive
on account of principal from the surplus assets of the corporation in
preference to the holders of other shares.” With this exception, none
of the certificates may express any nominal or par value and this
statement of the amount of preference is regarded as an expression of
par value for this purpose. Each share is equal to every other share
within its class.
Every certificate of such stock must bear plainly on its face the
number of shares which it represents and the number of shares the
corporation is authorized to issue. Regardless of the price paid for
a share of such stock, all shares issued by the corporation shall be
“deemed fully paid and non-assessable and the holder of such shares
shall not be liable to the corporation or its creditors in respect
thereof.”
To the heedless a named value on a certificate of stock is sometimes
misleading as to the real value of the stock. The no-par-value stock
overcomes this in that a prospective purchaser is at once put on his
guard to find out the worth of the stock. Another advantageous feature
is that the questionable practices sometimes indulged in of booking
stocks sold at a discount have no place here because the stocks, having
no par value, cannot be sold at a discount and the record of their sale
will carry therefore the price at which they were sold. Some points in
connection with booking this stock will be discussed later.
Watered Stock
So-called watered stock is stock which has a higher nominal value than
the true value of the properties for which it has been issued. Thus,
if $1,000,000 worth—par value—of stock is issued for the purchase of
property which has a marketable value of only $750,000, the stock is
said to be watered to the extent of $250,000. The bookkeeping equation
requires that an equality be shown between the properties purchased and
the par value of the stock, and this is usually done by inflating the
value of the properties when they are brought onto the books.
Treasury Stock
Treasury stock, when the term is used properly, is stock which has
been once issued as fully paid and which through purchase or gift
comes back into possession of the issuing company. Stock which has
never been issued should not be called treasury stock. The distinction
between the two lies in the liability (or freedom from it) to further
contribution, in case of need to meet the claims of creditors, on the
part of stockholders who have bought their shares at less than par
value.
In some states the sale of stock at less than par is forbidden.
In those states where the practice is allowed, the purchaser of a
previously unissued share at less than par is liable to the creditors
(if the assets are insufficient to satisfy their claims) for a further
contribution equal to the difference between par value and the price
paid for the stock. If, though he pays less than par, the stock is
issued to him by the corporation as fully paid and non-assessable, he
is not liable to the corporation for any further payment to entitle him
to all the rights and privileges of a shareholder; but he may be liable
in case of need to outside creditors who have a right to expect always
that assets of equal value to the stock issued therefor have come into
possession of the corporation. As mentioned above, this trouble is
obviated in the case of no-par-value stock. However, after stock has
once been paid for in full, all future purchasers may hold it without
liability for further contribution regardless of the price they pay for
it. Because of its freedom from this liability, treasury stock has a
readier marketability than unissued stock.
In some enterprises, particularly those of a speculative character
where it is extremely difficult if not impossible to place a true
valuation on the property to be used or exploited, the practice is very
prevalent of issuing the entire authorized capital stock in payment
for the properties to be acquired. The stock so issued thus becomes
fully paid and its owners liable to no further contribution. To provide
working capital, some portion of the stock is usually donated to the
company for resale. This is sometimes called donated stock and is, of
course, true treasury stock. In states where a corporation is permitted
to buy its own stock, treasury stock may be acquired by purchase.
Theoretically, stock which has been issued under a contract providing
for redemption becomes treasury stock when redeemed and may be reissued
until it has been canceled through charter provision to reduce the
capital authorized. (See also pages 15, 16.)
Forfeited Stock
Stock is said to be forfeited through failure to make the agreed
purchase payments on it. The laws of the different states vary with
regard to the conditions under which stock may be declared forfeited.
In some states the instalments paid on the stock—or all but a small
amount to cover the cost of handling the transaction, or a specified
portion of the amount paid in—must be returned to the purchaser. In
others, the entire amount paid in may be declared forfeited. In the
State of New York the provision in the law is as follows: “If default
shall be made in the payment of any instalment ... the board may
declare the stock and all previous payments thereon forfeited for the
use of the corporation, after the expiration of sixty days from the
service on the defaulting stockholder, personally or by mail directed
to him at his last-known post-office address, of a written notice
requiring him to make payment within sixty days from the service of
the notice at a place specified therein, and stating that, in case of
failure to do so, his stock and all previous payments thereon will be
forfeited for the use of the corporation. Such stock, if forfeited, may
be reissued or subscriptions therefor may be received as in the case
of stock not issued or subscribed for. If not sold for its par value
or subscribed for within six months after such forfeiture, it shall
be canceled and deducted from the amount of the capital stock.” The
provisions are very specific and must be carefully followed. The method
of accounting is given on page =19=.
Bonus Stocks or Bonds
Bonus stocks or bonds are stocks or bonds given as a bonus upon the
purchase of other stocks or bonds. Thus, upon the purchase of a share
of preferred stock, one share of common may be given as a bonus.
ACCOUNTING FOR STOCKS
Accounting for the original issue of stock has been treated in Volume
I. There several different methods of opening the records of the
corporation were given and the manner of treating premiums and discount
and instalment subscriptions was shown. Here some additional problems
peculiar to corporation accounting will be discussed.
Discount on Stock
In the State of New York the stock of a corporation cannot be sold
below par. Where sale below par is allowed, the proper booking of the
discount requires consideration. The Interstate Commerce Commission
requires that discounts or premiums be shown on the books under those
titles, i.e., Discount on Capital Stock and Premium on Capital Stock.
This method is to be commended as being true to fact and presenting a
full and sufficient record of the facts. In the case of other concerns
over whose accounting practices there is no regulation, that method is
honored more in the breach than in the observance. A prevalent feeling
is that the appearance on a balance sheet of such an item as discount
on stock is a serious reflection on the standing of the corporation
and is to be avoided in any way possible. Discount on stock is not an
attractive item on a balance sheet, but there is little justification
for such sentiment in those states where the sale of stock at a
discount is a perfectly legitimate transaction. The balance sheet
ought to represent facts as they are until they change; then the new
conditions should be shown. So long as the discount on stock remains
a fact it should be so shown. When the discount has ceased to exist
through its absorption against premium on stock or the general surplus,
it should no longer be reported because it is then a matter of ancient
history with which the present is not concerned.
A favorite method of charging the discount on stock to organization
expense is not approved, not because it is a misnomer, for discount may
well be looked upon as one of the expenses of organization, but because
it is an item of sufficient importance and interest to require separate
record. Charging the discount to some asset account, when payment
of stock is made by property instead of by cash, is to be severely
condemned. Inflation of asset values to cover up such an item cannot be
justified.
Premium on Stock
The premium on stock sold above par is best recorded in a premium
account which should remain on the books as a part of the permanent
capital and not therefore be transferred to surplus and returned as a
dividend to the shareholder. It may be legitimately used to cancel any
discounts.
In the State of New York a corporation cannot issue its stock “except
for money, labor done, or property actually received for the use and
lawful purposes of such corporation.” A broad interpretation has been
given the word labor so that under the law it may comprise both manual
and mental labor and services of almost any kind legitimately received
at the time of organization of the corporation or at any subsequent
time. Stock may thus be used to pay for organization expense,
promoters’ fees, etc.
Property Exchanged for Stock
Where stock is issued for property, no more is supposed to be issued
than has a par value equal to a fair market value of the property
received therefor. In valuing the property the judgment of the
directors is conclusive, unless fraud can be shown. Any stock issued
for property becomes full-paid and the owner is neither subject to
further call by the corporation nor liable to contribution for the
benefit of creditors. In all statements and reports required by law to
be published, stock issued for property purchased must be so reported.
Treasury Stock Donated
When treasury stock comes into the possession of the company by
donation, the entries needed to show the transactions are somewhat as
indicated below, some variations from the form shown being sometimes
met with. Practice varies as to the value at which treasury stock shall
be brought onto the books, some concerns booking it at an arbitrary
value based on an estimate as to what it will probably bring when sold;
others booking it always at par. Practice varies also as to the manner
of showing treasury stock on the balance sheet, some listing it among
the assets at the value at which it was brought on the books; others
treating it as a deduction from authorized capital, a sort of valuation
account for the capital stock. These points are discussed in Chapter
XXI and will not be treated here except to state a conclusion on which
the booking of the transactions depends. Manifestly, if treasury stock
is to be treated as a deduction from capital stock, it will have to be
brought onto the books at par. Such treatment usually results in an
inflated showing of the surplus arising from the donation until that
has been adjusted to the values realized from its sale—an adjustment
which cannot be completed with accuracy until all treasury stock has
been disposed of. If treasury stock is to be shown among the assets on
the balance sheet, it is perhaps best booked at an estimated realizable
price, a method which will show the donated surplus also at an
estimated realizable figure. While authorities differ on these points,
the weight of opinion seems to favor booking treasury stock at par and
showing it as a valuation account on the balance sheet.
For the sake of illustration assume that the stockholders donated
$100,000 par value of common stock to the corporation and that $50,000
of it is sold at 60 cents on the dollar. The entries to record the
transactions would be:
(1) Treasury Stock, Common $100,000.00
Donated Surplus $100,000.00
(With suitable explanation.)
(2) Cash 30,000.00
Discount on Treasury Stock, Common 20,000.00
Treasury Stock, Common 50,000.00
Other titles for Donated Surplus are “Donated Working Capital,”
“Donation Account,” etc. The account “Discount on Treasury Stock,
Common” will ultimately be closed against Donated Surplus, and there
is no objection to making the charge for discount directly to Donated
Surplus instead of as shown above, although the method shown perhaps
makes more easily available the information as to the discounts allowed
on sales of various portions of the treasury stock. If it is sold at
one price, the charge for the discount should be direct to Donated
Surplus. A balance sheet drawn up at an intermediate period, i.e.,
before Discount on Treasury Stock is closed, should show Donated
Surplus at its adjusted figure, viz., book value less discount. After
all treasury stock has been sold, the Donated Surplus account, as
adjusted, will show the true surplus arising out of the donation
transactions. The proper disposition of this—as to whether it should
be maintained as a permanent increase in capital, be transferred to
general surplus and so be made available for dividends, or be treated
as a deduction from plant values on the theory that they have been
overstated as originally booked—is discussed in detail in Chapter XXI.
Bonus Stock
Bonus stock is usually treasury stock for the very good reason that,
if it carried a liability for contribution in amount up to its par
value, recipients of such stock might not be overly appreciative of the
gift. Instead of being an incentive to purchase the securities which it
accompanies as a bonus, it might act as a deterrent. Bonus stock is a
gift on the part of the corporation and is therefore an expense. While
custom favors recording the expense under the title “Bonus”—or even
including it with organization expenses—and treating it as a deferred
expense for a number of periods, a correct analysis of a bonus stock
transaction may dictate other method of record. If the bonus stock is
given with an issue of bonds which could by themselves be disposed of
only at a discount, the difference between the market value of the
bonds alone and their par value should be charged to Bond Discount, and
the rest of the loss on the transaction may be charged either to Bonus
account or Discount on Treasury Stock. This distinction is important,
as will be seen in Chapter XX where the true nature of bond discount is
discussed. When data are available for making the separation it should
always be done. Thus, if a $1,000 par bond has a market price of $950
but when sold with one share ($100) of treasury stock as a bonus brings
$1,000, the record should be:
(3) Cash $1,000.00
Bond Discount 50.00
Bonus (or Discount on Treasury Stock) 50.00
Bonds Payable $1,000.00
Treasury Stock 100.00
The customary method of showing, as in entry (4) below, is
theoretically incorrect, though it may be necessary to use it when the
data needed for the other entry, i.e., (3) above, are not available.
(4) Cash $1,000.00
Bonus 100.00
Bonds Payable $1,000.00
Treasury Stock 100.00
If a bonus of treasury stock is given with the sale of preferred stock,
similar treatment would make possible a showing of the portion which is
really discount on stock and the portion, if any, which is true bonus.
Inasmuch as discount on stock and bonus are very similar in kind and
in manner of treatment on the books, nothing of real value is perhaps
gained in making the separation. The ultimate disposition of the Bonus
account is, as indicated above, to treat it as a deferred expense,
charging it against profits as rapidly as conditions warrant. It is an
undesirable item on the balance sheet or ledger and should be expunged
as soon as possible.
Treasury Stock Purchased
Treasury stock which is created by purchase by the issuing company
requires consideration. If the price paid is less than par, carrying
the treasury stock on the books at par requires an offsetting credit
account similar to the Donated Surplus account used above when the
stock is created by donation. This credit account simply represents a
book surplus and should not usually be made the basis for a dividend.
This account may be called “Treasury Stock Surplus,” “Contingent Profit
on Treasury Stock Bought,” or other title indicating the true nature
of the item. When the treasury stock is resold and the discount or
premium on it is charged against this surplus or credited to it, as the
case may be, the balance of the Treasury Stock Surplus account will
then show the realized profit or loss on the completed treasury stock
transactions and may be disposed of as indicated above for Donated
Surplus.
On the other hand, if the price paid by the company in the purchase
of its own stock is more than par, the premium paid must be charged
against general surplus because there is usually no other place for
the charge unless there is still open on the books a Premium on Stock
account arising out of a previous sale of stock at a premium. Purchase
of stock at a premium may represent simply the payment to the owner of
the stock of his share in the general surplus of the company, in which
case the premium paid must be shown as a reduction of that surplus.
Redemption of Preferred Stock
Handling redemption of a preferred stock issue is exactly the same
as handling treasury stock by purchase. If by contract agreement at
the time the preferred stock was issued it can only be redeemed at a
premium, the premium must be charged, as indicated above, to an open
premium account or to general surplus. The effect is similar to the
payment of a special or extra dividend at the time redemption is made.
Forfeited Stock
Payments made on stock which is declared forfeited constitute an item
of surplus but of a permanent nature, i.e., not a surplus applicable to
the declaration of dividends, though there may be no legal inhibition
to that use. If the stock is resold any discount on the resale is
properly charged against the surplus arising from the forfeiture.
By way of illustration, assume that $1,000 worth of stock has been
subscribed for and payments amounting to $400 have been made when the
stock is forfeited for failure to pay further instalments. The stock
is offered again for subscription and is sold for $900 and payment has
been received in full. The entries necessary to show the above are:
(5) Subscribers $1,000.00
Capital Stock Subscriptions $1,000.00
(6) Cash 400.00
Subscribers 400.00
(7) Subscribers 400.00
Surplus from Forfeited Stock. 400.00
To transfer the forfeited
payments to Surplus.
(8) Capital Stock Subscriptions $1,000.00
Subscribers $1,000.00
To reverse.
(9) Subscribers 900.00
Surplus from Forfeited Stock 100.00
Capital Stock Subscriptions 1,000.00
(10) Cash 900.00
Subscribers 900.00
(11) Capital Stock Subscriptions 1,000.00
Capital Stock 1,000.00
Stock of No Par Value
Booking capital stock of no par value presents no new principles.
Inasmuch as the stock has no fixed par value, its sale is recorded for
what it fetches. There can be neither discount nor premium. Payment of
the subscription may be made, just as in any other case, by means of
cash, property, or services, and the same care must be exercised in
placing proper valuations on the property taken over. Here there is not
the danger of inflating property values to show them equivalent to the
par value of the stock issued therefor. Rather, subscription for the
stock is made at the figure of the fair value of the property to be
turned over in payment of the subscription. In the case of no-par-value
stock even greater care must be exercised to see that the contributed
capital shall never be encroached upon in the declaration of dividends,
and careful supervision is somewhat more difficult because the _number_
of shares issued bears no relation to the _amount_ of the capital stock.
Distinctive Records
The accounting and other records peculiar to a corporation are
explained in Volume I, Chapter XLVIII. These records are the
subscription book and subscription ledger or instalment book, the
stock certificate book and stock ledger, the stock transfer book, the
minute book, sometimes a dividend book, in large companies a register
of transfers (which classifies the information as to transfers given
in the stock transfer book, and so may serve as a convenient posting
medium for the stock ledger), and a stock register (a record kept by
the officially appointed registrar of the corporation, whose duty it is
to see that there are no irregularities in the issue of stock and that
there is no overissue). The stock register should show the amount of
stock authorized and the amount issued at any given time, the balance
being the stock not yet issued. A form for the stock transfer book and
several forms for stock ledgers as prescribed by the Comptroller of the
State of New York are shown below.[3] The two latter forms of the stock
ledger are applicable only to the State of New York.
Ledger Folio 27 Transfer No. 556
ALLIANCE AUTOMOBILE COMPANY
For value Received, I hereby sell, assign and
transfer unto John H. Lansing, of Newark, New Jersey,
Seventy-six Shares of the Capital Stock of the
above-mentioned Company, now standing in my name on
the Company books and represented by surrendered
Certificates Nos. 32, 37, and 44.
Witness my hand and seal this 28th day of September, 1918.
GEORGE B. GOLDMAN [L. S.]
By GEORGE GALE, _Attorney_.
New Certificate No. 224
Issued to John H. Lansing
Ledger Folio 84
_Stock Transfer Book_
[3] From “Corporate Organization and Management,” by Thomas Conyngton.
JOHN H. KIRCHER, 230 Broadway, New York
=============+================+=========================+=======
| | CERTIFICATE |
| | NUMBERS |
| +-------------+-----------+
DATE OF | TO WHOM | | | NUMBER
TRANSFER | SHARES ARE | | | OF
| TRANSFERRED | SURRENDERED | REISSUED | SHARES
-------------+----------------+-------------+-----------+-------
1917 | | | |
March 13 | W. K. Howard | 15 | 70 | 10
July 15 | Robert Moyer | 70 | 145 | 40
July 31 | Harold McKain | 145 | | 40
December 3 | James McNeil | 85 | 175 | 20
December 16 | James Archer | {175} | 231 | 105
| | {165} | |
December 31 | Balance | | | 180
| | | +-------
| | | | 395
| | | +=======
=============+================+=============+===========+=======
DATE OF | FROM WHOM | AMOUNT |CERTIFICATE| NUMBER
TRANSFER | SHARES WERE | PAID ON | NUMBERS | OF
| TRANSFERRED | SHARES | | SHARES
-------------+----------------+-------------+-----------+-------
1917 | | | |
January 10 | Original Issue | Full-Paid | 15 | 90
March 25 | George Holmes | ” | 85 | 75
August 1 | Harvey Cornell | ” | 150 | 35
August 15 | Howard Gaines | ” | 160 | 50
September 2 | John Woodwell | ” | 165 | 100
| | | |
October 5 | Henry Simpson | ” | 42 | 45
| | | +-------
| | | | 395
| | | +=======
1918 | | | |
January 3 | | | | 180
-------------+----------------+-------------+-----------+-------
_Stock Book or Stock Ledger_
[Illustration: _Stock Book to be Kept by Brokers (New York Form
Prescribed by Comptroller)_]
[Illustration: _Stock Book to be Kept by Corporations and Transfer
Agents (New York Form Prescribed by Comptroller)_]
Stock Ledger
The stock ledger is a subsidiary ledger controlled by the Capital Stock
account or accounts on the general ledger. It may, of course, be made
self-balancing just as any other subsidiary ledger. There has been
some controversy as to whether the stock ledger is normally a credit
or a debit balance ledger. In some concerns the stockholder is debited
with the shares owned, and in others he is credited. Theoretically, in
accordance with the principle of all other controlling accounts, the
subsidiary ledger—in this case, the stock ledger—merely carries the
detail of the controlling account. If, then, the controlling account
is a credit balance account, the accounts on the subsidiary ledger
must similarly have credit balances. Accordingly, the stockholder
should be credited with his net holdings. Practically it makes little
or no difference because the subsidiary ledger is no integral part
of the debit and credit scheme of the general ledger. Of course,
unless practical difficulties prevent, practice should always follow
the theoretically correct method. No difficulty need be experienced,
however, in accommodating oneself to either method of record on a
subsidiary ledger. In the stock ledger the record of holdings is kept
in terms of the number of shares owned rather than by the par value of
the holdings.
Minute Book
Before leaving the subject of the records peculiar to a corporation, it
is desired again to call attention to the keeping of a careful record
in the minute book. This book should contain first a copy or duplicate
of the corporation’s charter. Following this should be the by-laws of
the corporation. Sufficient blank space should be left at the end of
each of these documents to make record of any amendments to charter or
by-laws. There should follow a complete record of the deliberations and
authorizations of the board of directors as affecting the management
and control of the corporation’s policy. The minute book is often the
source of authority for many of the most important entries made on the
books of account, and great care must be used to make the record full,
complete, and accurate. Such matters as leases, purchase and sale of
properties, bond issues, dividends, and other similar items should have
very careful record.
Conclusion
Other features of the corporation from the accounting point of view are
treated under their respective heads in later chapters. These include
such items as bond issues, sinking and other funds, reserves and
surplus, scrip and stock dividends and other dividend considerations.
It is proposed in the next two chapters to discuss the corporation from
the manufacturing viewpoint, types of accounting records sometimes
used therefor, and the elements of manufacturing costs. After that the
problem of the balance sheet and the principles of valuation applicable
to it will claim attention.
CHAPTER II
THE VOUCHER SYSTEM
Purchasing for the Manufacturing Business
Accounting for the business which manufactures its own product is a
much larger problem than that for the concern which limits its activity
to purchase and sale of a stock-in-trade. To the activities of a
trading concern the manufacturing business adds those of the factory.
Not only must more property, and a larger variety, be kept account of
and handled so as to get the most efficient return therefrom, but also
in the handling and operation of this property a somewhat distinct
type of expenses is incurred. The problems of financial and factory
management and control are different and more complicated than those of
the trading business. The period between the expenditure of funds for
the purchase of materials and the payment of expenses and the receipt
of money from the sale of the finished product is much longer. More
working capital must therefore be provided and its rate of turnover is
less. A larger element of risk enters in. Raw materials must be worked
and fashioned, machinery must be employed, a different class of labor
must usually be handled, perhaps will have to be trained—these are
problems calling for a special type of management for the manufacturing
end of the business.
The accounting department must be organized to serve these additional
demands and complexities of management and to give the needed
information. The amount and cost of the materials consumed in making
the product, the labor cost expended on it, and the various items of
factory expense incurred, during one period as compared with the same
items for previous periods—all must be kept under constant review if
successful operation is to be secured.
Expansion of the Purchase Journal
To make this information available as soon as the transactions giving
rise to it are entered into, a different method of gathering the
information becomes necessary. Because of the fact that the purchase
journal is limited to the record of purchases of stock-in-trade, and
that information in regard to expenses incurred is not usually brought
on the books until payment of them is made, not only do the books fail
to give the service which a management has a right to expect of them
but they fail to reflect many liabilities at the time they are assumed.
Thus a new type of record is needed.
This has led to an extension or expansion of the purchase journal.
The way in which this journal can be used so as to analyze purchases
of stock-in-trade on a departmental basis has been explained and
illustrated in Volume I. This new use of the purchase journal is
merely an extension of the principle of analysis there developed.
Instead of limiting it to a record of transactions involving purchases
of stock-in-trade, every purchase transaction, whether of assets,
supplies, or of service of any kind, finds this its place of first
record. By introducing sufficient columns, as detailed an analysis
of all the purchasing activities of the business can be secured as
may be desirable. Furthermore, entry here being made at the time of
the purchase rather than at the time of payment for the purchase,
the books make available a mass of valuable data needed for purposes
of management much sooner than it becomes available under the former
restricted use of the purchase journal.
Development of Voucher System
Had the evolution of this record stopped here, the resulting gain
would have been secured at high cost. The entry of all expense
purchases in the purchase journal creates the necessity of opening
accounts on the ledger with numerous creditors for small purchases, as
well as the more important items, both to show the liability incurred
and to provide a means of canceling it when payment is made. In large
corporations, where oftentimes the policy of securing bids on all
purchases is followed, resulting in a constant changing of firms
from whom purchases are made and no regularly established trade with
any of them, the burden of handling the creditors ledger becomes an
increasingly heavy one with little or no gain in desirable information
furnished by it. Accordingly, a further development took place which
eliminated the necessity of opening regular accounts with every
creditor, but instead made every transaction, whether one or many were
entered into with the same individual, independent of all others. This
makes possible the showing of the settlement of that transaction in the
place where its original record was made, without opening up a ledger
account for it. This use of the purchase journal with some slight
additions has given rise to the so-called “voucher system” of handling
purchases.
Definition and Description of Voucher
In a broad sense, a voucher is a statement which certifies, i.e.,
vouches for, the correctness of a transaction. As used in the
restricted sense to which it is limited under the voucher system, it is
a more or less formal document which shows a receipt for a particular
bill of items. As distinguished from a receipt in general, this latter
term is applied to all acknowledgments of money paid whether or not for
a particular bill; whereas the essence of voucher accounting requires
receipts for particular bills. At law a voucher has no more weight than
an ordinary receipt, and a signed receipt is only prima facie evidence,
capable of refutation, though the burden of proof of non-payment is
placed on the complainant.
A formal voucher must therefore provide for a statement of the bill of
which payment is being made and a place for acknowledgment of receipt
of payment by the payee. Usually provision is made also for: (1)
certification of the correctness of the bill by properly authorized
house employee and its approval for payment; and (2) a proper
distribution on the accounting records of the payments authorized,
i.e., an official determination of the debit and credit entries to be
made on the books.
A form of voucher is shown on pages 30, 31. On the face of the form
provision is made for (1) detailed statement of bill; (2) house
approval of same; and (3) receipt form to be signed by payee. On the
reverse side of the voucher the distribution of the charges is provided
for. This is the bookkeeper’s authorization for making the indicated
entries on his books. The form is so devised that, when doubled, it is
of a convenient size for filing in a vertical file.
Operation of Voucher System
When the invoice covering any purchase is received, it is held till
the commodities bought arrive. After inspection and acceptance of the
goods, a voucher is made out in duplicate on which is written a copy of
the invoice, with the cash discount, if any, shown deducted. Vouchers
are given consecutive numbering just like checks. If immediate payment
is to be made, the voucher will be “approved” and check drawn for the
amount. The voucher with check attached is sent to the creditor with a
request that he receipt the voucher and return it. A creditor is not
usually particularly interested in helping another concern keep its
books and the result is that a large number of vouchers find their way
into the creditor’s waste basket. It is here that the duplicate copy
retained in the files serves to keep the file of vouchers complete,
though it does not, of course, constitute a receipt for the payment.
Sometimes before sending the original voucher, the distribution of the
charges is made on it, and it is used as the basis of the bookkeeper’s
entries. An objection to this method is frequently made that the
creditor is thus given some insight into the business and perhaps a
more intimate view of it than may be desirable. Where such is the case,
only the office copy of the voucher shows the distribution and the book
entries are made from it. Both may be filed together when the original
is returned, or the one may be filed numerically according to voucher
numbers, the other alphabetically according to creditors’ names and so
serve as an index to the numerical file.
[Illustration: _Voucher (face)_]
[Illustration: _Voucher (reverse)_]
In some concerns the canceled checks when returned by the bank are
filed with their respective vouchers; in others, they are filed
separately in their own sequence. Inasmuch as each voucher also carries
its check number, cross-reference is easy.
Voucher Check
The difficulty referred to above in securing prompt return of receipted
vouchers has led to the introduction of a combined voucher and check
called a “voucher check.” The indorsement on the check, which is
necessary for its collection, serves at the same time as a receipt of
the bill. All vouchers thus ultimately find their way back through the
bank. The legality of the indorsement serving also as an acceptance
of the check in payment of the stated invoice has been thoroughly
established, particularly when on the blank space for indorsement
attention is drawn to the fact that such indorsement will constitute a
receipt for the bill; or where the face of the check states that it is
full payment for the invoices covered by it.
Two forms of voucher check are in use, the folded check and the single.
Below are given illustrations of both. If such checks are not unduly
large, banks do not object to handling them.
Because of lack of room on the voucher check, provision is not always
made for showing the distribution of the charges. The single form
of check can be used when a detailed statement of invoices is not
desirable or when invoices carry but few items. Such a voucher check,
but differing somewhat from the one shown, is frequently used for the
payment of dividends to stockholders and does away with the need of a
formal receipt or of signature in the dividend book.
[Illustration: _Voucher Check—Double (face)_]
[Illustration: _Voucher Check—Double (reverse)_]
[Illustration: _Voucher Check—Single_]
Form of Voucher Register
The “Voucher Register,” or the “Accounts Payable Register,” as it is
sometimes called, is the book of original entry in which the voucher
and its distribution are recorded. This register is a journal so far
as its scheme of debit and credit is concerned, but its record is
not usually supplemented by a formal subsidiary ledger—though it may
be—posting of it being limited to the general ledger. The register
must provide columns for date, voucher number, name of creditor,
explanation, amount, distribution, and payment. There are many
different forms and rulings, the information desired never being quite
the same in any two businesses, but a typical form of voucher register
is shown on page 35.
Distribution of Vouchers
As soon as a purchase invoice has been approved, a voucher—sometimes
called a voucher jacket where the original invoice itself is attached
to it—is made for it, the distribution of the charges is authorized,
and entry is made in the voucher register. All vouchers are numbered
consecutively and entered in numerical sequence, which is usually
also chronological sequence. The amount of the voucher is entered in
the total column, Vouchers Payable or Accounts Payable, whatever the
account title is on the general ledger. The next column, Purchase
Discount, may or may not be merely a memorandum column, depending on
the use made of it, as will be explained later.
[Illustration: _Voucher Register (left-hand page)_]
[Illustration: _Voucher Register (right-hand page)_]
From the Vouchers Payable column, distribution on the same line is made
into the columns for the various accounts to be charged. To secure a
complete distribution without waste of space, a Sundry Charges column
is provided for entry in detail of all items of infrequent occurrence,
each account to be charged being named in the explanation space to
the right of this column. Following this comes the record of date and
manner of payment, with a final column in which to extend at the end
of the month all unpaid vouchers and so indicate the detail of the
total outstanding liability. The voucher record is capable of almost
indefinite expansion through the use of short-margin insert sheets.
Provision can in this way be made for a large number of columns for
analysis.
Posting of Summary Totals
At the end of the month, or oftener if desired, the voucher register is
summarized and posted. Inasmuch as usually no subsidiary ledger is kept
when the voucher system is in use, there is no day-to-day record on
the ledger of the purchasing activities of the business. Accordingly,
a complete double entry must be made by way of periodic summary. It
was at one time thought desirable to make this summary entry through
the general journal or, at any rate, by setting up a formal journal
entry on the face of the voucher register. As the degree of analysis
increased, the futility of such a procedure became apparent and now
posting to the ledger accounts is made directly from column totals as
shown in the illustration. The Sundry Charges column is posted in
detail to the named accounts as indicated. Proof of distribution should
always be secured by checking the total of the distributive column
totals against the total of the Vouchers Payable column. In posting,
the total of the Voucher Payable column is credited to its account,
while the totals of the distributive columns are debited to their
respective accounts.
Effect on Cash Book and Bank Account
The advantage of this periodic posting of expense column totals as
compared with the detailed posting of such items from the cash book as
required under the old method is apparent. The cash book is in this
way relieved of all need of naming the account to be charged for each
detailed entry, the proper charge having been made from the voucher
register. If every transaction which will ultimately give rise to a
disbursement of cash is vouchered and therefore recorded through the
voucher register, there is really no need of a detailed entry of the
checks on the cash book, for only their total is posted. It is perhaps
more usual, however, to enter them in detail on the cash book. Entry
here is, as always, chronologic, by date of payment.
Sometimes, to facilitate reconciliation with the bank account, the
voucher checks are given a new series of numbers known as treasurer’s
numbers when issued in payment of invoices. Where this is done, the
cash book shows entry of all checks in the numerical sequence of
treasurer’s numbers, just as entry in the voucher record is in the
sequence of voucher numbers. Some checks are held before issue longer
than others, due to different lengths of credit term, etc.; hence the
need for this new series of numbers.
Payment of Vouchers
After a voucher has been made up and entered in the register, if
payment is to be made immediately, it is passed for payment by
the treasurer or other fiscal officer and the check is drawn and
issued. Any cash discount offered is shown deducted on the face of
the invoice and the check carries the net amount. Where payment is
not immediate, but observance of the terms of credit is necessary to
secure the discount, the voucher should be filed away in a tickler
file which will automatically bring it up for attention at the
proper time. The original invoice is placed in a temporary file,
arranged alphabetically, until paid, when it may be removed and filed
permanently with the paid voucher. Upon payment of the voucher, the
check is entered among the cash disbursements and a notation is made in
the payment column of the voucher register as to the date and manner of
payment.
Voucher Index of Creditors
It has been stated that one of the essential features of the voucher
system, as it is usually operated, is the dispensing with the formal
creditors ledger. This is accomplished by treating every transaction
as an independent unit, numbering it, and providing a place in the
voucher register to indicate its payment, so that there is no need of
a separate ledger to keep track of the cancellation of the liability.
The voucher system fails, however, to give a record of volume of
business done with each creditor. Furthermore, it is often desirable
to make reference to past transactions with creditors. This would be
very difficult without a definite knowledge of the voucher numbers
under which account has been kept of the transactions with a particular
creditor.
Accordingly, for the proper operation of the system an alphabetic index
of creditors must be made up on which should be shown the voucher
numbers relating to transactions with each creditor. This is usually of
the card index type, each creditor being provided with a card on which
is noted a list of the vouchers recording the business done with him.
This voucher index, while not a ledger in the accepted sense, yet when
operated in connection with the Payment column in the voucher register
serves all the essential purposes of a creditors ledger, and the use of
the “Unpaid Vouchers” column, as explained above, secures at the end of
the month the detail of the summary account, Vouchers Payable, carried
on the general ledger.
Control of Vouchers Payable
With the elimination of the detailed ledger record which served as a
check on its controlling account on the general ledger, particular care
must be exercised to see that the control account, Vouchers Payable,
reflects the correct summary of all detailed liabilities. This is
readily accomplished when every item that leads to a disbursement of
cash is vouchered. Then the only postings to “Vouchers Payable” come,
for their credits, from the total of Vouchers Payable column of the
voucher register, and for their debits, from the total of Vouchers
Payable column in the cash book.
Introduction of System
Some of the problems encountered in the operation of a voucher system
will now be discussed, the first of which is the introduction of the
system in a business where the old method of handling purchases is
in use. The requirement here is the closing of the open accounts on
the purchase ledger and their transfer to the voucher register. This
may be accomplished in two ways—one of which requires a change in
the controlling account, and the other of which does not. Under the
first plan without formality, the accounts in the purchase ledger are
balanced and closed by indicating in their explanation columns the
transfer of the balance to the voucher register. As these accounts are
entered on the voucher register, each of the _items_ comprising the
balance of an account should be given separate vouchers rather than
entered under one voucher for the whole amount. This is particularly
true where the different items are subject to different discount
and credit terms, rendering it undesirable to pay them all at the
same time. After entry on the voucher register, the amounts may be
distributed to the Sundry column and charged to the controlling
account, Accounts or Vouchers Payable, as the case may be. The register
should now be totaled, i.e., the Vouchers Payable and Sundry columns
should be added and the register ruled off. These totals, being to the
credit and debit of the same account, may or may not be posted, as the
balance of the controlling account is not affected. Under the second
plan the register is left open, i.e., not totaled. In this way the
credit to the Vouchers Payable account is included with the total to
be posted at the end of the current month when the register is first
summarized. This, of course, necessitates posting the corresponding
debit of the amounts distributed to the Sundry column as explained
above.
The new voucher system is now ready for use and current entries will be
made as previously explained.
Purchase Returns and Allowances
The handling of purchase returns and allowances is awkward under
the voucher system. If the goods can be inspected and accepted
or adjustment secured when necessary, before the voucher for the
transaction is made up, then the amount to be paid is always the amount
of the voucher and no change need be made in the amounts entered and
distributed on the register. Where this is done a Purchase Returns and
Allowances Account is not required. This procedure, however, is not
always possible, for a first inspection does not always show the true
condition of goods. Adjustment of the general ledger accounts could be
made by entry of the return or allowance through the general journal.
That would not, however, leave any indication in the voucher register
record of the fact that cancellation of the liability there shown was
made by payment of a lesser amount than the one entered, and it is
desirable that these two amounts be the same.
To accomplish this, entry of the allowance should be made, in small
red ink figures on the upper part of the line just below the vouchers
affected, entering in red the voucher number—the same as the voucher to
which it applies—and the amount of the allowance, both in the Vouchers
Payable column and the distributive columns affected by the allowance.
These red ink items are, of course, deductions, the summary amounts
of the various columns being net totals, i.e., the totals of regular
items less the red figures; or two totals may be shown, one above the
other, the regular and the red. Where both black and red totals are
shown, both must be posted, the red as contras or offsets to their
corresponding black postings. If desired, separate Purchase Returns and
Allowances accounts may be opened.
An alternative method, requiring more work but handling the difficulty
somewhat more neatly, cancels the original voucher by marking it paid
and its check void, and issues in its stead a new one for the correct
amount. The new voucher is handled regularly in the cash book, but in
the register distribution is made to the Sundry column and charged to
Vouchers Payable, as the purchase has already been charged from the
original voucher. This charge to Vouchers Payable cancels the credit
from the journal and allows the liability for the new amount to be
shown in the total of the Vouchers Payable column of the register. The
cancellation is best evidenced by entry in the general journal somewhat
as follows:
Vouchers Payable $2,150.40
Vouchers Payable $2,101.59
Purchase Returns and Allowances 48.81
To cancel Vo. #2158 and authorize
its reissue in Vo. #3245, account
of return of defective goods.
Under this method postings to the Vouchers Payable account, instead of
being limited in their origin to voucher register and cash book, will
be made also from the general journal.
Partial Payments
A similarly awkward situation is met when it becomes necessary to
make partial payments on a voucher. The whole system is built on the
idea that each voucher is the unit according to which the record is
kept. It, therefore, presupposes settlement in full of each voucher;
otherwise, the efficient operation of the system is interfered with.
Settlement in full is not always possible, however. Since provision
is made in the register for but one line on which to show payment of
the voucher, it is not possible to indicate partial payments in the
allotted space, nor would such practice be desirable.
Hence, where partial payments are to be made, the original voucher must
be canceled in full and two new vouchers issued in place of it—the
one for the amount of the partial payment, which will thus cancel it,
and the other for the unpaid balance, which will remain open until
paid in full or till other partial payment is made. In the latter case
the same procedure of cancellation and issuance in its stead of two
vouchers must be repeated. This process of cancellation by the reissue
of two new vouchers may be effected directly on the face of the voucher
register by a full cross-reference between the old and the new, usually
shown in the Manner of Payment column; or it may be done by formal
entry on the general journal, which will then constitute the authority
for the transaction. At the best, it is an awkward situation and where
financial arrangements cannot be made so as to make partial payments
unnecessary in large measure, the voucher system itself should be
discarded as not adapted to the conditions of the business.
Handling of Notes Payable
Practice differs, under the voucher system, in the handling of notes
payable. If a note is given or a draft accepted upon the purchase of
goods, the liability for it will appear on the books only as a note
liability, provided the purchase is recorded through some other medium
than the voucher register. This medium might be the general journal or
the notes payable journal. If, however, original entry of the purchase
is made in the voucher register, liability for it is thereby created
under the account title, Vouchers Payable. This must be shown canceled
by the creation of a note liability in its place, by entry in general
or notes payable journals. If the voucher check system is used, the
check on the original voucher must be canceled by marking it “Void”
or by running it through the bank with the day’s deposits. In either
case for the sake of a complete record of check numbers, it should
be entered among the cash disbursements. From all this it is evident
that less work is entailed and just as complete a record made by
entering the purchase originally in general or notes payable journal as
suggested above.
In order to maintain proper control over the cash, when the note
becomes due a check should be drawn for it rather than allow its
payment to rest merely on the bank’s memo of charge against the
account, where the note is made payable at the bank. If a voucher check
system is in use, payment by check results in a momentary transfer
of the liability from its status as a note liability to a vouchers
payable—an open account—liability. Cancellation of the note is made by
distribution of the voucher to the Sundry column of the register as a
charge to Notes Payable; the voucher not being made or entered until
the note falls due. Simultaneous entry of the check in the cash book
cancels the voucher payable liability and completes the transaction.
If the note is given in cancellation of the open account which had
been set up by previous entry in the voucher register, then the same
procedure must be gone through, as was explained above in connection
with the practice of invariably entering every purchase on the voucher
register. If the note transactions are many, it would prove much less
laborious to accept the bank’s memo of charge as adequate evidence of
payment, this memo being given a treasurer’s number in proper sequence,
where treasurer’s numbers are given to establish order of entry on the
cash book. Cancellation of the notes payable liability is then posted
from the cash book entry.
Cash Discount on Purchases
A final problem in connection with the voucher system concerns the
treatment of cash discount on purchases. As discussed in Volume I,
Chapter XXXVI, a cash discount is usually treated as a financial
management item, though it is sometimes looked upon as a purchase
department item. The handling of the voucher register so as to record
properly the purchase discount will depend somewhat upon which theory
of cash discount is adhered to. It is customary to carry a Purchase
Discount column in the voucher register, although this is unnecessary
if one is carried in the cash book. Where both cash book and voucher
register are provided with discount columns, one is usually merely a
memorandum carried for the sake of easy reference.
As regards the amount at which the liability under Vouchers Payable is
carried on the books, we find two methods of making up the voucher and
entering it on the register. This is in turn closely related to the
financial policy as to the taking of discount. If it is an invariable
rule of policy always to maintain a sufficient cash balance to take
advantage of all discount offerings, there is nothing seriously wrong
with the practice of making up the voucher and entering it for the net
amount in the Vouchers Payable column; for if the policy is adhered
to, no understatement of liabilities will result. If the policy is not
strictly adhered to, constant adjustment will be necessary to make the
books reflect the true liability.
A voucher entered net should have the discount shown in the Discount
column and the gross amount in the distributive columns. Mathematical
proof of the voucher register is secured by checking the sum of
Vouchers Payable and Discount columns against the sum of the
distributive columns. Here it is best to treat the Purchase Discount
column total as an item to be posted, and the Discount column in the
cash book as a memo. As regards the income from purchase discount,
the effect of entering the voucher net is to bring onto the books the
purchase discount income as soon as the voucher is entered. Purchase
discount is not usually looked upon as earned until payment of the bill
is made and thus the right to the discount established. This method
then necessitates at the close of the fiscal period an adjustment of
the difference between the Discount columns in voucher register and
cash book, in order to defer to the next period the discount not yet
earned on all vouchers unpaid at the close of the period. This may
be accomplished by the usual method of deferring income, or by the
following entry, on the theory that it is better for Vouchers Payable
to carry the gross amount of liability, at the _end_ of the period, at
all events.
Purchase Discount $........
Vouchers Payable $........
The entry must, of course, be reversed immediately at the opening of
the new period—a procedure which makes this method of adjustment of
doubtful value.
If there is any failure to take the discount, after the voucher
has been entered net, it becomes necessary to make up and enter a
supplementary voucher for the discount, with cross-reference between
the original and the supplementary vouchers. The new voucher must
be distributed to Sundry column as a charge to Purchase Discount.
One of the few advantages of this method is that it makes possible
reconciliation with the bank account by checking the canceled checks
against the voucher register, which thus carries in its Vouchers
Payable column the exact amount of the check and its entries are in
the sequence of voucher numbers; whereas on the cash book voucher
number sequence cannot be followed. Accordingly it is unnecessary to
use treasurer’s numbers on the checks in order to secure sequence of
numbers in the cash book.
The customary method, and one which usually proves most satisfactory,
is to make up and enter the voucher for the gross amount, using the
Discount column in the voucher register merely as a memo or not at
all, posting the discounts, as earned, from the cash book and using a
separate series of treasurer’s numbers when the checks are entered on
the cash book.
Strict adherence to the theory of cash discount as a purchase
department item would require making and entering the voucher net and
distributing it net. The Discount column in the register might well be
changed to a “Neglected Purchase Discounts” column into which would be
distributed the supplementary voucher required when discounts are not
taken. Under this theory, also, the voucher may be made up and entered
gross, with the discount handled as a regular purchase discount item,
and the net amount distributed to the other columns. The student should
work out the manner of handling all the discount contingencies under
this method.
Modifications of System
A regular purchase ledger is sometimes used with the voucher system. In
such cases the voucher register becomes merely an analytic purchase
journal and much of the advantage of numbering every transaction is
lost. Accounts may also be set up merely as memos to indicate volume of
business. The voucher index, as explained above, accomplishes this in a
limited way.
A hybrid voucher system is sometimes met, a sort of half-hearted
affair, which gives good results but does away with the essential idea
of the voucher as being a receipted bill. Under it, a house voucher—so
called because it never leaves the house—is made up and used as the
basis of entry. The bill is paid by independent check, which when
canceled is filed with the voucher. In all respects, except that the
voucher is not sent with the check to be receipted, the system is
operated as a regular voucher system. An advantage claimed is that in
this way all information as to distribution of the charge or use of the
purchased materials or services is kept strictly within the business
itself. This is done at the sacrifice of securing a receipted bill.
Summary of Operation and Advantages
By way of summary, it may be stated that a fully efficient operation of
the voucher system is comprised under the following routine:
1. A verification of invoices.
2. Making up and entering the vouchers.
3. Filing vouchers previous to payment.
4. Paying vouchers.
5. Filing paid vouchers.
6. Indexing vouchers.
Some of the advantages claimed for the voucher system are:
1. It gives a detailed analysis of all purchases.
2. It saves labor by doing away with the purchase ledger.
3. It secures an up-to-date entry of all liabilities.
4. It localizes responsibility by showing authority for
the auditing, payment, and entry of the items.
5. It secures a receipted bill for all disbursements of cash.
The chief disadvantages are:
1. Clumsy provision for returns and allowances, partial
payments on bills, and notes payable.
2. Inadequate showing of volume of business with each creditor.
3. The giving out of information about the business
which should be kept private.
It should always be borne in mind that any satisfactory method of
account-keeping must be adapted to individual conditions. If efficient
results are expected, a business man should beware of ready-to-wear
accounting systems. There are conditions in which the voucher system
gives excellent results. There are also conditions to which it is
entirely unadaptable and inadequate.
CHAPTER III
FACTORY COSTS
Difference between Factory and Financial Accounting
As was stated in Chapter II, the accounting records of a concern making
its own product are much more complex than those of a concern which
limits its activities to the buying and selling of stock-in-trade.
A much larger mass of detailed information is needed for the proper
conduct of the business. In this chapter it is purposed to study in a
broad way the fundamental principles involved in factory accounting and
to examine some of its distinctive problems. Factory accounting does
not differ in the real fundamentals of account-keeping from any other
kind of accounting. Its principles of debit and credit are the same; it
employs the same or similar kinds of accounting records; and the same
general use is made of the records, viz., to serve as a guide in the
proper management and control of the business. Its distinctive features
are seen in the application of certain principles to secure special
information. To understand the problems peculiar to factory accounting,
it will be necessary to consider the nature of this information.
Definitions of Terms
Three elements enter into the manufacture of a product. These are
material, labor, and expense. The problems of factory accounting
are therefore those connected with the accounting for the costs of
material, labor, and expense. Some terms used in this connection will
need explanation. A standard terminology for cost-keeping is becoming
fairly well established. Direct and indirect costs, prime cost,
factory burden, or overhead expenses, factory cost, full cost or cost
to make and sell—these are some of the terms needing definition. Direct
costs are those which can be allocated directly to a specific product.
They are items which can be separated from all other cost items and
applied solely to a particular product. Indirect costs are those which
are shared in common by the various products and so must be distributed
over them on some equitable basis. Direct costs are sometimes called
prime costs. The cost elements which can almost invariably be applied
directly to the product are material and labor. The sum of these two
items constitute, therefore, the prime or first cost of the product.
The other items of cost which are incurred _in the factory_ or with
which the factory is chargeable are variously called factory expense,
overhead, or burden. These indirect costs cannot be charged directly
to any specific product, and so they are shared by the entire factory
output.
The sum of prime cost plus factory expense constitutes factory cost,
i.e., the entire cost of manufacture up to the point at which the
product is turned over to the selling department for sale. This is
sometimes called total manufacturing cost.
Full cost is the price at which the manufactured article can be made
and sold. In other words, to the factory cost of the article must be
added its equitable share of all the other costs of conducting the
business and also a margin of profit in order to arrive at a selling
price. These definitions indicate some of the purposes of cost-keeping.
Other purposes are given below.
Special Purposes of Cost Records
To maintain adequate control over production, careful records as to
consumption of material and labor must be kept, so that the cause of
any marked fluctuations of the costs of the current period from those
of former periods can be investigated. The determination of factory
cost makes possible a comparison of the policy of manufacturing with
that of buying the manufactured article on the open market. This
sometimes shows that manufacture is being carried at a loss. Again,
the fixing of a sale price on the article, which while covering all
expenses, shall at the same time leave a margin of profit, is a prime
essential in every business. To be of the greatest advantage and
usefulness, cost records should not only determine factory cost but
they should accumulate the data needed to _predetermine_ the selling
price with accuracy.
Nature of Raw Materials and Supplies
Materials or raw materials constitute the crude commodities or
semi-manufactured articles which are to be worked upon and fashioned
into a new product. It is seldom that any factory takes its material in
the raw form in which it comes from nature. The product of the mines
goes through many degrees and stages of refinement and at each stage of
the process some of it becomes the “raw material” for another class of
industry. The term is therefore relative; that which is the finished
output of one factory becomes the raw material of another factory, to
be worked upon and given new forms.
Auxiliary material and supplies are also made use of. Thus, certain
parts such as screws, bolts, hinges, casters, fastenings, trimmings,
and the like, are incorporated into the finished product without change
of form or the application of any labor thereto. These also constitute
a part of the raw material of the factory, their value as finished
product being due to place utility rather than form utility.
Supplies are to be distinguished from raw materials. This also is a
relative term. In general, material which does not directly form a
part of the finished product is carried under the head of supplies.
Materials used in getting ready or seasoning the raw material, i.e.,
auxiliary material, such as paint, putty, etc., the quantity of which
used on each piece of product cannot be measured with exactitude and
must therefore be spread over the entire product—these and similar
items constitute manufacturing supplies. They are usually treated as a
part of factory expense rather than as belonging to prime cost.
There are also factory operating supplies. These comprise the materials
used in the operation of the factory. Repairs material, brooms, oil,
waste, packing, nails, fuel, etc., are examples of this kind of
supplies. These, of course, are classed with factory expense, also.
The raw material which enters into _prime_ cost is thus seen to be only
that which can be charged directly to the particular product. All other
material is overhead or expense.
Accounting for Material Cost
The problem of applying the cost of the material directly to the job is
largely a problem of systematizing which requires the careful oversight
and accounting for all materials bought and used in manufacture. Two
general methods are employed. Under the one, the old method of keeping
record of all purchases and taking the inventory periodically to
determine how much material must have been used in the processes of
manufacture, is deemed sufficient. In a small factory making just one
product—or a few simple products—where the conditions are such that the
manager has an intimate knowledge of all processes and can exercise
personal control over them, fairly satisfactory results may accrue
under this method, though the amount and therefore the cost of the
material consumed in the product can never be known accurately until
the inventory has been taken.
The other method requires almost as accurate accounting for material
as for cash. A stores room or department must be established and a
stores ledger installed. As materials are purchased and come into
stores, they are classified in whatever detail is desirable and charged
to their respective class accounts kept in the stores ledger. As
material is needed for manufacture it is drawn by properly authorized
order on the stores-keeper. These orders are called “requisitions” and
indicate the material needed and the job or product to which it is
to be charged. The requisitions constitute the source of the credit
entries to the various stores ledger accounts as well as the charges
to the job or product. The balances on the stores ledger accounts thus
show the amount of each class of material which should be on hand in
the stores room.
This method of keeping track of materials is known as the perpetual
inventory system. By its use, it is possible to know without the taking
of a physical inventory how much material is being used in manufacture
and the cost of it. In this way much better control is secured over
materials than under the physical inventory method. In keeping track
of material values, of course, inward freight, cartage, handling and
stores room cost must be loaded onto the invoice cost of the materials
to arrive at the full cost at which they are issued for manufacture.
Direct and Indirect Labor
The second element of prime cost is labor. In factory accounting, labor
is divided into two classes, direct and indirect. These are sometimes
called productive and non-productive, terms doubtless carried over
from the old economics which looked upon some labor as productive and
some non-productive—necessary, it is true, but rather of the nature of
a necessary evil. Direct labor is a direct cost as explained above.
That is, it is the labor of the workmen who apply themselves directly
to the manufactured product as distinguished from the labor of those
employees who plan, lay out, and supervise the work of others.
Direct labor can be definitely allocated to specific product or jobs,
because it is applied directly to them. Indirect labor cannot usually
be allocated to a definite product because it is applied to all the
product, not being employed long enough or definitely enough on any
specific product to justify keeping track of the time and charging it
to specific product. Direct labor is a prime cost; indirect a factory
expense. It is with direct labor that our present discussion is
concerned.
The problem to be solved in accounting for labor is not the
determination of the total cost of labor used, as is part of the
problem of accounting for materials, but the distribution of that cost
over the product. Determination of labor cost, except that accrued at
any time, is a comparatively simple matter because the workmen have to
be paid at regular intervals. Distribution of the labor cost over the
product is more difficult. This necessitates keeping a record of the
amount of time spent by each workman on specific product. In that way
the labor costs can be figured quickly and distributed to the various
products worked upon.
Time-Keeping Records
To keep track of the workman’s time spent on each unit of product,
record must be kept by means of time cards, timekeepers, time clocks,
or other similar device which will show the time at which work was
commenced and the time at which it was finished or when the working
force is transferred to other work. The time card is arranged with
space for number or name of the jobs or products worked on and the time
spent on each. Use of the hour or day rate of wages paid the workman
gives the labor charge to each particular product worked upon. This
time card, or its equivalent, may be kept by department foreman, a
special timekeeper, or by the workman himself. At the end of the week
or other period, these time cards are turned into the office and they
serve as the basis for making up the past week’s pay-roll or as a check
against the pay-roll where some other source for the make-up of the
pay-roll is used.
Pay-Roll
The pay-roll is merely a list of the names or numbers, or both, of the
workmen, showing the time employed during the past period, and the rate
of wages. A column to carry total amount due each workman is provided,
as well as in some cases a place for the signature of the workman’s
name to acknowledge receipt of payment. Provision may be made for
other information, also, such as distribution of the labor cost to the
specific product, but this is not usual. When the time cards of the
workmen are turned in, they are checked against foremen’s reports or
sick notices. The total time spent by each workman multiplied by the
rate of wages gives the amount earned by each man. From this may be
deducted any claims, such as insurance, rent, store charges, hospital
and sick benefit, giving the net amount due the workman.
Safeguarding the Pay-Roll
Since the pay-roll is such a frequent source of error and fraud, all
possible safeguards, chiefly of an internal sort, should be made use
of. Where possible, workmen should be employed through an employment
department to which requests for men needed should be sent. Some form
of card record should be kept for office files of all men taken on—and
perhaps of all men interviewed. Additions of names to the pay-roll
should not be allowed without authorization, and the payment of the
men should not be made by the same clerks who make up the pay-roll.
The pay-roll should be checked as to mathematical correctness and,
where possible, as to the content of the roster, both before and after
making payment. Too often has the total of the pay-roll been changed
after its correctness has been proven but before it has been presented
to the treasurer to provide the funds needed, the thief pocketing the
difference between the amount needed for payment of labor and the
raised amount of the pay-roll. Checking before and after payment will
prevent this.
If payment is by check, the total amount of the pay-roll should be
transferred by check to a special bank account on which the individual
checks are drawn. If payment is in currency, this will be secured by
check on the bank and the pay envelopes made up from it. Before drawing
the currency, the individual amounts should be analyzed to determine
the denominations of the coins and currency needed for filling each
envelope.
_Methods of Pay-Roll Payment._ On each pay envelope should be marked
the name and the amount. One pay-roll clerk should count out the
amounts, the other clerk verifying them and filling the envelopes. A
very ingenious pay-roll machine can be used for filling envelopes with
the proper amount. The total amount of the pay-roll is placed in a coin
rack operated by a keyboard. As the amounts of the individual envelopes
are set up on the keyboard, the coin rack delivers the correct amount
into a chute which carries it to the envelope. At the same time the
amount delivered is listed, making it easy, in case of error, to
locate the envelope containing the wrong amount. When the envelopes
are delivered to the workmen, each man should identify himself in the
presence of his foreman and give receipt for his pay. This is usually
done by signing the pay-roll. The clerks making payment and the
witnessing foremen should sign the pay-roll. Any unclaimed envelopes
are returned to the treasurer to be held a certain length of time for
claiming, after which time they may be diverted to other uses, though
the liability for them must still be shown.
Distribution of Labor Charges
Distribution of the labor charges may be made in several ways. The
precise method must depend largely on local conditions. In a small
factory making only a few products, or where cost by departments is
the desideratum, the voucher register may be provided with sufficient
distributive columns to meet the requirements. At the time the pay-roll
check is entered, it is distributed according to the labor cost in
the various departments or on the various batches of product. This
dispenses with a general pay-roll or labor account on the ledger.
In a larger concern or one in which a more detailed distribution
is desirable in order to secure definite and accurate costs on a
diversified product, distribution on the face of the voucher register
might not be feasible. Here, the pay-roll check will be run through the
register as a charge to pay-roll. When the desired analysis is made in
accordance with workmen’s time cards or other sources of information, a
general or cost journal entry is made, charging the proper accounts and
crediting Pay-Roll. Or, and usually better, a “Pay-Roll Distribution
Book” may be used. This book is a recapitulation of the time cards
distribution sheets. Each time card must be analyzed according to jobs,
product, or departments, and these distributions as summarized should
as a matter of permanent record be entered in a recapitulation book.
This, by being made a posting medium, becomes the pay-roll distribution
book. Charges to the proper accounts are made from this book, offset by
a credit of the total of the book to Pay-Roll account. Sometimes the
pay-roll book itself carries distributive columns and can therefore be
made to serve as a pay-roll distribution record.
_Accrued Wages._ Distribution of wages accrued at the end of the fiscal
period is perhaps best made through the general journal, although it
can without much difficulty be run through the distribution book by
making two recapitulations of the last week or pay-roll period at the
end of the fiscal period, the portion of the week belonging to the last
fiscal period being summarized separately from the portion belonging to
the next period. Both summaries, however, should be run through on the
regular pay-roll voucher for that week’s wages.
Expense
The third item or element which goes into the cost of manufacture
is factory expense. Under this head are included all the costs of
manufacture excepting the prime cost elements of materials and direct
labor. Indirect labor, factory supplies, light, heat, power, repairs
and maintenance to factory buildings and equipment, depreciation on
factory buildings and equipment, rent, insurance, etc., constitute
the main items under this category. These are the indirect costs
of manufacture because, while just as necessary as the prime cost
elements, it is impossible to allocate them directly to the product.
How much of the cost of light, how much of repairs cost, how much of
the cost of factory supplies, etc., shall be charged to each unit
of several different kinds of product constitute a problem on the
solution of which depends the whole structure of accurate costing.
Accurate distribution of materials and labor costs may be complex, but
presents no real difficulties. It requires little more than careful and
painstaking work. On the other hand, to secure an equitable basis for
the distribution of factory expenses, and one which is at the same time
a workable basis, is in some cases well nigh impossible.
One common basis of distribution for all the factory expenses will
not usually give satisfactory results. Each item of overhead must
be considered separately and will often require a distinct basis of
distribution. Thus, indirect labor is sometimes distributed over
product on the basis of the cost of the direct labor item in the
product, on the theory that the cost of supervision is a cost of
supervising the direct labor and so closely related and dependent on
that cost. Under some conditions, the number of direct labor hours is
used instead of the _cost_ of direct labor. Again, the time the product
is worked on in a given _department_ is taken as the most equitable
basis for distributing indirect labor costs. Power, where metered to a
machine, may be charged to the product on the meter basis. Where not
metered, it may be charged on the basis of the time the machine is
operated. So, every item of expense must be analyzed and effort made to
secure an equitable basis of distribution.
Summary of Manufacturing Cost
Each unit of product, therefore, as it comes from the factory must
carry its burden of cost composed of materials, labor, and factory
expense costs. The sum total of all of these costs for all products—the
entire output of the factory—will be the record of manufacture on the
general books, the detailed record being carried in subsidiary books.
At the close of the fiscal period when the temporary proprietorship
activities of the business must be summarized, an entirely distinct
group or section will be devoted to the activities of the factory
because these costs must be shown separately from the others. For this
purpose, the first section of the profit and loss statement and account
is treated as the “Manufacturing” section, and under it are summarized
in two groups the prime cost elements of materials and direct labor
and the factory expenses. The total of this manufacturing section
gives the cost at which the manufactured product is charged to the
sales department of the business, and there this item takes the place
of the cost of purchases in a business which buys its stock-in-trade.
A detailed explanation of the manufacturing section as a part of the
profit and loss summary is given in Chapter XXVII. The principles
of cost accounting cannot here be developed further than this mere
statement of the ends sought.
CHAPTER IV
THE BALANCE SHEET
Business Methods under the Microscope
The balance sheet is occupying an increasingly large place in all
affairs of business and even of state, because the state is taking
cognizance of business as never before. All phases of commercial
activity are under the microscope. In these war times the government
is tapping every available source of revenue. Kinds of property,
property values, profits, rates of profit on capital invested—all are
under investigation and the publicity resulting therefrom should make
for a better conduct of future business. All this is forcing home to
the manufacturer and trader some very obvious but long disregarded
principles of business conduct necessary to secure health and long
life. And these timely lessons will be of even greater use in the
struggle for world markets that is imminent. As an interested party
to any condition of business, labor also is claiming the right to
be heard. The public in its direct dependence on certain classes of
corporations for many of its necessities and most of its conveniences
is also interested in the proper conduct of those businesses. As
a factor in this increasing interest and scrutiny over business
enterprises, exercised both from the inside and from external sources,
banks are exerting a large and beneficent influence. The extension
of credit, both bank and commercial, is no longer done by haphazard
rule-of-the-thumb methods as in days gone by. Every applicant for
credit must prove his right to it, must show cause why he deserves it,
must present evidence of financial condition and standing on the basis
of which the banker, the money lender, or the seller will be justified
in extending all or some portion of the credit asked.
The Reading of the Balance Sheet
Because, in these and many other ways, the balance sheet offers the
readiest means of securing the necessary information, it becomes an
increasingly prominent statement. Before a proper understanding of the
balance sheet can be had, and therefore before it can serve the various
purposes to which it can be adapted, certain principles governing its
make-up, both as to form and content, should be established. A proper
reading of the balance sheet cannot be made without a thorough grasp of
these principles.
The knowledge necessary for this is broadly of two kinds, viz.: (1) a
knowledge of accounts, their technique, construction, and meaning; and
(2) a knowledge of the principles of valuation as applied to business
enterprises. The latter is not a domain of knowledge pre-empted by
the accountant nor limited exclusively to his use. It touches more or
less intimately all related fields of business endeavor. That is why
the modern accountant needs a broad training and something more than a
cursory knowledge of business practices and conditions. He should have
a close acquaintance with the fundamental currents of business life,
its organization and finance, and its basis in law, if he hopes to
measure up to present-day requirements.
Thus not only is the accountant interested in the form and content of
the balance sheet, but a proper understanding of it is valuable and
increasingly necessary to all business men. In this chapter and those
which follow, it is purposed to study these two problems of form and
content, first establishing the broad basic principles and then showing
in detail how these apply to various conditions and particular data.
This chapter will concern itself with the problem of the make-up of the
balance sheet so far as it relates to form.
Definition
George Lisle[4] defines a balance sheet as “a concise statement
compiled from the books of a concern which have been kept by double
entry, showing on the one side all the liabilities and on the other
side all the assets of the concern at a particular moment of time.”
Another writer says, “It is a cross-section of the business at a
given instant”; and another, it is a “screen picture of the financial
position of a going business at a certain moment.” As indicated by
the first definition, an attempt is sometimes made to limit the term
balance sheet to a statement made up from a double-entry set of books.
With equal propriety it may be applied to any statement, whether made
up from single- or double-entry books, or from any formal records, or
from no records at all, which shows the assets and liabilities of a
concern and the difference between them, i.e., the balance, as the item
of net worth.
[4] In “Accounting in Theory and Practice.”
To distinguish this latter statement from the balance sheet when used
in the restricted sense above referred to, the title, “statement of
assets and liabilities” is sometimes used but there seems little
reason for the distinction. Here the terms will be used as synonyms.
The balance sheet then is a statement of financial condition as
distinguished from a statement showing the operations of the business,
and it is true only for a given moment of time. Theoretically the
wheels of business are stopped momentarily, all operations cease, and a
summary of the assets and liabilities then existing with their balance
shown as net worth constitutes at that moment the balance sheet—the
financial statement.
Relation between Balance Sheet and Trial Balance
A balance sheet when made up from a double-entry set of books bears a
close resemblance to the trial balance. The trial balance is simply a
list of ledger balances. Due to practical considerations in making the
record from day to day, the ledger seldom reflects the true condition
of the business, as there is no distinct separation of assets,
liabilities, expenses, and income. Some accounts take on a mixed
character, making necessary the periodic separation of their elements.
This separation is effected by the adjusting entries explained in
Volume I. A trial balance of the ledger after the adjusting entries
are made contains the data for both the financial statement and the
operating statement. After the operating data, i.e., the income and
expenses, have been summarized through the Profit and Loss account and
its balance has been transferred to some vested proprietorship account,
the records left on the books relate only to assets, liabilities,
and vested proprietorship. A trial balance now taken—a post-closing
trial balance—contains only balance sheet items and to all intents
and purposes is a balance sheet. While, as we shall see, the form
in which the data of the balance sheet are presented is a matter of
serious importance, any showing of assets, liabilities, and net worth
constitutes a balance sheet.
Form of Balance Sheet
A balance sheet is not an account, nor is it the statement of an
account. It is simply a statement of assets, liabilities, and
proprietorship, arranged in whatever form best suits the purpose. Where
set up in parallel columns, it is frequently called the account form;
when shown vertically on the page, assets followed by liabilities and
the difference indicated as net worth, it is called the report form.
A balance sheet therefore being only a statement cannot properly be
said to have either a debit or a credit side. It is not a complete
system for the record of the transactions of a business set up in debit
and credit form for the sake of proof, although on its statement of
fundamental equality may rest the whole scheme of debit and credit.
While usually made up from a system of double-entry books and so often
spoken of as the goal of record-keeping, it may be made up from sources
entirely extraneous to the books.
Purpose and Uses
The purpose of the balance sheet is, as indicated, to show financial
condition. It may be made also to show the amount of profit for the
period by elaborating the information given in the net worth section.
If there has been during the period neither a withdrawal of any funds
nor an additional investment, a comparison of net worths as at the
beginning and at the end of the period will bring out the increase or
decrease in net worth and therefore establish the _amount_ of profit
or loss, though telling little or nothing as to its source. If there
has been withdrawal or investment or both during the period, adjustment
must be made on account of these before the amount of profit or loss
for the period can be determined from the balance sheet. The balance
sheet may thus be made to show profit, though that is an incidental
rather than an essential purpose of the statement.
As a statement of financial condition the balance sheet should make
possible the determination of several facts. It may be used as the
basis for short-time credit. If so, its purpose then is to show facts
as to solvency. It may be used as the basis for floating a bond issue.
If so, other groups of data in addition to the solvency facts must be
held under view. It may be used for determining the advisability of
an investment in the business. If so, its data must be examined from
still another angle. In all of these cases the balance sheet must set
forth clearly the relationship of the interests of the various parties
in the business. The assets of a corporation are listed usually so as
to show the total properties to which all the parties may look for the
satisfaction of their claims. Of the claimants there are first, then,
those whose claims are redeemable within a short time. Failure to meet
these claims may mean insolvency. There are those also whose claims are
not necessarily of immediate urgency, though they may be. Inability to
meet these claims may mean bankruptcy and dissolution. Finally, the
owners themselves have a proprietor’s right only to any residue of
assets left after the claims of all outsiders have been satisfied or
are capable of being satisfied. Thus the balance sheet may serve many
purposes.
Types of Balance Sheet
As the balance sheet must serve, or can be made to serve, several
definite purposes, the best way to accomplish the end in view must
receive careful consideration. It is here that the question of form
enters. The various problems in connection therewith will next be
discussed.
As to types of form there are in the main two, the English and the
Continental or American, both of them well standardized, although many
variations from the types are found. The chief difference between
the two types lies in the showing of assets on the right side and
liabilities and capital on the left under the English form, and a
reversal of the sides under the Continental form. So much useless
controversy has been carried on with such a waste of effort and words
over the relative merits of the two types, that a writer now scarcely
dares venture into the subject. As a matter of historical interest and
information to the student, an effort will be made to summarize briefly
the two positions.
Origin of English Form of Balance Sheet
In the development of record-keeping a stage was passed through in
which every account on the ledger was closed. Not only were the
temporary proprietorship accounts cleared through the Profit and
Loss account, but all the remaining asset, liability, and vested
proprietorship accounts were in like manner closed into a Balance
account opened on the ledger for this purpose. The Balance account,
after transfer of the various accounts into it, became virtually
a balance sheet and so was itself in balance. In this way the
whole ledger was closed. The Balance account at this stage, so the
controversialists maintain, represents, and was later adopted as, the
Continental form of balance sheet. The ledger could not, of course,
remain closed; it had to be reopened for the record-keeping of the next
fiscal period. This was accomplished by credit entries to transfer the
assets, and by debit entries to take out the liabilities and vested
proprietorship. These reopening entries as appearing in the Balance
account represent the English form of balance sheet.
This explanation of the origin of the two forms is ingenious and even
plausible, although not synchronizing historically with the lapse of
use of the Balance account. Others have attempted an explanation on
purely logical grounds. These hold to the theory of the personality of
accounts, which looks upon the business always as an entity distinct
from its owners. Here, the English form of balance sheet is said to
be the statement of account rendered by the business to its owners,
whereas the Continental is the account given by the owners to the
business. A. Lowes Dickinson,[5] in discussing the two forms, says:
“The balance of argument would seem to favor the latter (English) on
the theory that a balance sheet is intended to set forth the position
of the owner of the property, who should therefore be credited with
what he possesses and charged with what he owes.”
[5] In “Accounting Practice and Procedure.”
Quite opposed to this view is the position taken by an English
authority, George Lisle,[6] He says: “Why ... the assets which are on
the debit side (of the ledger)[7] and the liabilities which are on the
credit side, as according to the principles of accounting they ought to
be, should change places (in the balance sheet),[8] it is impossible
to justify. The custom seems to have arisen through the influence of
the forms given in Acts of Parliament, chiefly The Companies Act, 1862,
which must have been prepared by those unacquainted with the theory of
accounts. The Profit and Loss account is taken from the ledger, and the
sides are not transposed, and there is no logical reason why the sides
in the balance sheet should be reversed.... The form of balance sheet
in which the assets appear upon the left side is both theoretically the
correct form and in practice is the most convenient form to use....
Prior to about the passing of The Companies Act, 1862, it was the form
chiefly adopted in England, but is so no longer.”
[6] In “Accounting in Theory and Practice.”
[7] Material in parentheses is author’s.
[8] Material in parentheses is author’s.
R. H. Montgomery[9] proposes a psychological explanation. He says: “The
only sound reason the author can think of for the custom is that a
conservative Englishman looks for his liabilities first and then looks
to see if he has enough assets to discharge, them ... that the average
American looks for his assets first and subsequently glances at his
liabilities in order to assure himself that his excess of assets is
as much as he believes it to be.” Regardless of the origin of the two
types and their respective merits, a balance sheet is everywhere used
to show assets, liabilities, and net worth, and less and less regard
is being paid to debit and credit or left and right sides, technical
form giving place to an elasticity in the method of showing adapted to
accomplish definite purposes.
[9] In “Auditing, Theory and Practice.”
Variation of English Form
A variation of the English form of balance sheet is seen in the make-up
of the balance sheet for British public service companies. These
companies are authorized by special act of Parliament to raise money
for designated purposes. The act, therefore, requires as a part of
the statement of financial condition the rendering of an accounting
of the receipts from sale of stock and bonds. Accompanying the
financial statement, or rather as a part of it, is the statement,
“Receipts and Expenditures on Capital Account,” comprising the fixed
asset and liability sections of the ordinary balance sheet. Illogical
as it may appear in view of the usual English practice, this account
is _credited_ with the capital stock and bonds issued to establish
the undertaking, and is _debited_ with the fixed assets in which the
capital funds have been invested, the intent of the law being that the
capital funds raised should be applied to purchase of fixed equipment
with which to earn revenue and that all other expenditures should be
made from revenue. If the fixed assets exceed at any time the fixed
liabilities and capital, it means that the excess has been supplied
out of revenue. If the reverse is true, it means that capital receipts
are being used as working capital. Any balance is carried down to
the second part of the financial statement known as “General Balance
Sheet,” in which arrangement of the two sides is made according to
English custom. The act authorizing this double-account form of balance
sheet allows the valuation of the fixed assets always at cost, on the
theory that their maintenance in a state of constant good repair and
efficient working condition constitutes a charge against revenue and
hence that depreciation need not be considered.
It has been suggested that the double-account form of balance sheet,
or rather the law on which it rests, has been responsible for the
decisions in the cases of Lee v. Neuchatel Asphalte Co. and Verner
v. The General and Commercial Investment Trust, Ltd., reference to
which is made later in Chapter XXII, “Profits,” and Chapter XXIV,
“Dividends.” Here the decisions rested on the distinction between fixed
and circulating assets and declared in favor of the maintenance of
the capital funds invested in circulating assets but not necessarily
of those invested in fixed assets. The following illustrates the
double-account form:
THE EAST AND WEST RAILWAY COMPANY
RECEIPTS AND EXPENDITURES ON CAPITAL ACCOUNT
====================================================================
|
Railroads, Franchises | Capital Stock:
and Other | Common $200,000.00
Properties $410,000.00 | Preferred 75,000.00
Current Expenditures | Debenture 50,000.00
for Construction | Funded Debt:
and | General Mortgage
Equipment 65,000.00 | Bonds 150,000.00
Investments in Other | Equipment Trust
Companies 50,000.00 | Bonds 100,000.00
Securities in Hands |
of Trustee 15,000.00 |
Balance carried to |
General Balance |
Sheet 35,000.00 |
----------- | -----------
$575,000.00 | $575,000.00
=========== | ===========
GENERAL BALANCE SHEET, DECEMBER 31, 1918
====================================================================
|
Capital Account, | Securities $50,000.00
credit balance $35,000.00 | Prepaid Expenses 750.00
Special Betterment | Accrued Income 1,250.00
Fund 15,000.00 | Accounts Receivable 25,000.00
Accrued Expenses 1,500.00 | Materials and Supplies 10,000.00
Dividends Payable 17,500.00 |
Accounts Payable 25,000.00 | Cash 7,000.00
---------- | ----------
$94,000.00 | $94,000.00
========== | ==========
It will be noted that the sides of the capital account follow the debit
and credit order of the ledger, whereas the general balance sheet
reverses that order—an inconsistency for which even the English do not
attempt explanation.
Balance Sheet Titles
The title of the balance sheet is fairly well standardized. Other
titles are sometimes met, such as Financial Statement; Statement
of Assets and Liabilities; Statement of Resources and Liabilities;
Statement of Assets, Liabilities, and Capital; Statement of Financial
Condition; etc. The title “Balance Sheet” seems best. Though not
so fully descriptive as some of the other titles, it is generally
understood and has not the objection of inadequate descriptiveness
and unwieldiness often raised against the other titles. There is a
similar variation in the titles used for the three main groups of items
shown in the balance sheet, viz., assets, liabilities, and net worth.
Obviously, portions of some of the general titles cited apply here with
equal appropriateness. In addition, we find in use or suggested as
appropriate, Property and Assets, Active and Passive, Debit and Credit,
Positive and Negative, Proprietorship, Capital and Surplus, Capital,
etc. None of these suggested titles have met with favor in practice,
but they have served the worthy purpose, perhaps, of providing fuel for
academic controversy. The titles, Assets or Resources, Liabilities, and
Net Worth or Capital, seem thoroughly established and seem to cover the
need.
Grouping and Classification
In the matter of classification and arrangement of the items under
these main groups there is room for greater diversity both in practice
and in theory. The need and purpose of classification and arrangement
is obvious. While any statement, list, or schedule which shows assets,
liabilities, and net worth may properly be called a balance sheet,
only by a careful grouping and formulation of the items can their
mutual interrelations and proper dependence be shown. Not only does the
bringing of similar items into groups put them in proper perspective,
but the arrangement of the groups to show their relations to one
another makes for a more intelligent interpretation of the balance
sheet. The controlling principle underlying classification of the items
into groups is, in the main, their relative degrees of liquidity.
Sometimes other factors, such as emphasis, perspicacity, publicity,
and so on, bring about groupings which differ somewhat from those
based solely on degree of liquidity. Thus it may be desirable to call
particular attention to, say, the permanent investments of a concern,
to the condition of its sinking and other funds, to the amount of new
construction and betterments for the current period, or to the values
tied up in intangible assets. No hard and fast rule can therefore be
followed; elasticity, flexibility to the desired purpose are working
rules which must underlie any scheme of classification.
As to titles for the various groups, one finds many. The current
assets are variously styled Quick, Floating, Liquid, Circulating. As
a sub-group under Current or as a separate group we find Working and
Trading assets. Other groups are Fixed or Capital, Investments, Sinking
and Reserve Fund Assets, Deferred Charges to Operation, Deferred
Assets, Deferred Debits, Suspense Debits, with similar titles for
corresponding credit items, Contingent Liabilities—in short almost any
title which seems best to fit the needs of the particular case. Some of
these may need some explanation.
The distinction between current and working assets is a somewhat
fine-drawn one, although well taken under certain circumstances. Where
the two groups are used, current assets include the cash, receivables,
and temporary investments, and the working assets group (or working
and trading assets as it is sometimes captioned) includes the
stock-in-trade (finished goods, goods in process, and raw materials),
supplies of all sorts used in preparing the goods for sale or in making
the sale, office supplies, working funds in the hands of branches and
agents, and the like. The line of demarcation between the two groups
is not always clearly drawn, some placing the stock-in-trade among the
current assets, others putting finished stocks in the current group
and process materials in the working group. There is apt to be an
overlapping also between the working and the deferred charges groups,
supplies of various sorts often being treated as deferred charges to
operation. Capital assets are fixed assets—the plant and those assets
in which the capital must first be invested before revenue can accrue.
When the group of capital liabilities is shown it usually includes both
the long-term obligations incurred for raising capital as well as the
capital stock. This unfortunately does not recognize a distinct section
for the net worth items.
Arrangement of Groups
The arrangement of the groups among themselves, while showing
variations, offers few important matters for consideration. Here,
also, the principle of degree of liquidity controls. The arrangement
is sometimes from fixed to liquid but rather more frequently from
liquid to fixed. If the chief interest in the balance sheet is as to
the amounts of capital invested in properties and the growth of such
investments, it is claimed that the fixed asset group should be shown
first. This might be the case with railways, steel corporations, and
other large concerns wherein the ratio of the fixed assets to the
current is large. In other concerns—and these constitute the larger
number—chief interest centers in the current group. Here, the ability
to pay dividends, to extend a sales market through carrying larger
stocks of merchandise, to secure credit, are the items of chief moment.
It is contended that in these cases, the order of the groups should be
from current to fixed.
Whatever grouping is made for the assets, a similar arrangement of
groups must be insisted upon for the liabilities; it is the placing
in juxtaposition or the same relative positions of similar groups
among the assets and liabilities which makes for an easily intelligent
reading of the statement. After all, the order of the groups, as from
fixed to current or vice versa, is of small importance in comparison
with the similar arrangement of both assets and liabilities and with
the surety of the proper content of each group. The thing to be sought
is the arrangement which will facilitate comparison of similar groups.
A rather serious objection to the “fixed to current” arrangement is
that it almost invariably necessitates the separation of the net worth
elements. Thus, capital stock and long-term bonds are grouped together
at the top for comparison with the fixed assets; the remainder of the
net worth—surplus and reserved profits—must be shown at the end. The
group of all net worth items together compels a general scheme of
logical grouping from current to fixed.
A difference as to order is also found in the placing of deferred
charges to operation. Regardless of the scheme of general grouping, one
frequently finds the deferred charges placed as the last group. This
also seems illogical. Only items of prepaid operating expenses should
be included in that group. Such prepayments, while made in the one
period, are properly chargeable to the next. Their effect, therefore,
is to bring about a saving of the cash and other current assets for
other uses during the next period. They are thus nearly related to the
current group and could without any serious violation of principle be
included thereunder. For the sake of emphasis and a more open showing,
they are best shown in a group by themselves immediately following the
current assets.
The intangible assets, good-will, franchises, patents, etc., are
usually included among the fixed assets. Where so shown they should be
given unmistakable titles and are best set up at the end of the group
so as not to be covered and lost among the other items. A suggested
scheme of grouping which will make an intelligent showing for most
purposes follows:
=======================================================
|
_Assets_: | _Liabilities_:
1. Current Assets | 1. Current Liabilities
2. Deferred Charges to | 2. Deferred Income
Operation | 3. Fixed Liabilities
3. Investment of Reserves |
4. Permanent Investments | _Net Worth_:
5. Fixed Assets |
| 1. Capital Stock
| 2. Reserves of Profits
| 3. Surplus
|
The content of these groups and any further explanations necessary are
treated in the chapters which follow, where the detailed application of
principles is discussed.
As stated above, the important desideratum is a like arrangement of
groups to facilitate comparison and care to secure the proper content
of each group. Within the group itself, while the arrangement of the
items is not so important, the principle of degree of liquidity should
govern here too. Whatever the order of general arrangement of the
groups, the same order may well be observed for the items within the
group.
Report and Account Forms
Something should be said with regard to the merits of the two
methods of arranging the three main classes of items, i.e., assets,
liabilities, and net worth, on the balance sheet. As previously stated,
the method known as the report form makes a vertical showing of the
classes, while the account form shows the items in parallel columns.
The one lists the assets and from their total shows the subtraction of
the total liabilities which are in a subjoined list. This difference,
representing net worth, is explained in detail as to the portion
represented by capital stock, surplus, etc. The account form method
lists the assets in one column and the liabilities and net worth in a
parallel column, bringing about a balancing of the two columns.
For the report form, it may be said that this method follows
the reasoning of the average business man, particularly the man
unacquainted with accounts, who subtracts his liabilities from
his assets to find how much his present net worth is. The account
form rests on the fundamental desire, deep-rooted in the system of
double-entry bookkeeping, to show the two sides in balance. It may
be looked upon as the technical form and therefore well adapted for
publication purposes. It secures also a convenient juxtaposition
of groups for purposes of comparison. The one may be regarded as
non-technical, easily within the intelligent grasp of the layman; the
other as technical and addressed to those trained to read that form of
statement. As previously stated, any method of showing which fails to
list separately the three distinct classes of assets, liabilities, and
net worth is not usually to be justified; a mixture of net worth and
liabilities is bad. Omitting detail, the two following type forms meet
the conditions laid down above:
REPORT FORM OF BALANCE SHEET
_Assets_
Current Assets:
Cash $........
Receivables ........
Stock-in-Trade ........ $........
--------
Deferred Charges to Operation:
(See Schedules) ........
Investment of Reserves:
Sinking and Other Funds
Permanent Investments:
(Held for purposes of control) ........
Fixed Assets:
Plant $........
Equipment ........
Good-Will, etc.
........ ........
-------- --------
Total Assets $........
_Liabilities_
Current Liabilities:
Notes Payable $........
Trade Creditors ........
Accrued Expenses ........ $........
--------
Deferred Income:
(See Schedules) ........
Fixed Liabilities:
Bonds $........
Long-Term Notes ........ ........
-------- --------
Total Liabilities ........
--------
$........
_Net Worth_
Represented by:
Capital Stock $........
Reserves of Profits ........
Surplus ........
--------
Total Net Worth $........
========
ACCOUNT FORM OF BALANCE SHEET
=================================+==============================
|
_Assets_ | _Liabilities and Capital_
|
Current Assets: | Current Liabilities:
Cash $.... | Notes Payable $....
Receivables .... | Trade Creditors ....
Stock-in-Trade .... $.... | Accrued Expenses .... $....
---- | ----
Deferred Charges to Operation: | Deferred Income:
(See Schedules) .... | (See Schedules) ....
| Fixed Liabilities:
Investment of Reserves: | Bonds $....
Sinking and Other Funds .... | Long-Term Notes .... ....
| ---- ----
Permanent Investments .... | Total Liabilities $....
Fixed Assets: |
Plant $.... | Net Worth represented by:
Equipment .... | Capital Stock $....
Good-Will, etc. .... .... | Reserves of Profit ....
----- ----- | Surplus .... ....
| ----
| ----
Total Assets $.... | Total Liabilities
==== | and Capital $....
| ====
Valuation Accounts
Nothing has been said thus far concerning the showing of valuation
accounts on the balance sheet. Two different practices are met with.
Sometimes such accounts are listed with the liabilities, and there
is a sense in which they may be regarded as liabilities. Rather,
however, they should be looked upon as credits to asset accounts, held
temporarily in suspense until they can be definitely allocated to their
assets. They are offsets to show the _appraised_ values of the various
properties. As such, therefore, they are best shown as deductions from
their corresponding assets with the appraised value full-extended. This
applies to both the debit and the credit valuation accounts. A full
discussion of these and other reserves is given in Chapter XXIII.
Statutory Requirements as to Frequency of Balance Sheets
Excepting in the case of corporations, there are few, if any,
compulsory regulations governing the frequency of balance sheets. Some
of our tax laws have brought about an increasing regularity with regard
to the issuance of formal statements, both balance sheet and profit
and loss. England, France, and Germany require a formal statement from
corporations once a year. In this country, most states require some
form of statement but oftentimes the requirement is so indefinite or so
inadequately or half-heartedly enforced that the statement submitted
is of little value. On the other hand, some classes of financial and
public service corporations are required to present full and adequate
reports periodically, at least once a year. In the case of national
banks five reports are asked for; in the case of savings banks in some
states two reports are required.
Condensation of Information in the Balance Sheet
The relation of the formal balance sheet to the post-closing trial
balance needs further consideration. It has been stated that a
post-closing trial balance is essentially a balance sheet. As the
purpose of the latter is to present a bird’s-eye view of financial
conditions, much of the detailed information shown in the post-closing
trial balance must be condensed and consolidated with similar items,
so that only totals are shown on the balance sheet. Just as the
purpose of the ledger is by a process of analysis to secure detailed
information for use in the current control of the business, so the
balance sheet by losing sight of the detail and by setting forth the
fundamental currents of business life and health, provides the data for
the larger aspects of control. How far this process of condensation
should be carried depends largely upon the use to which the balance
sheet is to be put. A statement of financial condition to be issued to
the public—stockholders and outsiders—can well omit data which would
be required for internal use. Care must always be taken in condensed
statements to avoid consolidation of detail in such a way as to render
the statement misleading. The English Companies Act of 1862 provided
that the “auditors’ report should state whether in their opinion the
balance sheet was a ‘full and fair balance sheet’ containing the
particulars required by the company’s Articles and ‘properly drawn up
so as to exhibit a true and correct view of the company’s affairs.’”
This represents the proper attitude for every accountant to assume in
the making of statements. This is not meant to require the publication
of information which is the private property of the business. The
phrase, “full and fair,” must be interpreted to mean sufficiently full,
and only so much so that it will be fair to both parties. The company
is entitled to withhold legitimate information the publication of which
would be detrimental to it, and not to do so would be unfaithful to the
proper guardianship and protection of its interests, and this in turn
would bring about dissatisfaction with the management and oftentimes
ill-feeling among the owners.
Use of Supporting Schedules
By means of supporting schedules, as illustrated and discussed briefly
on pages 411 and 412 of Volume I, it is possible to carry condensation
to almost any desired degree and still have available all necessary
detail in the accompanying schedules. What items in the balance
sheet should be supported by schedules and what should not, must be
determined by the conditions peculiar to each case. Here again, the
determination rests largely upon the use the statement is to serve. The
informational content is therefore largely dependent upon the purpose
for which the statement is drawn.
Balance sheets may serve any one of the following purposes:
1. Internal use by proprietor or manager.
2. Formal report to stockholders.
3. As a basis for application for credit.
4. For publication or report to regulating or
supervising commissions.
5. For annual report to the state.
6. For advertising purposes to float new issues
of bonds, preferred stock, etc.
When used for some of these purposes, oftentimes condensation is made
a convenient method of bringing about a misrepresentation of true
condition. Of course, no justification can be found for this.
Emphasis has already been placed on the necessity of choosing titles
and captions which shall indicate clearly the nature and content of the
transactions or data recorded thereunder. Statements of condition which
are misleading, whether with intent or by chance, are to be condemned.
As H. R. Hatfield[10] so well summarizes, the lack of clearness and
consequent misunderstanding of the balance sheet are due in the
main to three causes: (1) vagueness of terminology; (2) purposeful
misrepresentation; and (3) the very nature of accounting itself
which so largely rests on estimates rather than on facts of definite
determination. Some of these troubles have their origin in the form of
the balance sheet, the manner of showing the items; while the others
inhere in its content. It is to a study of the content of the balance
sheet from the standpoint of the statement of values, with the emphasis
on quantitative analysis, that we now turn.
[10] In “Modern Accounting.”
CHAPTER V
GENERAL PRINCIPLES OF VALUATION
Content of the Balance Sheet
The problems of content and valuation strike at the very heart of
the balance sheet. Form, framework, and method of presentation are
important and their usefulness should not be discounted. Particularly
is this seen to be true from the standpoint of availability of the
information presented and facility in its interpretation; but the meat
of the balance sheet is its content. In connection with this, two
points demand consideration, viz.: (1) what items shall be admitted
to a place in the balance sheet; and (2) on what basis shall they be
admitted, this latter being the problem of valuation.
The first question can be answered without much trouble. All
properties owned and all liabilities incurred must find a place in the
balance sheet. The properties belonging to a business include both the
tangibles and intangibles, rights and claims. Most of these have cost
value, some may have been gifts. All the assets must, therefore, be
listed. Similarly, the liabilities, all those things which represent
debts owed by the business or established claims against it, must be
given place in the balance sheet. Neither from the assets nor the
liabilities must there be allowed omission. As stated in Chapter IV, as
to content, the balance sheet must be “full and fair.” Some classes of
items, known as _contingent_ assets and _contingent_ liabilities, will
be discussed and their place determined as they are met. The net worth
items, in whatever detail desirable, must also be included.
Valuations for Rate Regulation
The second problem as to the basis on which items shall be valued
for the balance sheet is our chief problem. The general question of
valuation may be viewed from so many points that definition of its
meaning here is necessary. Principles that are applicable to valuations
for one purpose frequently cannot be made to serve another purpose.
Because of the agitation in recent years relative thereto, when the
problem of valuation is mentioned it is associated almost invariably
with public service corporations. Most of the so-called valuation
work has been done in connection with railroads, water companies, gas
and light companies, etc. Here the issue of regulation is involved.
Regulation of rates is price regulation and therefore regulation of
profits. The purpose of valuation in connection with public utilities
is the determination of the amount of investment on which rates must be
so regulated as to secure a return based on fairness and equity to all
parties.
Where such valuations have been made they have not proven entirely
satisfactory and it is placing too great faith in human kind to expect
the satisfaction of all parties with the results of any valuation.
Where the properties involved have not been exceedingly complex and
have been fairly well localized, results have seemed to justify the
effort; but in the case of a large and complex plant covering widely
separated areas and serving many and different communities, as is the
situation with railroads, in the minds of many the results obtained in
such instances are of doubtful value when compared with the effort and
cost expended. Though much can be learned from such valuations, the
principles underlying them differ at many points from those which must
control in valuations as applied to commercial balance sheets. It is in
connection with public service valuations that very valuable studies of
the depreciation problem have been made.
Valuation for Sale and Purchase
Again, valuations and appraisals are often made in cases of prospective
sale and purchase negotiations. While most of the determining
principles are the same, not all apply to our problem of going concern
valuation. Thus, the plant to be purchased may not be continued in its
present use but must be adapted to other uses. Results secured towards
controlling the market by means of this purchase may make the plant
much more valuable than its physical worth. Elements of “going concern”
and good-will call for valuation in the case of a purchase and sale
transaction and are frequently not present in commercial balance sheet
valuations. These last questions touch closely our problem and will
receive careful consideration in their proper places.
Other Kinds of Valuations
There are several other kinds of valuations, all more or less closely
related to commercial balance sheet valuations but differing from
them in some respects because of their differing purposes and ends
sought. The chief of these are: (1) valuations for purposes of fire
loss adjustments; (2) valuations for purposes of liquidation to satisfy
creditors and determine the owners’ equities, as in bankruptcy and
voluntary dissolutions; and (3) valuations for purposes of taxation.
In all of these cases, many points of similarity to, and of some
differences from, our present problem are found. In the first and third
kinds enumerated, there is marked similarity, but the problem in the
case of the income tax is not so broad. In the second kind, the problem
is entirely different, as values have to be determined on the basis of
forced sale.
Going Concern Valuation
The kind of valuation to be treated here may be called “going concern”
valuation. By that will be meant the values at which the various items
shall appear in the balance sheet when viewed from the standpoint of
a concern which expects to continue operations—a going concern as
contrasted with one which is facing dissolution, reorganization, sale,
or other eventuality. As stated above, the principles of going concern
valuation are not distinct and separate, except in a few instances,
from those governing the other types of valuation referred to.
Oftentimes they are the same principles applied in the same way because
the purpose is practically the same; again they are the same principles
but applied differently in order to serve different purposes; and
finally they are sometimes entirely distinct principles because the
purpose to be served is entirely different.
It is not purposed in this treatment of valuation to set forth the
points of variance and sameness with the other types; that is beyond
the scope of the present volume. Endeavor will be made to set forth
clearly underlying principles and their detailed application to the
chief items met in the average balance sheet as viewed from the
standpoint of a going concern. Elsewhere, notably in Chapter XXXV, some
principles of another type of valuation will be discussed.
In any consideration of valuation, it is necessary to seek out the
sources and kinds of value to determine in the one case its basis, and
in the other to establish the type of value applicable to the given
conditions. Value is not of spontaneous origin; it cannot be created
out of nothing. Here it is not intended to search for causes of value
or to inquire into the forces back of them. The author is content to
leave that to the economist.
Kinds of Value
Various kinds of value are established facts of the world of business
and by their sources, as the term is used here, is meant the
information which vouches for or establishes the fact of value, rather
than a search for the cause of it. Thus we find, among others, the
following kinds of value:
1. Cost value
2. Market value
3. Sales price value
4. Reproduction cost value
5. Scrap, salvage, junk, or break-up value
6. Service value
7. Present or depreciated value
8. Tangible or physical value
9. Intangible value
10. Taxable value
11. Earning value or earnings-capitalized value
12. Liquidation or forced-sale value, etc.
It is to be understood that these various kinds are in no sense
mutually exclusive and separate; they are met in the common vocabulary
of men of affairs, are construed loosely in most cases, but have quite
technical connotations in some places. Any of the terms employed
here will, whenever necessary, be defined. Thus, in accounting, by
cost value is usually meant full cost of a product or other asset in
position ready for its intended use.
Source of Data as to Values
The sources of data as to values are several. Where double-entry
books are kept, the original cost of the various assets can usually
be secured from the books of account, barring errors of principle and
omission in making the record. If not found there (as is often the case
where single-entry books are kept), the original purchase invoice gives
the chief item of cost, but does not usually show any inward-carrying
or placement costs. Where there is a formally established market,
this may give the information as to value when no book entries are
available. Quoted prices in trade catalogues or lists as of the date of
purchase, offer another means of procuring the information. Sometimes,
even the memory must be relied upon.
Present values of properties purchased formerly may be determined on
the basis of original cost adjusted to take cognizance of depreciation
and, sometimes, of appreciation. This adjustment is made in the light
of the best available experience. The amount of the adjustment is
sometimes called an “experience figure.” Stated otherwise it is an
_estimate_ made on the basis of past experience with some regard
to future contingencies. This estimate may be made by some one
within the organization—manager, owner, etc.—or by regular appraisal
companies who specialize on this kind of work. Usually, however, the
appraisal company bases its value on present cost less depreciation—a
reproduction cost value.
Again, for some purposes the statement of earnings as giving the
amount to be capitalized becomes the source of values. As has been
seen, however, earnings themselves contain many elements which rest
on estimated values. In almost all instances there is an element of
speculation—an estimate—in the determination of values.
Cost Value the Usual Basis
The values which are, for the most part, shown in the commercial
balance sheet are cost value or adjusted cost value. Occasionally,
values which bear only an indirect relation to cost must be taken into
account. The determination of cost value is sometimes a comparatively
simple matter, as where the source is a purchase invoice, but more
often it involves numerous other costs in addition to those shown by
the purchase invoice, both definite and indefinite, i.e., estimates.
It is in connection with the determination of cost that the proper
segregation of the so-called capital and revenue charges is of vital
importance. An effort will be made to formulate the distinction between
them so as to give a working rule for their determination under most
circumstances.
Definition of Capital and Revenue Expenditures
Capital expenditures may be defined as expenditures of funds or other
assets on capital account. In accounting language, they may be said to
be those expenditures which result in charges to some asset account.
They may sometimes ultimately result in a charge to a liability account
by the conversion of the asset to the decrease of the liability.
Expenditures of capital may be made on account of expenses. This can
occur only when revenues are insufficient to meet all expenses. Such
expenditures of capital bring about an impairment of capital. As the
term is generally used, however, capital expenditures have the meaning
first given.
Revenue expenditures may be defined similarly as expenditures of funds
or other assets on revenue account. That is, such expenditures must
be booked as charges to expense accounts. They represent the expenses
incurred in the earning of the revenue, and measure its cost. Just
as the original capital fund, through its expenditure, must provide
the plant and equipment with which to work, so the other expenditures
necessary to prepare and market the product must provide the revenue
out of which to meet these expenditures and secure a margin of profit;
else there is encroachment upon the original capital funds.
A few other terms need definition by way of differentiation from these.
The term “capital receipts” is used to differentiate receipts of funds
from the sale of capital stock or the sale of capital or fixed assets,
from funds or other assets received from revenue or profits sources.
Thus, upon the sale of any asset which was originally purchased out of
capital, the receipts therefor must first be applied to take the place
of the capital expended for the asset, and any balance not used for the
first purpose is then a receipt of revenue.
The term “capital expense” is sometimes used to indicate the group of
expenses incurred in providing the capital needs of the business. They
are the financial management expenses as the term is used in Volume I.
Opposed to capital expenses are the capital income or revenue items.
These are the receipts or income from portions of the capital employed
otherwise than in the purchase and sale of commodities; or the income
which represents savings effected through the handling of the funds of
the business as distinguished from income derived from the handling of
stock-in-trade. They are _deductions_ from the financial management
expenses.
Capital and revenue expenditures are thus easily differentiated on
paper. It is in the application of the definition to situations as
they develop in practice that difficulty is encountered. Some of
these situations will be examined with the purpose of determining the
application to them of the distinction between revenue and capital
expenditure.
Organization Expenses
Upon the organization of a new enterprise the distinction between
capital and revenue expenditures can usually be made without much
difficulty. All costs incurred to put the concern in a position to
earn revenue are properly treated as capital expenditures. Sufficient
capital must be provided to put the undertaking on an earning basis,
as otherwise it fails. These costs will include many items which upon
their _second_ incurrence must be treated as expense charges because
the revenue must provide for keeping the plant in a state of efficient
repair. One group of capital expenditures, usually carried on the books
under the title “Organization Expense,” is often treated as a revenue
expenditure as soon as sufficient revenues have accumulated to care
for them conveniently. This is discussed in detail in Chapter XVIII
on intangible assets. It is sufficient to say here that upon their
incurrence organization expenses constitute capital expenditures, for
no other funds are available for the purpose.
Definition of Replacements, Renewals, Maintenance, etc.
Only after the concern becomes a revenue-producer is the chief
difficulty encountered in determining the proper record as between
capital and revenue. In all cases of new construction and additions
to the existing plant or equipment, no question arises as to the
legitimacy of such capital charges. But when replacement, renewal, or
betterment of existing properties take place, difficulty is met in
determining the portion chargeable to the asset and the portion to
be charged against revenue. The dividing line between renewals and
repairs, maintenance, and up-keep is a closely drawn one, and usually
an arbitrary working rule suitable to conditions must be adopted by
each concern. R. P. Bolton[11] gives for some of these terms very
suggestive definitions which the author quotes in full:
[11] In “Power for Profit.”
“Maintenance is a process of continuous attention to, and supply
of, operating necessaries, including solicitous observation of the
condition of the object cared for, corresponding to the protecting
shelter, clothing and food supplies to living beings, in order to
maintain their functions in operating condition. It includes supplies
which form part of the food of the appliance. Part of the labor in
attendance on machinery is involved in this element of its care.
“Up-keep is a course of partial recreation, involving the expenditure
of time and money in anticipating causes of decay, of failure, or of
possible injury to the object under care, corresponding to hygienic
and recreative methods, often involving considerable expenditures
without apparent direct results, which are or should be followed in
safeguarding the general health and strength of human beings. Thus,
welfare and recreation of employees is a justifiable expense of an
industry. It is part of the cost of the human machine.
“Repair is the course of partial reconstruction, replacement, or
renewal of worn or of injured portions, after the necessity therefor
becomes apparent, and, unless brought about by accident, the need
for the process is brought about by the failure or inability of
maintenance, and also of up-keep, wholly to arrest the progress of
decay by age or continued use. Provisions to preclude accident or to
cover the cost of its results are part of the cost of repair. Health
insurance of employees is a repair cost paid in advance.”
While these definitions were not intended for accounting purposes and
are not fully applicable thereto, they call attention to the basic
ideas of the terms. The distinctions are in some cases too finely
drawn. For accounting purposes the title “maintenance and repairs”
usually gives sufficiently detailed information. Repairs is a part of
the process of maintenance, as is also renewals. Maintenance, from an
accounting standpoint, may be defined as “the act of keeping a property
in condition to perform adequately and efficiently the service for
which it is used.” A. Lowes Dickinson[12] defines repairs and renewals
as follows:
[12] In “Accounting Practice and Procedure.”
“Repairs. This should include all current expenditures recurring from
day to day and from month to month on the general up-keep of the
existing property without the renewal of any substantial part thereof,
and generally all periodic repairs which are necessarily undertaken
within, say, one year.
“(This caption will, of course, include certain renewals of small
parts, etc., such as would be necessary to continue the useful life of
any unit of building, plant, or machinery over the estimated period of
its life.)
“Renewals. This should include all expenditures incurred in renewing,
in whole or in part, any unit of building, plant or machinery,
which tend to extend its useful life beyond the average term. These
expenditures would in general be those which would only occur at long
intervals of two or three years, and whose effect would last for a
number of years afterwards.”
As distinguished from renewals, a replacement may be defined as “the
act of replacing a plant unit which is going out of service, with a
_substitute_ which may be either identical with the unit replaced or
different from it.” In accounting terminology the terms “renewals” and
“replacements” are for the most part used synonymously and will be so
used here.
Treatment of Renewal of Parts
In the maintenance of a property in efficient condition, repairs and
renewals are constantly taking place. When for an old part or plant
unit a new one is substituted, the question of betterment immediately
arises. If an old machine with book value of $500 is replaced by one
costing $750, the excess of $250 is classed as a betterment and is
properly a charge to capital. A renewal of machine _parts_ cannot be
handled so easily. The parts of a machine are subject to diminution in
value due to wear, tear, and obsolescence, along with the machine as a
whole. The machine was purchased for a lump sum. What portion of the
cost is applicable to each individual part is difficult to determine
and must usually rest on estimate or guess. Similarly, the book value,
i.e., the present depreciated value of a part, is not accurately known.
Accordingly, the amount of betterment, if any, in the replacing of
an old part by a new part is difficult to determine. It is here that
working rules must be adopted for each concern.
Thus, it has been suggested that only when the renewal involves an
expenditure of $5 or more should there be any attempt to determine
the amount of betterment, every expenditure under $5 to be charged
to expense. In an establishment of any size this is altogether too
small an amount. The Chicago Traction System through its board of
supervising engineers has established $200 as the minimum charge to
capital or renewals. All transactions involving even a true betterment,
if the amount is less than $200, are to be recorded as maintenance
charges. As a means of simplifying the accounting, a working rule, with
a minimum capital charge adapted to the conditions of each concern,
serves a practical and useful purpose.
Treatment of Cost-Cutting Changes
Other kinds of expenditures which cause trouble as to their proper
place of record are those incurred for the purpose of facilitating
the handling of the work. They may result in an increase of capacity
to earn revenue through a speeding up of production, or the result
may be simply a lessening of the expense of turning out the various
units of product. A test frequently applied in such cases is that of
increased earning capacity. It is argued that even though nothing
tangible which did not exist before has been added to the plant,
there has been a rearrangement of the factors of production with a
resulting co-ordination of effort, and this has increased the capacity
of the plant, thus making it more valuable. Inasmuch as this value is
measured by earnings, the cost incurred in securing the increase is a
very proper and legitimate charge to capital. Against this argument,
it may be said that plant or structural changes are always made to
improve operation. To make increased earning capacity the sole test is
virtually to capitalize all expenditures of this kind—a policy which
would soon lead to an unconscionable inflation of assets. Only by a
policy of very liberal depreciation can such values if capitalized
be kept within reasonable bounds. The impropriety of charging such
expenditures to the current profit and loss account is generally
acknowledged.
The best practice is to handle items of this kind as deferred charges
under suitable descriptive caption, instead of as charges direct to
the asset account where the nature of the items is soon lost from view
and the need of a high depreciation rate to write them off is soon
forgotten. Thus, a rearrangement of the machinery in a plant may bring
about a more economical routing of the product, or the introduction of
a new machine may entail an entirely changed disposition of existing
machines—all for the purpose of, and actually accomplishing, a saving
in costs. Rather than a charge of the costs incurred to the asset
account Machinery, a setting of them up under the title “Rearrangement
Costs of Machinery,” or other similar title, shows their exact status
and makes possible an intelligent writing down of them periodically
in accordance with the estimated life or continuance of the savings
effected. Practically this amounts to treating the costs as capital
expenditures if the saving effected is judged applicable to more than
the current period. The chief difference is that booking such items as
deferred charges calls for specific attention to the need of a speedy
writing off.
Asset Subject to Depreciation a Deferred Charge to Operations
In this connection it may be pointed out that the cost of all assets
subject to depreciation may well be looked upon as deferred charges
to operation, some portion of that cost being charged off at the
close of each fiscal period. “So we see that capital expenditures,
as distinguished from expenses, are at last an arbitrary conception.
It begins with the idea that certain expenditures have an efficiency
which reaches over many earning periods extending indefinitely into the
future. But nothing physical would last so long, and its earning power
might have even less permanence. To meet this condition we arbitrarily
designate certain expenditures whose effect indefinitely outlasts the
immediate earning period as ‘capital,’ and then in the same arbitrary
way, through all subsequent vicissitudes, we hold them to their first
value by maintenance, renewal, and depreciation charges which are borne
by other expenses.”[13]
[13] “Handbook of Railroad Expenses,” by J. S. Eaton.
Authorization for Booking Capital Expenditures
As regards a suitable method for handling transactions which involve
a separation into capital and revenue charges or a determination of
the status of the transaction as between capital and revenue, proper
authority should be secured for making the expenditure. Where possible,
before its incurrence, authorization as to its proper booking should be
given, even to the amounts where feasible, and this order becomes thus
the voucher supporting the entries on the books.
Repairs on Second-Hand Plant
In one situation repair charges which are ordinarily an expense must be
capitalized. Where a company takes over a plant which is badly run down
and out of repair, the expenditures necessary to bring it to a state of
efficient operation are capital expenditures. Such a plant resembles
a partially completed plant, and the purchase price is supposed to
take that fact into consideration. It is expected that additional
capital will have to be sunk to rehabilitate the property and put
it in a condition of repair necessary to earn revenue. Accordingly
the expenditures necessary to do this are rightly treated as capital
charges.
Construction Costs
A final consideration in the distinction between capital and revenue
expenditures has to do with certain costs incurred during the period
of original construction. We may cover the situation by a general
statement to the effect that all costs necessary to produce a complete
plant in condition ready to earn revenue are proper charges against
capital. Thus, interest on moneys borrowed for construction purposes
is a proper charge to capital, and in England it has been held that
dividends in the form of interest are allowable to _shareholders_
during the construction period. Also, such items as engineering
and superintendence, law expenditures, injuries, taxes, etc., both
preliminary to the construction period and during it, are to be
capitalized. On the other hand, profits on own construction work are
never to be counted as costs. To do so reveals a misunderstanding of
the difference between a profit and a saving. The matter is discussed
more at length elsewhere.
As to whether any portion of the overhead expenses has a rightful place
among the assets must be determined by the conditions in each case.
In original construction work, before operations begin, all overhead
charges constitute a part of the cost of the assets. For betterment
work and additions carried on concurrently with operation, the case
is not so clear. A safe principle is to treat as capital charges all
increases in overhead above what would normally have been incurred
for operation only. To free operation of any portion of the _regular_
overhead just because betterments are in progress is not recognized as
a sound or conservative policy.
Distinction between Capital and Revenue Expenditures often Based on
Opinion
Thus it is seen that many phases of the problem of capital and revenue
expenditures are extremely difficult of determination and in their
final analysis rest on estimates and opinions rather than definitely
established facts. Too often it is feared that decision in matters
of this kind is “influenced by unsuspected individual caprice and by
considerations of the financial convenience of the moment”; for the
allocation of such items may sometimes represent the margin between
a profit or a loss for the current period. As is said to be true of
geometry, so here there is no royal highway to the solution of these
problems.
Main Groups of Asset Items
If, therefore, it can be determined what items are to be included
in the balance sheet and the proper basis for their valuation can
be established, the problem as to its content is well on the way to
solution. Having discussed the elements and factors entering into
a determination of cost value, we are in a position to state the
principles of valuation applicable to the main groups of items as
set up in the balance sheet. These may be listed, for the purpose of
this generalization, under three heads, viz.: (1) current assets, (2)
deferred charges to operation, and (3) fixed assets.
1. For the current assets, the principle of valuation may be stated
as valuation on the basis of cost or market, whichever is the lower.
Since speedy realization of the current assets by conversion into cash
for its equivalent is the aim and expectation of every business—for on
such conversion depends the ability to meet the current liabilities
and so have working capital available for another cycle of purchase
and sale (another turnover)—it would seem that the realization price
as given by the market should govern. In the interest of conservatism
and as producing certain other desirable results which will be brought
out as each asset is examined in detail, cost price, if lower than
market, is deemed the desirable basis for the valuation of this group.
By way of explanation, it should be said that working capital as used
here is the difference between current assets and current liabilities
and so represents the portion free to be put to the further pursuit of
business.
2. The principle of valuation involved in deferred charges to operation
is simply the principle of equitable prorating between periods on the
basis of a going concern. Here, not sale value, cash surrender value,
or forced sale value govern, but their value to a concern which expects
to continue operations.
3. For the fixed assets, the principle of valuation generally
applicable may be stated as valuation on the basis of cost less
depreciation. This group of assets represents the properties held for
operating and without which operation could not continue. They are the
very essence of the enterprise. Disposal of them would mean abandonment
of the undertaking. Hence they are not held for realization and
conversion into cash, and in a going concern market value has no effect
on them. To a going concern they are worth at any time what they cost
less the portion used up in operations to date. Therefore valuation at
cost less depreciation is the proper basis for showing the fixed assets
in the balance sheet.
Valuation of Liability Items
To the liability items of the balance sheet, principles of valuation
are not directly applicable as such, except so far as content or
inclusion and measure of quantity or amount may be said to embody
considerations of valuation.
Over- and Under-Valuation
The need for correct valuations requires no comment and can best be
appreciated as compared with the effects of over- and undervaluations.
Particularly bad and harmful is overvaluation of the assets and
undervaluation of the liabilities. The use of the balance sheet as
an index of financial condition makes apparent the harm of wrongful
content or valuation of the items entering into it.
The Balance Sheet an Expression of Opinion
It is thus seen that the main problem in connection with the
presentation of a true balance sheet is a problem in valuation and
content rather than form. From what has been said it will be evident
that valuation in the vast majority of cases is not an exact science—a
process of definite determination. Rather, from the nature of the data
to be handled and the principles of valuation given as applicable
to the various groups of data, valuation must almost always be an
estimate. The determination of the value of the elements of cost,
the proper differentiation between capital and revenue charges, and
finally the calculation of the amount of depreciation necessary to
the valuation of fixed assets—all are estimates. It is true, they are
estimates based on experience, but, from their nature and the influence
of local conditions in a given case, no universally applicable law of
experience can be formulated. It is safe to say that two men would
seldom, if ever, arrive at the same estimate of the values of given
assets. Accordingly the conclusion is reached that a balance sheet
is not a statement of fact but always an expression of opinion. If
estimates are carefully made in the light of all available facts
applicable thereto, the expression of opinion in the balance sheet will
approximate as nearly as may be to a statement of fact.
Because depreciation plays so important a part in making these
estimates, it seems necessary, before setting forth the detailed
application of the principles of valuation to the various assets, to
devote several chapters to a full discussion of the subject, chiefly
as it is related to the problem of valuation but also in some of its
correlated aspects.
CHAPTER VI
DEPRECIATION—ASPECTS AND DEFINITIONS OF TERMS
Aspects of Depreciation
Depreciation is intimately related to practically all problems
of valuation. The engineering profession has made many valuable
investigations and contributions to the literature of the subject and
constant reference to them and use of some of their findings will here
be made. Most of their studies relate to the vexed and still unsettled
question of the valuation of public utility properties for the sake
of its bearing on the problem of fair and equitable rates to the user
or consumer. Accordingly much of this material is not applicable to
the accounting phases of the subject. It is purposed here to treat
the question from the standpoint of accounting rather than that of
engineering.
Depreciation may be considered from many viewpoints. It is involved in
the problem of rate-making referred to above; it must be considered in
the valuation of fire insurance adjustments; it is bound up with most
questions of taxation, with all transactions involving the purchase
and sale of enterprises, with negotiations for the procuring of loans,
for the determination of the limitation of capitalization; and in all
studies of commercial balance sheets depreciation is found to affect
the value of going concerns. As stated in Chapter V, these are not
always separate and distinct problems of valuation; they may and often
do overlap, one basis for valuation sometimes serving several of the
purposes or classes named above. The treatment of the subject will be
limited in this book to the latter phase of the subject, i.e., going
concern valuation, with the object of establishing certain norms and
differentiating this phase of depreciation clearly from its other
relations.
Definitions
A clear-cut definition of depreciation is desirable. The word in a
general sense means a lessening, a decrease in value; decretion;
deterioration. Various specific definitions are given, among them
being: “the loss, arising from years of service, in the value of the
investment in perishable property”; “expired capital outlay.” These and
many other similar definitions are met with.
The term “depreciation” is frequently used when the term “amortization”
would be more appropriate. R. P. Bolton[14] says: “The subject of
depreciation has been greatly misrepresented, because depreciation,
which is a financial result, has been confused with obsolescence, which
is an economic process, and with deterioration, which is a physical
condition. Either of the latter brings about depreciation, and the
physical process rarely happens to be more rapid than the economic.
“An illustration of the processes involved is that of the physical
deterioration and obsolescence of a work horse, the capacity of which
is definitely connected with its condition, and the value of the labor
of which is discounted by its up-keep and the cost of its supplies
and feed. Its age is productive of reduction of capacity, but this
process may be, and often is, anticipated for commercial reasons by
its supersession by some other form of apparatus. The horse may be in
ever so good a condition at the time when the motor displaces it, but
its financial depreciation then is complete, for it could be maintained
only at a loss. All the elements which come into consideration in
connection with machinery will be better understood if considered in
relation to such an animal, the life of which may readily extend beyond
the point at which its commercial value has terminated.”
[14] In “Power for Profit.”
Authoritative Opinions
The special committee appointed by the American Society of Civil
Engineers for the purpose of formulating principles and methods for
the valuation of railroad property and other public utilities, after a
study of the question covering a five-year period, presented its report
at the annual meeting of the society, January 17, 1917. The question of
depreciation receives full and serious consideration in this report,
which although treated mainly from the rate-making standpoint offers
many suggestions for the valuation of commercial balance sheets. Their
statement reads:
“Perhaps there is no single subject in connection with valuation that
has caused more trouble than depreciation. This has been due to various
causes, perhaps not the least of which has been confusion in the use
of the term. Depreciation is sometimes used to mean decretion, which
is loss of service life; sometimes to mean the money allowance made in
the bookkeeping to offset accruing loss of service life; and sometimes
the loss of value existing at any time due to the loss of service life
or any other cause. The committee will use it only as meaning the loss
of value or worth of property units which are parts of going concerns.
Although this may be due to many causes, the general discussion will
include consideration only of those effects which, like wear and tear,
age, use, and obsolescence or inadequacy, bring a physical property
unit gradually to the end of its service life.”
Earl A. Saliers[15] says: “This loss of value, whether tangible or
intangible in form, resulting from physical decay, or from obsolescence
or inadequacy, which indicate functional decay, is known as
depreciation. It necessitates repairs, renewals, and replacements. Did
it not occur, every outlay on plant would add to the investment. It
does not result from one cause but from many causes, and this sometimes
leads to the belief that it cannot be scientifically handled. But some
adequate method of handling it is not merely desirable, but necessary,
to a solution of the problems arising in the valuation of public
utility properties, and in the management of industrial enterprises
generally.”
Henry Floy[16] says: “It (depreciation) is used broadly to mean a
reduction in utility value, expressed as a percentage but more usually
in dollars, due to any deterioration in physical plant by reason of:
(a) normal wear and tear, (b) age or physical decay, (c) inadequacy,
(d) obsolescence, (e) deferred maintenance. The term depreciation,
always used in connection with a reduction in value, has, however,
four distinct and separate shades of meaning, so that the term must be
qualified when used in order to distinguish which one of the following
meanings is intended:
[15] In “Principles of Depreciation.”
[16] In “Value for Rate-Making.”
“First. The annual amount, expressed as a percentage or in dollars,
that should be laid aside to renew or replace the article in question
at the time of its abandonment.
“Second. The annual amount, expressed as a percentage or in dollars,
that should be laid aside to renew or replace the article in question
at the time of its abandonment, plus the annual expense of maintenance
and repair expended in removing such part of depreciation as is
practicable and good economy.
“Third. The total amount—usually that estimated as necessary to
be expended to put the physical property in perfect operating
condition—determined by the inspection and observation of an
experienced engineer, expressed in a percentage or in dollars, which
must be deducted from the ‘original cost’ or the ‘cost to reproduce
new,’ in order to determine the absolute, actual, present value.
“Fourth. The total amount—it may be the sum of several years of
depreciation—computed from ‘expectancy of life’ tables, more or less
authoritative, expressed in a percentage or in dollars, that must be
deducted from the ‘original cost’ or the ‘cost to reproduce new,’ in
order to obtain the theoretical, present, depreciated value. This
value may be increased or reduced by the condition of the property, as
determined from inspection.”
The foregoing quotations from authoritative sources not only show the
efforts made to define the term accurately, but also indicate the
various elements included by different writers under the term, and
suggest the need of further effort toward the standardization of its
meaning.
Why the Depreciation Factor Arises
The distinction made in Chapter V between capital and revenue charges
draws attention to the fact that the depreciation factor arises
only because the fiscal or other period when information concerning
values and costs, i.e., financial condition, is desired, does not
coincide with the expiration of service life of the properties used in
production. If the information just referred to were not desired at
intermediate periods between the date of acquisition of the asset and
the date of its discard or obsolescence, its cost should be treated
solely as an expense of operation to be charged to the whole period
in the same way that the fuel consumed, the raw materials used, etc.,
are regarded as revenue charges, or costs of manufacture. Practically,
therefore, depreciation must be considered because a statement of
financial condition is needed at regular stages of the life of the
enterprise; and furthermore because the life of the various assets used
in an undertaking is not uniform in length and their life histories
in consequence overlap. Some assets wear out and have to be replaced,
while others have still many years of useful service in them.
Actual or Absolute Depreciation
Before considering the various elements of depreciation, an explanation
of some related terms will be given. A distinction is sometimes made
between “absolute or actual” and “theoretical” depreciation. Absolute
depreciation is the decrease in value of an asset from its state when
new, to its present condition _as viewed either from the standpoint
of the amount it could be sold for_ or from the standpoint of its
serviceability. In the first place, therefore, absolute depreciation
is not applicable to going concern valuations. A machine after only a
short term of service becomes, from the standpoint of its salability,
a second-hand article and suffers a large decrease in _market_ value.
A water-pipe or an underground telephone cable immediately after its
installation and even before it is brought into service depreciates
materially from the standpoint of its salability as a disconnected
unit. But from the standpoint of service and operations, i.e.,
adaptability to its intended use, such an asset may really be more
valuable than before or immediately after installation. Again, an asset
because of the excellent state of repair in which it is maintained
may, so far as the serviceability required of it is concerned, be
practically as good as new from the date of its installation until
well along towards the end of its life-term. Its actual or absolute
decrease in value is very slight during the early years of its life but
increases rapidly just before it is discarded. This fact is illustrated
by the example of the water-pipe. Slight repairs, the replacement of
parts and small units, keep it for a long period 100% efficient, but
the time comes when it is completely worn out and repairs are no longer
economically advisable. These two examples illustrate absolute or
actual depreciation.
Theoretical Depreciation
Theoretical depreciation is based upon, and has reference to, _all_ the
factors which must be considered in taking account of depreciation. As
so considered the subject is viewed from the standpoint of financing
the item of depreciation (sometimes called “accounting depreciation”)
rather than from that of its serviceability. The engineer attempts to
determine the actual, present serviceability of the asset in comparison
with its serviceability when new, and so he leaves out of account its
expectancy of life due to whatever causes.
Comparison of Actual and Theoretical Depreciation
The following chart adapted from Henry Floy’s “Value for Rate-Making”
admirably illustrates the difference between actual and theoretical
depreciation.
[Illustration: _Chart Showing Actual and Theoretical Depreciation_]
Curves 1, 2, and 6 representing actual depreciation have been
sufficiently exemplified in the foregoing explanation of actual
depreciation. Curves 1 and 2 may well represent the actual depreciation
of two assets as viewed from the standpoint of salability; whereas
curve 6 represents the actual depreciation of an asset viewed from
the standpoint of serviceability, assuming that maintenance has kept
the asset practically 100% efficient during most of its life-term.
Curves 3, 4, and 5 are illustrations of _theoretical_ depreciation,
the different curves representing different bases for calculating the
annual amount of the decrease in value, as will be explained in Chapter
IX, “Depreciation—Methods of Calculating.” To quote from Mr. Floy’s
work at length:
“The curves 3, 4, and 5 indicate several classes of ‘theoretical’
depreciation which have been quite widely used in some cases for
estimating present values, but more often for determining the yearly
theoretical deterioration for purposes of establishing depreciation
funds, which, however, is quite a different subject. Making a
theoretical estimate of the probable, future, average, annually
accruing deterioration of certain property to provide an item in
bookkeeping accounts of operating expense has nothing whatever to do,
in making an appraisal, with fixing the definite amount of absolute,
actual, or accrued depreciation which depends upon the present
condition of physical property, determinable from inspection and not
upon historical documents, depreciation funds, or disputed theoretical
conclusions.”
In an opinion filed March 8, 1916, by the Public Service Commission of
Maryland in the matter of the Chesapeake and Potomac Telephone Company
of Baltimore City, an interesting commentary on the relative merits
of actual versus theoretical depreciation is made. While the opinion
concerns primarily depreciation from the rate-making point of view,
it shows well the interrelation between the two kinds and answers so
conclusively the objection often raised to accounting depreciation that
it is here quoted. The statement is:
“Any theory for ascertaining existing depreciation in the plant of a
public utility which confines such depreciation solely to the actual,
visible, physical, demonstrable deterioration which can be seen by the
human eye and measured by the human hand, must of necessity ignore
that other species of deterioration which the experience of the past
has demonstrated beyond peradventure exists in the property of every
telephone company, although it cannot always be seen by the human eye
or measured by the human hand. We refer to that tendency upon the part
of all such property to become inadequate or obsolete with the lapse of
time.”
“Accounting” and “Fair” Depreciation
Another distinction is sometimes made between “accounting”
depreciation, previously mentioned, and “fair” depreciation or
depreciation of valuation. Accounting depreciation signifies the
depreciation, determined by whatever method, which has been taken
into the accounts, i.e., the depreciation as shown on the books. This
is approximately the same as theoretical depreciation defined above.
Its point of view is that of financing the loss of value caused by
depreciation so as to cover the entire loss by the time the asset is
retired from active service rather than that of establishing a true
actual value of the asset at intermediate periods. On the other hand,
fair depreciation or depreciation of valuation is the “sum that should
be deducted from original cost to date (or from estimated cost of
reproduction new)[17] as a step in finding that which the courts have
called ‘fair value.’” Here the point of view is essentially that of
showing the true value of the asset at a given date. Determination of
this is fundamentally an engineering problem in the solution of which
cognizance must be taken of:
[17] Material in parentheses is the author’s.
1. Accounting depreciation.
2. The managerial policy as to repairs, maintenance,
and renewals.
3. The past performance and expected future performance
of the asset.
4. All other factors locally present which may affect
the determination of the _present_, existing values
in the asset.
Under certain conditions fair depreciation corresponds roughly with
actual or absolute depreciation as defined above.
Complete and Incomplete Depreciation
Depreciation is sometimes classed as “complete” and “incomplete.”
Complete depreciation refers to those assets or properties which have
been discarded because no longer capable of economical service. When
their cycle comes to an end, depreciation is complete. Incomplete
depreciation refers to the amount of the decrement in value of assets
which are still in service. The accounting for complete depreciation
requires little consideration except so far as _rates_ of depreciation
are concerned. This class of depreciation represents the accomplished
fact and therefore furnishes data and statistics by which the
_expected_ depreciation of similar new assets can be calculated. The
accountant, therefore, is concerned with it purely as an experimental
means of forecasting the future.
Individual and Composite Depreciation
Again, depreciation is classed as “individual or unit” and “composite.”
Unit depreciation is the amount of the decrease in value of the
individual parts which compose the whole of a property; composite
depreciation is the amount of the decrease in value of the plant or
property as a whole. Its amount in dollars is the sum of all unit
depreciations similarly expressed. Expressed as a percentage it
represents the effect of all unit depreciations weighted by the ratio
of the value of each to the whole. Thus a plant as a whole may be
depreciated 20%, but the numerous units of that plant may have a range
of depreciation of from 0% to 100%. Some items may be ready to be
discarded and others will probably have just been newly installed.
In connection with composite depreciation the term “normal” or
“average” value is used. The normal value of a plant is the average
value at which it must be maintained to give efficient service. Any
drop below that point results in increased cost per unit of service
rendered, and is consequently evidence of poor management. Normal value
may sometimes be expressed in percentage as the difference between
100%, original cost, and composite depreciation. In the case cited
above, where composite depreciation is 20% the normal value would be
80%, under a proper policy of management.
Physical and Functional Depreciation
Finally depreciation is classed as “physical” and “functional,”
definition of which are deferred for treatment in Chapter VII,
“Depreciation—Its Causes.”
Deferred Maintenance and Accrued Depreciation
Other terms needing definition are: “deferred maintenance” and “accrued
depreciation.” The former refers to repairs which at any given time
are needed for the proper up-keep but which for one reason or another
have not yet been made. So long as an asset is giving reasonably
satisfactory service, repairs are usually deferred to a convenient
time—such as when work is slack, or until similar repairs may have
accrued elsewhere, or until weather conditions have changed, or in
general until the repairs can be most economically done. Similarly,
accrued depreciation refers to the depreciation which has taken place
between the last time an item was brought on the books and the present
time. The inevitable forces causing depreciation are constantly at
work bringing about the decretion of the asset day by day, but it is
impracticable to reflect such condition daily. Only at the close of
each fiscal period is it deemed necessary to adjust the books so that
they reflect the depreciation which has taken place during the period
just closed.
Attitude of the Law
Before studying the factors of depreciation it is interesting to note
the attitude of the courts towards depreciation. Accountants and
engineers recognized the necessity of taking account of depreciation
considerably in advance of its recognition by the courts of this
country. H. R. Hatfield[18] says: “France, Belgium, Switzerland,
Germany, Austria all prescribe in their statutes that depreciation must
be reckoned before showing profits.” The French Joint-Stock Company Law
specifically requires the reservation of some portion of the company’s
surplus for taking care of the depreciation of the assets. While the
method may not be scientific, the principle involved is recognized as
correct. But in an early English case, Lee v. Neuchatel Company, it
was held, in the case of a company operating inherently wasting assets
“that even depreciation by waste is not necessarily a revenue charge.”
[18] In “Modern Accounting.”
Early decisions in this country likewise fail to sustain the propriety
of depreciation charges. The cases usually cited are The Union
Pacific R. R. Co. v. United States, 99 U. S. 402, and United States
v. Kansas Pacific Ry. Co., 99 U. S. 455 (1878), the first not passing
specifically on the question of depreciation but showing a lack of
appreciation of the distinction between capital and revenue charges,
and the latter stating that “only such expenditures as are actually
made can with any propriety be claimed as a deduction from earnings.”
The Supreme Court of California in San Diego Water Co. v. San Diego,
118 Cal. 556 (1897), and in Redlands, etc., Water Co. v. Redlands,
212 Cal. 312 (1898), refused all allowances for depreciation except
necessary amounts for “maintenance and repairs during the year.”
However, in Pioneer Tele, and Tele. Co. v. Westenhaver, 118 Pac. 354,
the language of the court is not uncertain: “A sufficient sum should be
allowed from the earnings of a utility to make good the depreciation
of the plant and replace the deteriorated portions thereof, when they
become so impaired that they can no longer be made useful by repair.”
Decision of Supreme Court
The United States Supreme Court recognizes the necessity for an
allowance for depreciation in Mayor and Aldermen of the City of
Knoxville, Appt., v. Knoxville Water Co., 212 U. S. 14 (1909), which
forms the basis of judicial attitude towards the question at the
present time. The decision of the court which has been supported and
reaffirmed in all subsequent decisions, reads, in excerpts:
“A water plant with all its additions begins to depreciate in value
from the moment of its use. Before coming to the question of profits
at all the company is entitled to earn a sufficient sum annually
to provide not only for current repairs, but for making good the
depreciation and replacing the parts of the property when they come to
the end of their life. The company is not bound to see its property
gradually waste, without making provision out of earnings for its
replacement. It is entitled to see that from _earnings_ the value of
the property invested is kept unimpaired, so that, at the end of any
given term of years, the original investment remains as it was at
the beginning. It is not only the right of the company to make such
a provision, but it is its duty to its bond- and stockholders, and in
the case of a public service corporation, at least its plain duty to
the public. If a different course were pursued, the only method of
providing for replacement of property which has ceased to be useful
would be the investment of new capital and the issue of new bonds and
stock. This course would lead to a constantly increasing variance
between present value and bond and stock capitalization—a tendency
which would inevitably lead to disaster either to the stockholders or
the public, or both.”
Recognition of the Depreciation Factor
Following this decision the rules and regulations of the public service
commissions of practically all the states now require that provision
for depreciation be made. In the case of some of the smaller public
service companies the failure to make this provision is overlooked
but the practice is generally recognized as absolutely necessary. The
Interstate Commerce Commission has led in this respect, although its
early rulings relative thereto were strenuously objected to in some
quarters. Private concerns in their contact with the government now
almost invariably see the value, or at any rate the self-interest,
of a deduction for depreciation. In the case of the Special Excise
Tax, a Treasury decision on account of Internal Revenue provides that
“deduction on account of depreciation of property must be based on
lifetime of property, its cost, value, and use, and _must be evidenced
by a ledger entry_ and a like reduction in the plant and property
account with respect to which depreciation is claimed.”
Similarly, the present Federal Income Tax Law recognizes allowances
for depreciation, but perhaps errs in placing too stringent safeguards
on the amounts to be deducted therefor, whereas the Federal Trade
Commission realizes the need of liberal provision. The law reads:
“That in computing net income in the case of a citizen or resident of
the United States, for the purpose of the tax there shall be allowed
as deduction a reasonable allowance for the exhaustion, wear and tear
of property arising out of its use or employment in the business or
trade. No deduction shall be allowed for any amount paid out for new
buildings, permanent improvements, or betterments, made to increase the
value of any property or estate, and no deduction shall be made for any
amount of expense of restoring property or making good the exhaustion
thereof for which an allowance is or has been made.” The depreciation
allowed as a deduction from income must have actually been charged off
the books. Many interesting rulings—some almost absurd if carried to
their logical conclusions—have been made by inspectors and the Treasury
Department on points raised as to the application of the above law to
particular cases. A perusal of these decisions will well repay the
student who is interested in the subject.
Distinction between Repairs and Renewals
At this point attention is called again to the need of a careful
distinction between repairs (up-keep and maintenance charges) and
renewals (replacements and betterments). Only a clear definition of the
terms and a strict adherence to an adopted policy can prevent endless
confusion and absolutely misleading results. Such a policy is necessary
because in the practical handling of such items on the books the
theoretical aspect of the distinction between repairs and renewals must
always be modified by reason. The student is referred to the preceding
chapter where more detailed treatment of this point is given.
Depreciation and Plant Efficiency
The relation of depreciation to the efficiency of a plant or an asset
will now be considered. The amount of depreciation is not based on the
degree of efficiency of the service rendered by the asset. In other
words, a depreciation reserve is not in any sense an inverse measure
of the productive efficiency of the asset to which it relates, nor
does the sum of all depreciation reserves either indicate or measure
the degree of efficiency of the whole plant. A comparison of present
with normal value (as defined above) affords some index of productive
efficiency, but there is no direct ratio between the two. In any
well-maintained plant, however, the normal value is the value below
which the plant cannot be allowed to fall if the standard of efficiency
is to be maintained; and good management requires nothing less than
this. It has been variously estimated that normal value ranges from
75% to 90% of the original cost, and in some instances runs as low as
50%. The composite depreciation of from 10% to 50% represents the limit
beyond which the decrease in value cannot pass if efficient service is
to be given by the plant. Usually the sum of the depreciation reserves
for all the assets of the plant remains fairly constant because the
large reserves against assets that are almost ready to be scrapped are
offset by the smaller reserves of the assets just replaced.
Unit Efficiency
The efficiency of the _unit_, however, has a somewhat different
relation to depreciation. Units, i.e., individual assets comprising
the plant, are constantly wearing out and being replaced. The plant,
aside from exceptional cases, never reaches the point where it must be
discarded in its entirety and replaced as a whole. The depreciation
of each unit continues until the point of inefficiency is reached,
when it is scrapped and replaced. The unit frequently is allowed to
drop below its margin of efficient service before being scrapped, and
it may be made to render service much longer than is customary, by
means of heavy repairs and a relatively high up-keep expense. When to
scrap a particular unit involves a nice calculation. The heavy cost
of repairs necessary to secure good service from the old unit and the
possible loss through failure to accumulate a sufficient reserve must
be weighed against the cost of a new unit and its up-keep and running
expense. Usually the efficiency of the individual unit is very like the
parson’s one-hoss shay which “ran a hundred years to a day and then of
a sudden it went to pieces all at once.”
The following chart illustrates accurately the relation of efficiency
to uniform depreciation, the XCY line being the efficiency curve and
XY the depreciation curve. Also curve 6 of the chart on page 105 gives
a good illustration of the same point. Inasmuch as the depreciation
reserve must provide for the loss of the entire asset by the time it
goes out of service, it is readily seen that in judging an asset from
its bookkeeping record of cost and reserve there is no measure of
efficiency shown therein, since a normal efficiency must be maintained
by repairs at all times. The record is, however, a good index of the
_time_ when the point of inefficiency will be reached.
[Illustration: From “Principles of Depreciation,” by Earl A. Saliers.
_Chart Showing Progress of Uniform Depreciation and of Diminishing
Efficiency_]
Engineers hold the opinion that machinery as a rule cannot suffer more
than 25% to 50% _actual_ depreciation and give efficient service. A
depreciation reserve of anything more than that does not mean that the
point of inefficiency has been reached, for the reserve is usually
estimated and applied on the basis of _theoretical_ depreciation and
so takes cognizance of all its factors. It has sometimes been stated
that inefficiency is a factor of depreciation distinct from wear and
tear, obsolescence, and supersession. It seems a better statement of
the relation to say that the point of inefficient service is the limit
beyond which the three factors named cannot be allowed to operate or
have effect. The need of judging the efficiency of some kinds of assets
is not so apparent as of others. Thus in the case of poles, wires,
conduits, and the like, efficient service is secured until they are
worn out, with very little expense for up-keep. That is, such assets
are normally efficient throughout their whole term of life, and the
application of repairs will not appreciably extend their life nor
will it affect their efficiency. In the case of other assets, such as
machinery, telephone switchboards, motors, etc., the item of up-keep is
a very vital one in the determination of the point or margin between
efficient and inefficient service, and that in turn is an important
factor in the determination of the length of service life of the asset.
Thus, although efficiency and depreciation are intimately related, the
degree of depreciation at a given time is not by any means an inverse
measure of the efficiency of the service being rendered by an asset.
Depreciation and Fluctuations in Market Value
The relation of depreciation to fluctuation in value, due to whatever
causes affect the market, also deserves consideration. Depreciation
primarily refers to a decrease in value from a definite cost figure,
such decrease being due to certain well-recognized causes, of which
change in market value is not one. Thus, while it may be correct,
through a loose use of the term, to use the expressions, “depreciation
of securities,” “depreciation of real estate,” and similar phrases,
and there may be no likelihood of any misunderstanding, that is not
the sense in which the term depreciation is used here. Unfortunately,
market fluctuations are sometimes allowed to influence depreciation
charges.
Such influence may come about in three ways: (1) In valuation
proceedings for the determination of rates for a public utility
company, a basis frequently used is that of the cost of reproduction
or renewal less depreciation. The theory is that under existing views
of private property such a company has the right to the enjoyment of
all increments in its own properties and therefore has a right to
such rates as will earn a fair income on the present value of those
properties. Depreciation based on the present reproduction cost is in
this way influenced by fluctuations in market value, and the oftener
a physical appraisal is made and its determined values brought upon
the books, the greater will be the disturbance of the basis for
the depreciation charge. (2) Occasionally the practice is met with
of basing the present depreciation charge upon the estimated cost
to replace the old asset. This is discussed later and is mentioned
here merely to show a possible relationship between fluctuations and
depreciation. (3) Finally, in the _periodic adjustment_ of depreciation
rates and charges, the estimated scrap value of the asset does affect
the amount of the periodic charge. Changes in market value of scrap,
which may be considered as due to causes which will continue in force
rather than to the ups and downs of the market, may _legitimately_ be
reflected in the depreciation charge for the remaining life-term of
the asset and must be so reflected in the interests of accuracy in any
statement of true values.
Distinction between Depreciation and Depletion
Inasmuch as depreciation is not here used to apply to current assets
(with one exception noted below), and fluctuations in the market
value of any asset subject to depreciation need not be considered,
it may be well to state the class of assets to which it does apply.
In general the value of all fixed or capital assets is affected by
depreciation. The term frequently used in this connection is “wasting”
assets. Under this nomenclature is included any asset which wastes
away or is used up. For the sake of clarity the author desires to
limit the term depreciation to those assets which are clearly affected
by any of the causes of depreciation as discussed in the following
chapter. For those assets which are used up without any possibility
of their being replaced, and the life of which cannot be prolonged by
repairs and renewals, the term depletion will be used. Accordingly the
term “depreciation” will be applied to mine buildings and machinery;
“depletion,” to the mine. Both are wasting assets, but their waste is
due to somewhat different, although vitally related, causes. No better
definition of wasting assets has been formulated than that by P. D.
Leake[19] who says that they “consist of all forms of exchangeable
value which inevitably diminish while applied to the purpose of seeking
profits, increase, or advantage otherwise than by purchase and sale.”
[19] In “Depreciation and Wasting Assets.”
Effect on Different Kinds of Business
Some types of undertakings are more subject to the effects of wasting
assets than others. Concerns dealing in investments, insurance of
all kinds, brokerage and commission, manufacturers’ agents, banking
and financial houses, professional firms, and the like, only a small
portion of whose capital is tied up in fixed assets, are comparatively
unaffected by the charge for depreciation. Practically all other
concerns are subject to it in marked degree—manufacturers, mines,
transportation companies, light, heat, and power concerns, the
telephone, telegraph, and cable, construction companies, agricultural,
etc. Those engaged in extracting raw materials from the ground are,
with few exceptions, subject to a charge for depletion. Those with an
investment in any kind of terminating rights, such as leases, patents,
copyrights, non-renewable franchises for a fixed term of years, and so
on, are also subject to it. Opinions differ as to whether good-will and
trade-marks may properly be considered as subject to depreciation. They
will not be so considered here for reasons which will be stated when
the principles of their valuation are discussed.
It will be noted that thus far all examples given have been those of
fixed assets. The exception already referred to is made in the case of
the current asset, merchandise or stock-in-trade. The term depreciation
can perhaps correctly be used in connection with merchandise, which,
however, is not to be classed as a wasting asset. Due to some of
the causes discussed in the next chapter, the stock-in-trade of an
undertaking does truly depreciate in value. The method of accounting
for such depreciation differs entirely from that used for wasting
assets. Hence, the treatment of depreciation of merchandise will be
considered at the same time that its valuation is discussed (see
Chapter XIII.)
Having cleared the ground with this definition of terms and the general
statement of what the depreciation problem is, attention will now
be directed to a consideration of the causes of depreciation, to be
followed by the method of accounting for depreciation and a treatment
of some points growing out of the general discussion.
CHAPTER VII
DEPRECIATION—ITS CAUSES
Analysis of Causes
Most definitions of the term depreciation set the boundaries or
limits of its meaning by naming the causes. These are normally: (1)
wear and tear, or physical factors; (2) inadequacy and obsolescence,
or functional factors; and (3) accidents or contingent causes. This
statement of causes applies specifically only to physical or tangible
properties. In the case of intangible property, consisting for the
most part of rights of various sorts, the controlling cause is usually
merely lapse of time. The chart on the following page analyzes the
various causes and shows their detailed ramifications.
Age as a Cause of Depreciation
The physical depreciation of tangible properties arises from two main
causes, viz., the wear and tear from operation and the use of the
asset and the wear and tear of age, known as decrepitude. Immediately
upon the installation of an asset the forces of time and the elements
begin their ravages even before operations begin. As H. R. Hatfield[20]
trenchantly puts it, “all machinery is on an irresistible march to
the junk heap,” and the statement is equally applicable to all other
forms of wasting assets. The ties placed on the roadbed of a railway,
conduits put in place for carrying water, gas, steam, electric current,
or oil, rolling stock, poles for telephone and telegraph lines,
buildings, even interior installations of various types—all are subject
to the normal ravages of time and the elements, and nothing which man
has been able to devise can do more than retard the inevitable. Thus,
all assets decrease in value through the inevitable lapse of time.
Attention should be here directed to the fact that decrepitude depends
on the _normal_ action of time and the elements, whereas accidents due
to action of the elements (listed in the chart on page 121, under III,
1, b) are of an _abnormal_ character and cannot usually be taken into
full account at the time of the installation of any particular piece of
property.
CAUSES OF DEPRECIATION[21]
{ { 1. Wear and Tear from Operation
{ I.Physical { (a) Maintenance Policy
{ { 2. Decrepitude
{ { (a) Action of Time and the Elements
{
{ II.Funct- { 1. Inadequacy or Supersession
{ ional { 2. Obsolescence
{ { { (a) Negligence
{ { { { Fire
{ { { { Lightning
{ { 1. Accidents { (b) Elements { Wind
A. Tangible { { { { Water
Property { { { { Temperature
{ { { (c) Structural Defects
{ {
{ { { (a) Parasites
{ III.Contin-{ { (b) Pollution of Water
{ gent { { { Mineral
{ { 2. Diseases { (c) Growths in { Vegetable
{ { { Water-Mains{ Animal
{ { { (d) Electrolysis
{ { { (e) Crystallization
{ {
{ { 3. Diminution in Supply { (a) Natural Gas
{ { { (b) Water
B. Intangible Property—Rights { 1. Limited in Time
{ 2. Abandoned
[20] In “Modern Accounting.”
[21] Chart adapted from “Regulation, Valuation and Depreciation,” by S.
S. Wyer.
Wear and Tear of Use
The wear and tear due to use or operation usually has a much more
potent effect on the service life of an asset than that due to
decrepitude. The established policy as to repairs and maintenance has
an important effect on this kind of depreciation. Sooner or later
every machine becomes unfit for service, due to the friction of its
parts, the strains to which it is subject under normal load, those
of much greater effect under abnormal load, the method of applying
its power, etc. It must then either be withdrawn from service and
completely depreciated, or it must be repaired in an effort to lengthen
its life. It should be kept in mind that the determining factor here
is efficiency. The serviceability of the machine must be kept up to
a recognized standard through adequate expenditures for repairs and
up-keep until the cost of up-keep is disproportionate to the service
rendered, or until the machine becomes so decrepid as to make its
operation hazardous.
The application of theoretical depreciation to operating wear and tear
must proceed with great care. This is so because of the varying factor
of maintenance. If the cost of maintenance Could be standardized,
experience under such standard would give a reliable basis for the
calculation of the depreciation charge. Since adherence to such a
standard is difficult or impossible under the conditions that are
constantly arising in a given establishment, the depreciation policy
must of necessity be based on actual observation and inspection by
experts. The expenditure necessary to restore an asset to a state of
operating efficiency is called “deferred” or “accrued” maintenance,
and it is the amount of this at a given time, estimated by expert
inspection, which compared with normal maintenance forms the basis for
an estimate of the depreciation charge.
Functional Depreciation
Tangible property is subject also to “functional” depreciation. This
means a lessening in worth or service value due to causes, other
than those already treated, which interfere with and operate against
the proper functioning of the asset, making it impossible to render
effectively and economically the _full_ requirements of service
expected of it. This inability to fulfil its proper function may
result either from inadequacy or obsolescence. “Thus the structure
may suffer total depreciation and be thrown out of service, not only
because through wear and tear it has reached a condition where further
expenditures for repairs or attempts to make it suitable for the
required service would not be economical or expedient, but also because
recent improvements, or new inventions, new developments and radical
changes in service, or the demands of one kind or another involving
sweeping changes in the existing plant, make abandonment necessary.”[22]
[22] Leonard Metcalf paper on “Water-works Valuation and Fair Rates”
before the American Society of Civil Engineers, Vol. LXIV, 1909, page
16.
Inadequacy as a Factor
Inadequacy is a condition in which the asset is found unable to meet
the demands made upon it, due usually to growth of business or to some
rearrangement made necessary by changed policy before the asset has
reached the end of This condition is also called “supersession.” For
economical operation the asset must be discarded and superseded by a
larger unit. As an example, dynamos and motors of a capacity sufficient
to meet all demands on them at the date of their installation may,
through growth of business, prove entirely inadequate after a few
years to meet the service expected of them. Inadequacy as a factor of
depreciation will have no appreciable effect in cases where the demand
is fairly constant and the market does not permit of much expansion.
Where there is a growing community and (or) a growing appreciation
of the commodity manufactured, demand may increase to a point where
original judgment and expectation will be shown to have been in error
and the equipment will have to be superseded if advantage is to be
taken of the expanding market.
Two main factors or compelling forces may bring about inadequacy,
viz., those of internal origin and those of external origin. Those of
internal origin may become effective because of: (1) abandonment of
original financial policy, (2) considerations of engineering economy,
and (3) unforeseen development.
Inadequacy through Change of Policy
Perhaps the best illustration of the first type is that of a plant
built to supply a certain commodity to the local community. A change
in ownership brings about an abandonment of the original policy and a
determination to provide neighboring communities with the commodity
also. This change in policy frequently comes about when several smaller
plants are merged under one control and the original units are found
to be entirely inadequate to meet the demand. Again, when through a
change in financial policy it is decided to lower the rates of a public
service commodity, the original equipment may prove inadequate to
meet the increased demand. It is not contended here that this type of
inadequacy is to be taken into account in estimating the depreciation
charge. Usually it cannot be foreseen and should therefore be provided
against under the head of a general contingent reserve or appropriation
of profit. If it can be foreseen intelligently, it should be taken into
account in the estimate of depreciation.
Inadequacy through Motives of Economy
The second type of inadequacy may be a foreseen and calculated
inadequacy. In a new community or in the case of a new commodity
whose virtues are little known, it may be the part of economy and
business sagacity to install originally only such equipment as will
be adequate to meet the requirements during the development stage and
then when the commodity is introduced and established to discard the
old and install larger and more adequate structures. Although it may
be foreseen with reasonable certitude that a power plant generating a
thousand horse-power will be entirely inadequate in ten years, yet it
may be the better business economy to scrap it at the end of ten years
rather than incur the up-keep and depreciation charges on a larger
plant which would give longer service. Whichever policy, according
to best engineering economy, results in the lowest unit cost of
product is usually the determining factor. If with all the facts and
reasonable expectations under view the smaller plant is decided upon,
then assuredly the depreciation due to inadequacy must be taken into
consideration.
Inadequacy Due to Unforeseen Development
The third type of inadequacy, unforeseen development, has been shown
to be due to an _unexpected_ expansion of the market. This may be
brought about by growth in population of the present market, growth in
appreciation of the commodity manufactured, or sometimes by a lowering
of transportation rates whereby new markets are opened. The very fact
that this kind of inadequacy is _unexpected_ and _unforeseen_ makes
impossible its inclusion in the current depreciation charge. This kind
of inadequacy is revealed by a post-mortem determination of causes of
which there were no symptoms leading to a correct diagnosis during
life. The loss to be incurred through the scrapping of the property
before its expected termination of service is a loss which must be
borne by the future and not by the past. It is in the nature of a
development cost which must be incurred if the opportunities of the new
market are to be seized, and which must enter into a consideration of
the advisability of making a bid for the new business.
Business policy might or might not dictate that these costs be charged
against reserves of profits from the past. Theoretically they should
be spread somewhat evenly over the future but in neither case can they
have any place in present depreciation charges. It should be thoroughly
understood that depreciation is a charge which relates always to the
past, never to the future. There is no contradiction here in that
a consideration of the future must help to determine the amount of
waste which has taken place in the past. P. D. Leake[23] says: “It is
a misconception to describe the annual provision for depreciation as
a provision for future renewals, as though it has reference to the
future. The annual provision for depreciation has nothing to do with
the future but relates solely to the past. It is a replacement of
capital in respect to past capital outlay expired in the process of
carrying on the business.”
[23] In “Depreciation and Wasting Assets.”
Inadequacy Imposed from Without
Inadequacy may be imposed by external forces or authority. In public
service utilities this has often proved a source of expense. In the
interests of a supposedly enlightened opinion—oftentimes a badly
mistaken opinion—present equipment is found inadequate to meet the
new demands. This type of inadequacy merges imperceptibly into
obsolescence. Again, a municipality at the time of repaving the streets
may require that the utility company discard present equipment and
install a larger and heavier type; it may require that overhead wires
be carried in underground conduits; and prudence on the part of the
company may lead to the installation of larger carriers than the old.
These losses—and there is almost invariably a loss to the utility
company—must be charged against the future. So also, the passage of
laws and ordinances in the interests of sanitation and fire protection
frequently compels the private owner to discard equipment and devices
before their service life has passed and install more adequate
equipment.
Obsolescence as a Cause
The second factor of functional depreciation is obsolescence. By
this we mean that lessening in worth which is brought about by
the development of something new whereby production becomes more
economical or is changed to meet new ideas, fads, or fancies of the
consumer. Obsolescence may be imposed by outside forces through the
exercise of the police power under circumstances analogous to those
mentioned under the discussion of inadequacy brought about by external
means. Municipalities and regulating commissions have speeded up
the “irresistible march to the junk heap” in numberless instances.
Cotton-spinning and shoe machinery, lasts and patterns of all sorts,
electrical devices in particular—all have been subject to obsolescence
charges. The horse car gave place to the cable car, which in its turn
was displaced by steam locomotion, and today this has given way to
electrically propelled street cars. The old wooden rail gave way to the
rail of wood capped with a strip of steel, the light “T” steel rail,
and the present heavy steel rails—changes all necessitated by changes
and developments in the art and a demand for better service by the
public. The stick used by the Indian to turn the ground and plant his
corn has been displaced successively by hand tools of iron and steel,
horse-driven plows, and the big steam and gas tractors of the present
day. No industry has escaped the seemingly inevitable trend towards the
displacement of the old and antiquated but not worn-out equipment, by
newer, more up-to-date, and more economical equipment. Obviously the
last word has not yet been spoken or the last refinement been made in
the development or application of art and science to any industrial
enterprise. Life means development; dry rot and retrogression are the
fate of any art, any industry, any people which has reached the limit
of its development.
Since, therefore, obsolescence is so common an occurrence, so
absolutely a fact of general experience, it would be folly to ignore
it. Many writers and some authorities have said that while obsolescence
is as certain and ever present as the forces of nature, it seldom is
more possible of measurement than are they. However, engineers tell us
that in most cases it is possible for qualified experts to foretell
with _reasonable_ certainty the effect of obsolescence. “Those most
familiar with the art know the units which will be able to serve their
entire physical life, and what classes are so uneconomical or otherwise
defective that some improvement must be expected.”
Treatment of Obsolescence
As to the effect of obsolescence, attention should be called to the
fact that it is seldom operative to its full extent. The decision
as to the exact time of discarding the old and installing the new
rests on a nice balancing of many factors. Thus, the safety devices
operated by hand on railroads are not displaced in a wholesale manner
by those which operate automatically. In a large telephone company
old switchboards are not discarded for new over the entire system at
the same time. Much of the old is oftentimes allowed to serve out its
life-term, and obsolescence has no effect. Under the circumstances
stated above, and many similar and more complicated conditions, it
requires a nice calculation to determine the actual effect of the
factor of obsolescence in depreciation. Many inaccuracies, even many
ridiculous conclusions, in estimates made by experts are met with,
times without number. The novice thus fears even to guess as to the
amount of the depreciation due to this factor. That is perhaps as it
should be; there is no place here for the novice. Inasmuch, however, as
the trend is to estimate the depreciation due to obsolescence, and such
practice has the unqualified approval of many public service boards
and at least the silent approval of our courts, it would seem that
an attempt should be made to include it in the depreciation charge.
As to its sufficiency or insufficiency, an amount can be estimated
with as much accuracy under the head of depreciation as under that
of a contingent reserve, and the former course is to be preferred in
that an inevitable fact of experience in almost every industry is
thereby recognized. The past, and not the future, is thus burdened
with the accomplished waste. There doubtless will be instances where
depreciation due to obsolescence palpably cannot be foreseen. For such
there is but one of two courses, viz.: either to charge it against
profits reserved out of the past, or burden the future with its cost.
Relative to the inclusion of obsolescence in the depreciation charge,
the Illinois Public Service Commission says in the case of the City of
Springfield v. Springfield Gas and Electric Company, March, 1916: “In
view of all the facts in this case, the Commission finds that it is
but reasonable, proper, and equitable to make deductions from cost new
to cover accrued depreciation, both physical and functional....” The
statement of the Maryland Public Service Commission in the case of the
Chesapeake and Potomac Telephone Company of Baltimore City has already
been cited on page 106. Quoting from the report of the Valuation
Committee of the American Society of Civil Engineers: “A limited
search ... indicated that inadequacy and obsolescence were included
either in ascertaining the amount of depreciation to be included in
cost, or to be deducted from earnings ... by the commissions of the
following states: Arizona, California, Colorado, Illinois, Maryland,
Massachusetts, New York, Oregon, South Dakota, Wisconsin.”
Covering this feature, i.e., the depreciation feature, in making
returns to the government under the Federal Income Tax of 1916, the
Commissioner ruled as follows: “The deduction for depreciation should
be the estimated amount of the loss, accrued during the year to which
the return relates, in the value of the property in respect of which
such deduction is claimed, that arises from exhaustion, wear and tear,
or obsolescence out of the uses to which the property is put....
The depreciation allowance, to be deductible, must be, as nearly as
possible, the measure of the loss due to wear and tear, exhaustion, and
obsolescence.”
Although not specifically mentioned, functional depreciation may be
said to have the sanction of the United States Supreme Court in its
decisions covering the Knoxville and Minnesota rate cases. In the case
of the Des Moines Water Company v. City of Des Moines, 192 Fed. 193,
September 16, 1911, the court allows both “functional and physical
depreciation.”
It would seem, then, that the legality of the practice is pretty
well established and the ability to compute the amount has been
recognized. It is not often the case in matters of business policy and
prudence such as this that the courts lead where business men and some
professional men are reluctant to follow.
Contingent Depreciation
A third factor in depreciation is given in the chart on page 121 as
contingent. The term would seem to indicate on the face of things
that it is not a factor of sufficient definiteness and certainty to
make possible its prevision and therefore the calculation of its
effect. Hence it might seem that provision could be made for it only
by means of a general reserve. In many individual cases and as to its
application as a universally operative factor in the same sense that
are use and wear and tear, the position is undoubtedly well taken.
The term contingent, as here used, is meant to cover not only things
which have happened and _may_ happen again, but also things which in
given localities and under known or knowable conditions are more or
less inevitable. Hence while not found present in all cases, where
conditions are favorable to the happening of any of the contingencies,
from the standpoint of prudence and an equitable distribution of the
burden of costs, provision should be made for them as one of the items
comprising depreciation. Contingent depreciation may comprise three
classes of contingencies, viz., (1) accidents, (2) diseases, and (3)
diminution in supply.
_Accidents._ With regard to the first class, M. E. Cooley, in the
Milwaukee Three-cent Fare Case, says: “An engine or a boiler may be
wrecked and with it other machinery. This might, and probably would,
involve a considerable expense for repairs or replacement, besides
possibly crippling the plant in part. Cars may collide or a car may
drop through a bridge. A bridge itself may fall or be carried away
by floods. A storm, as a cyclone, may work havoc, entailing costs
in excess of those proper to be charged to ordinary maintenance of
property.” Accidents may happen either as a result of negligence or as
a so-called “act of God,” i.e., the elements, or a hidden defect in the
structure. With regard to depreciation from accidents it may be quoted,
“There is always a certain amount of loss by accident which seems to
be inseparable from the business. Usually it can be counted on in
advance, and no amount of care and precaution will entirely eliminate
it.”[24] The Railway Library for 1910 says that of 899 railroad
accidents the various causes were:
Malicious acts 30 accidents
Elements 104 ”
Structural defects 117 ”
Various forms of negligence 648 ”
[24] Spring Valley Water Co. v. San Francisco, 165 Fed. Rep. 703.
In a large concern where past experience may serve as a guide to the
future, depreciation of this sort can be rather accurately estimated.
In the case of the rolling stock of a railroad, statistics make
available the yearly loss due to accidents from whatever cause. It
is argued that such losses are fairly uniform from year to year in a
large system of that sort, and each year’s operation carries the burden
simply by charging all repairs incident thereto against the revenues
of that period. This is, of course, true in the main and may give
sufficiently accurate results. The same treatment may also be applied
to replacements, and if the units are sufficiently small in value
in comparison with their number, practically no inequity as between
periods will result. However, the Interstate Commerce Commission has
ordered that depreciation reserves shall be set up for the proper
handling of such accidents and this seems the better method. Statistics
are available as to how frequently explosions in powder factories
are apt to occur and the losses due to them, so that a manager can
calculate the provision to be made on that account. Those are simply
the risks of the particular business, and wherever it is known that
they are applicable to any kind or group of equipment or other assets,
certainly the current operations should bear their share.
After all, depreciation charges due to any causes are much of the
nature of insurance which has to be carried by the enterprise itself
because the risks have not yet been reduced to an insurable basis. Much
as a proprietor may dislike to carry his own depreciation insurance,
he is compelled to. In connection with accidents as a part of the
depreciation charge, it should be noted that the product should not be
charged twice for this item. If regular insurance is carried for fire,
flood, tornado, earthquake, and the like, certainly those elements
should be omitted from the insurance risk carried as depreciation by
the concern itself.
_Disease._ Under certain conditions as to climate and local
environment, the ravages of disease must be reckoned with. Diseases are
caused by:
1. Parasites
2. Water pollution
3. Growths in water mains
4. Electrolysis
5. Crystallization[25]
[25]
A. S. C. E., Vol. 31, page 220, article by R. Montfort.
A. S. C. E., Vol. 40, page 178, article by C. H. Snow.
Association Engineering Societies, Vol. 31, page 49,
by F. W. Hodgson.
U. S. Gov’t, Bureau of Entomology Bulletin #94, Pt. 1,
by T.E. Snyder.
U. S. Gov’t, Bureau of Plant Industry Bulletin #64,
by G.T. More and K.F. Kellerman.
U. S. Gov’t, Bureau of Plant Industry Bulletin #76,
by G.T. More and K.F. Kellerman.
U. S. Gov’t., Dep’t of Agriculture, Forest Service,
Circular #128 by C. S. Smith.
Losses and deterioration from these causes are quite appreciable in
some enterprises. Telephone poles are subject to attack by borers
and woodpeckers. “More than 50% of the weight of the wood may be
removed ... without being greatly manifested upon the surface.” “At
least 10% of the chestnut poles reset or replaced are injured by
insects.” Railroad trestles, bridges, docks, piers, wooden shipping,
and structures of all sorts are more or less subject to this kind of
depreciation. Minute vegetable growths known as algae may cause a
marked depreciation in a water utility. Other forms of vegetable and
animal organisms sometimes cause growths in water-pipes, resulting in
a partial shutting off of the capacity. Similarly, mineral growths may
produce like effects. Iron oxide (common rust) and lime deposits or
scale are frequent causes.
_Electrolysis._ Depreciation caused by electrolysis is a highly
technical subject, discussion of which will not be attempted here.
“Electrolysis is a chemical decomposition produced by an electric
current. As applied to utilities, electrolysis is the disintegration
of metal structure caused by the electrolytic action produced by
stray electric currents, generally from the return circuits of single
trolley electric railways.” The damage, both direct as above stated,
and indirect as in the leaking of water, gas, etc., or in the flooding
of adjacent premises or injury through gas explosions, is recognized
by the courts, but the satisfaction granted is limited to enjoining a
continuance of the injury.
_Molecular Change._ In some kinds of machinery subject to heavy strain
and shock when in use, a disintegration of the structure itself takes
place whereby its resisting power and therefore its efficiency are
greatly impaired. This condition is known as a crystallization of the
molecules.
_Depletion._ Finally depreciation due to contingent causes may be
brought about by a diminution in the supply. This is more in the nature
of a depletion charge and will be fully considered in connection with
that subject treated on page 117.
Terminable Rights
The intangible property subject to depreciation consists of terminable
or limited rights. Rights given or held for a definite period of
time expire or waste away through the lapse of time. Decrepitude
is the controlling factor here, and because of the definiteness of
the length of time, the depreciation charge is easily calculated.
Therefore provision must be made for it. Various methods, resulting in
quite different charges to each period, are sometimes employed. These
methods will be discussed in Chapters IX and X. Rights which are not
terminable or limited—and even limited rights—may, however, be given
up or abandoned. This is a situation which cannot usually be foreseen
and therefore cannot be provided against except by means of a general
reserve.
Effective Depreciation
One final point in connection with the causes of depreciation needs
consideration. Though _all_ of these various causes or kinds of
depreciation are seldom found operative on a given asset, frequently
several of them are so operative. Where this is the case their effect
is not cumulative. One or the other will prove a controlling factor in
determining the service life of the asset and thus the amount of its
periodic depreciation. There is a close relation between the operation
of the chief factors in depreciation and the scrap value of the asset.
Thus, if it is estimated that physical depreciation will be complete in
8 years, obsolescence in 10 years, and inadequacy in 12 years, scrap
value would be slight. If, however, inadequacy is the controlling
factor, becoming operative in 8 years, with obsolescence in 10 years,
and physical depreciation in 12 years, clearly scrap value might be
quite appreciable. Whichever factor is the controlling one, that factor
is said in a given case to constitute the _effective_ depreciation for
that asset. Thus, in the first case mentioned, physical depreciation
constitutes effective depreciation and would form the basis for the
estimated charge, while in the second case inadequacy is the effective
factor.
CHAPTER VIII
DEPRECIATION—FACTORS OF RATE DETERMINATION
Fundamental Purpose of Depreciation
Under the head of accounting for depreciation, which forms the subject
of this and following chapters, will be considered:
1. The purpose of the depreciation charge.
2. Rates of depreciation and their relation to repairs,
renewals, and replacements.
3. Methods of reckoning depreciation and their effects.
4. Handling depreciation on the books.
5. Financing depreciation and some related problems.
Though much has been written about the causes and kinds of
depreciation, the necessity of considering it, and methods of
calculating its amount, so far as the author knows there has been no
adequate presentation of the fundamental purpose of the depreciation
charge viewed _both_ from the valuation or balance sheet point of view
and the operation or profit and loss standpoint. The statement is
frequently made that the purpose of depreciation and the necessity for
considering it is to maintain intact the value of the original capital
invested. In so far, therefore, as this necessitates a periodic charge
against revenue, resulting in a retention in the business, either in a
specific or floating form, of some of the revenue-producing assets, the
operating or profit and loss phase of the business is affected. This
secures the integrity of the original fund of capital by making the
revenue receipts unavailable for distribution among the stockholders
until the portion of the assets wasted away has been made good. This
view of depreciation has as its actuating purpose a showing of correct
values in the balance sheet, with little regard to the purposes to be
served by the depreciation charge against operations. This emphasis
of the problem of valuation is usually looked upon as primarily the
engineering viewpoint.
Depreciation a Cost of Operation
On the other hand, many students of the problem view the depreciation
charge as incurred for the sole purpose of determining the correct
costs of doing business. Unquestionably, depreciation is a cost of
production. A portion of the service life of equipment goes into each
unit of the product, and depreciation constitutes a cost which must
be borne by the product with as much reason as the labor power that
fashions and forms it and the raw material out of which it is made.
To determine a cost of production and a profit without the inclusion
of the depreciation charge would be, as R. H. Montgomery[26] says,
just as logical as “to state that a candy manufacturer had earned a
net profit of $100,000 and that out of said $100,000 there had been
set aside $20,000 to pay for the sugar consumed in the manufacture of
the product. The use of that which is consumed is a loss or expense.
Machinery is consumed; sugar is consumed. You cannot say that one
is an operating expense and the other is an item which need not be
ascertained nor taken into account until the net profit is shown....
If the provision for depreciation is an item which cannot be included
among the costs of operation, there is something wrong.”
[26] In “Income Tax Procedure, 1918.”
This view of depreciation attempts to show the correct costs in the
profit and loss statement of operations, without much regard to its
effect on the balance sheet except that, in so far as every charge
against operations is reflected among the assets, the fact of its
inclusion as an operating cost automatically works also as a means
of declaring correct values. Under this view—which may, without any
misstatement perhaps, be called the accountant’s viewpoint—the emphasis
is placed on the effort to show true costs of the product, and only
incidentally a true valuation of the assets.
Complication of Short Fiscal Periods
Theoretically there is no conflict of views here—only a difference
in emphasis. It is purposed, however, to show some of the practical
difficulties encountered in the full application of either view. As
has been stated in an earlier chapter, the ideal time in so far as
depreciation is involved for the determination of financial results
would be the time when all the elements of production entering into
the product have been completely used up—if this were possible. There
would then be no troublesome problems as to inventories, accruals, or
deferred charges. The fiscal period would coincide with the natural
service-life periods of all the producing elements. The problem of
depreciation would then be a simple one, and the entire value of the
equipment would be a charge to the product turned out during its
life-period. Such a method of determining the financial results of
an enterprise is, of course, merely fanciful. There is always, and
will be always, an overlapping of the life-periods of the various
units of a plant. Furthermore the practical necessities of modern
business and competition require a much shorter fiscal period with a
more frequent figuring of results and showing of condition. It is due
to this shortening of the fiscal period to one month, six months, or
a year that the difficulties of the depreciation problem arise and
inaccuracies of statement are consciously or unconsciously made.
The handling of the problem hinges on the answer to the question as
to the correct basis for the distribution of the depreciation charge.
Shall a fiscal period of arbitrary length be used as the basis for
determination of the service life of the operating equipment? Or
shall the life of inanimate equipment be measured in terms of units
produced, service rendered, results achieved, just as human life and
age may be measured in terms of intensity of thought and action? It is
unfortunately true that once the depreciation charge is settled, this
same charge is constantly applied with little adjustment to changing
conditions. Thus, varying intensity of service is not reflected in the
periodic charge.
The Factor of Idle Time
Were it possible to foretell length of service life in terms of units
of product instead of units of time, a much better approximation to
actual results would be secured. And this very thing is _attempted_
under almost all methods of estimating depreciation. The life-period of
the equipment is estimated on an assumption of _average_, _normal_ use
of the equipment—an assumption which will give good practical results
when and so long as operations are normal or average. When, however,
a period of depression comes and much of the equipment is idle, it is
clear that that period would be burdened unduly with a depreciation
charge based on _years_ or _months_ of service life. On the other hand,
a period of feverish activity would not bear its just share of the
burden of wasting assets. The period which is really overburdened must
necessarily reflect it as an undervaluation of the assets—more has been
charged off than has been used up; while the opposite is true of an
underburdened period. Of course, on the theory of averages, by the end
of the life-period of an asset all inequalities would be ironed out.
Some methods of cost-keeping take this factor of intensity into account
and spread the depreciation charge on a man-hour or machine-hour
basis, which proportions it somewhat equitably to the product turned
out by the use made of the machine and not to its elapsed life in days
or months. The best that can be hoped for is as near an approximation
to the truth as possible.
Depreciation a Means of Financing
Another view of the purpose of the depreciation charge is that it is a
method or means of _financing_ depreciation as it is sometimes termed.
Under this view the effect of the depreciation charge on intermediate
periods is lost sight of and it is used solely as a means of securing
a sufficient contribution in hand _at the end_ of the service life of
the asset to finance its replacement. In other words, no attempt is
made through the periodic depreciation charge to secure an accurate or
necessarily true statement of the values of the assets, nor to see that
the product of a given period is burdened with its just share of _all_
costs, though this may be an incidental purpose. H. V. Hayes[27] in
discussing this phase of depreciation says:
[27] In “Public Utilities, Their Cost New and Depreciation.”
“It is argued that the plant unit ‘deteriorates’ year by year and that
this ‘deterioration’ is the true measure of the ‘depreciation’ in the
value of the unit during the intermediate years of its life, and,
being a physical condition of the plant, can in no way be measured
by the purely financial considerations upon which the reserves for
depreciation necessarily must be based. Such a line of reasoning is
absolutely faulty. Any attempt to reconcile ‘deterioration’ with
‘depreciation’ at any intermediate period in the life of the plant of
an undertaking, is not only unnecessary but futile. The error in such
an attempt arises from a failure ... to recognize the fact that ... if
definite agreement has been reached as to the serviceable life (of the
asset), the physical ‘deterioration’ of the unit, at any time during
its life, can be a matter affecting its intrinsic value in no way
whatever.”
Danger of the Financing Viewpoint
The above statement is a fair presentation of the case for depreciation
as a financing device. It would seem, however, that the exponents of
this view lose sight of the inevitable fact that the depreciation
charge is _pro tanto_ an evaluator of the wasting asset during the
intermediate period of its life. Therefore a logical conclusion to be
drawn from the view as expressed in the quotation above, would be the
countenancing of any method by means of which provision could be made
to replace the asset by _the end_ of its life, no matter whether the
charge was spread evenly over its life, was made all in one year, or
was made to depend on the amount of the net profits at the end of a
given year. This latter alternative is a dangerous policy, always to
be deprecated, for depreciation is a cost of production to be taken
account of _before_ profits can be determined.
After all, it may be said without fear of serious contradiction that
all three views, i.e., the engineering, the accounting, and the
financing viewpoints, must be held in mind in any adequate treatment
of the depreciation charge. The important point from the commercial
and accounting standpoint is to secure a fair and equitable charge
to each unit of product, regardless of whether or not the burdens of
each fiscal period are equal. This is particularly evident when wear
and tear from use is the _effective_ factor in depreciation—and it is
also contended that the factors of obsolescence and inadequacy may be
as successfully and relevantly estimated in terms of business output
as in years. If this results in an accurate valuation of the asset—and
it is conceded that from the engineering viewpoint it may sometimes so
result—the inaccuracy is of minor importance. According to the general
law for the valuation of fixed assets, changes in the market need not
and should not, as a general thing, affect the values at which the
assets are carried on the books _of a going concern_. It is, of course,
a corollary to the main proposition that this treatment also makes
adequate provision for financing the fact of depreciation. Various
methods and means for the accomplishment of these purposes are given in
Chapter IX.
The Standardization of Depreciation Rates
The determination of the rate of depreciation of a given asset
is essentially an engineering problem. But as the accounting for
depreciation is dependent on the rate, and the records of the
accounting department must furnish much of the information for
estimating the rate, the whole problem of fixing depreciation rates
will be considered under the one head. Much study and effort to reduce
all the conditions under which assets depreciate to a common basis
and so to a definitely stated rate for each set of conditions, have,
so far, come to naught and all qualified experts say without reserve
that the rate of depreciation is an individual problem. It is to be
hoped that a further gathering of statistics as to expectations of
life of different assets under varying conditions will ultimately
furnish tabulations, corresponding to insurance tables, according to
which under known and expected conditions a fairly accurate rate of
depreciation for a particular asset may be made. Unlike insurance
rates, however, the depreciation rate once established will not
necessarily remain constant, but must be subject to a periodic revision
in the light of new data and conditions.
Effect of Local Conditions
Many factors enter into the rate of depreciation. They may be classed
roughly as “stable or normal” factors and “contingent” factors. It
should be constantly borne in mind that in the present state of the
actuarial development of the subject, general rates, i.e., rates
which will apply without readjustment, cannot be determined. For
the determination of individual rates local conditions are always
the controlling factor. An illustration in point is given by Henry
Floy,[28] showing the varying rates used by thirty-one different
concerns for the depreciation of their rolling stock equipment. The
methods vary in almost every case, comprising annual charges of an
arbitrary amount, per cent of the original cost, cents per car mile,
arbitrary deductions from income irregularly applied, per cent of gross
earnings, per cent of present estimated values. Reduced to a common
basis, the per cent methods show a range of expected life varying
between ten and one hundred years. While it is improbable that had
the determination of the depreciation rate for the different concerns
been in the hands of the same expert, there would have resulted these
bewildering variations in method, still it does bring out in strong
relief the fact, well recognized by experts but so often lost sight
of by those unacquainted with the technical phases of the problem,
that local conditions are a _controlling factor_; and that until
local conditions can be somewhat standardized there is no hope of
establishing rates of depreciation which will be of general application.
[28] In “Value for Rate-Making,” pp. 255-256.
Factors in Determining Depreciation Rate
In the determination of rates the factors to be taken into account are:
1. Normal operating conditions.
2. Normal load or normal _intensity_ of operation.
3. Normal repairs policy.
4. Normal climatic conditions.
These constitute the most important stable or normal factors. Among the
contingent elements, the most important are:
5. Probable misuse and neglect brought about by the
demands of the trade, resulting in a change in the
factor of normal intensity.
6. Probable change in ownership and consequent
change in policy.
7. Probable change in the requirements of the market,
necessitating an adaptation of the equipment to
uses for which it was not originally intended.
At the time of installation the rate of depreciation must be based
only on the normal factors—things which can with reasonable certainty
be counted on. At intermediate periods in the life of the asset, a
physical inspection should be made to compare the actual depreciation
of the property with the estimated. If, then, it is found that any
contingent factors have become real or reached the point of reasonable
expectancy, these provide the basis for an adjustment of the rate for
the remaining life-term of the asset.
Basis of Normal Rate
With regard to the normal rate, the following items demand first
consideration:
“1. Exterior or movable apparatus
(a) Abuse
(b) Neglect
(c) Temperatures
(d) Oxidation
(e) Irregular shocks in use, such as starting
or braking, also road or rail defects
2. Installed operating and generating machinery
(a) Reversals, increased by rapidity and
aggravated by shock
(b) Irregular loads or service, aggravated by
speedand sudden character
(c) Excessive usage, resulting in increase of
temperature of parts
3. Fixed equipment including boilers and piping
(a) Excessive and irregular strains
(b) Interior causes of decay
(c) Chemical action
—all these being of greater or less effect, according to the time of
daily usage and lack of periods of rest.”[29]
[29] R. P. Bolton in “Power for Profit.”
Policies as to Repairs
Without doubt the most important single factor in the determination
of the depreciation rate is the normal policy as to repairs and
maintenance. Physical deterioration is constantly at work. If this
is counteracted by a liberal maintenance policy, not only is more
efficient service secured but a longer service life is thereby insured.
As soon as repairs are needed, although the efficiency of the asset
may not be immediately impaired, the _rate_ of deterioration is much
accelerated unless the condition is corrected. Deterioration takes
place day by day, but repairs obviously cannot be made at such short
intervals—both because of the difficulty of detection and also because
such a policy would not be economically practical. Every concern must
consider its own peculiar problems and determine from these what shall
constitute its normal repairs policy, and so far as possible this
should be adhered to. The charges for repairs are bound to be of a more
or less irregular character. Their handling is discussed on page 147.
Regardless of what the established policy as to repairs may be,
conditions are sure to arise which make strict adherence to it
impossible. There may occasionally be lack of funds at the time
repairs are customarily attended to; it may be impossible to get the
expert labor needed or the parts to replace worn-out units; or, and of
oftenest occurrence, the need of repairs may coincide with a period of
intense activity when the plant is being worked to its limit and in
consequence there is no opportunity for making repairs. It is clear
that rates based on one shift and the normal use of equipment during
eight hours would be inadequate for three shifts and twenty-four hours
of use; for in addition to a threefold intensity of operation this
makes impossible adherence to the normal repairs policy based on an
eight-hour schedule.
Depreciation Rate an Engineering Problem
From the above discussion it is apparent that the determination of
rates is essentially an engineering problem. The accountant, however,
needs a knowledge of the fundamental considerations and requirements
of fixing depreciation rates and an appreciation of the difficulties
of the problem. As Henry Floy[30] says: “What engineer is able to
foretell the misuse and neglect or care and high degree of maintenance
that any given apparatus or ... property as a whole will receive, even
during the next five or ten years, with vicissitudes of climate, load
conditions, changes of management, and requirements of the public?”
On the other hand, in the opinion of another prominent engineer,
“Consideration of these matters (misuse, neglect, etc.) may eventually
form the basis for a systematic appraisal of the probabilities of life,
or average of the risks, which would provide a method for the insurance
of the life of machinery.”
[30] In “Value for Rate-Making.”
The author does not attempt to discuss the relative merits of the
two contentions other than to point out the fact that engineers are
not discouraged in spite of the many contingencies and uncertainties
inherent in the problem. They are constantly gathering data from which
conclusions as to rates are being formed, the use of which is being
compelled by regulating bodies. It is possible that the problem will
ultimately be worked out on some kind of an insurance basis.
Attitude of Regulatory Bodies
At the present time the attitude of most regulatory bodies—public
service boards, federal commissions, and tax officials—is well
expressed by a regulation of the Public Utility Commission of New
Jersey which says that, “Until otherwise prescribed, the amount
estimated to be necessary to cover such wear and tear and obsolescence
and inadequacy as have accrued during any month shall be based on a
rule to be determined by the accounting corporation; such rule may be
derived from a consideration of the said corporation’s history and
experience. A general statement of the rule in use by each company,
together with the general information upon which it is based, is to be
filed with the Board of Public Utility Commissioners.” The trend at the
present time is towards a more thorough supervision of depreciation
rates on the part of many public service boards, and the future will
undoubtedly see interesting developments.
Methods of Handling Repairs
Three distinct practices are met with in handling repairs and
renewals on the books. The most general method is dictated by ease of
application and rests on the theory of averages, viz.: that the amount
of repairs annually recurring for depreciating equipment in all degrees
of deterioration and all stages of decay and age is a fairly constant
figure which secures an equitable distribution over the product of the
different years. The larger the plant and the greater the variety of
the equipment used, the more nearly does this work out as expected.
Further consideration will be given to this point in the discussion in
Chapter X of the effect of the various methods used for calculating
depreciation on the equality of the distribution of the charge.
Another method, used in plants where a very accurate determination
of the costs of production is desired, has as an outstanding feature
a preliminary estimate, made at the time of installation, of the
expected amount of repairs needed during the entire life of the asset.
Periodically this estimate, or proportional share thereof, is brought
on the books as a charge to Repairs and credit to Reserve for Repairs
and so is spread evenly over the service life of the asset. As repairs
are actually made, the cost of these is not charged against operation
but against the reserve created for that very purpose. At a given time,
the status of the reserve account shows: (1) if the equipment has just
been placed in a normal state of repair, the under-or over-estimate of
the amount of actual repairs needed, or (2) if the equipment is not in
repair, the reserve account gives an index of the probable amount of
deferred maintenance. Both items of information are of value in the
proper management of properties. It is to be expected, of course, that
during the early years of the life of an asset there will be a fairly
large credit balance in the reserve because repair charges are light.
The credit balance so accumulated will be needed during the later years
when the costs of maintenance become heavier.
The third method, which is a variation of the second, has as its
characteristic feature the inclusion of the repairs cost with the
depreciation charge. This likewise necessitates a preliminary estimate
of the amount of expected repairs during the life of the asset.
Instead of being handled separately, it is added to the depreciation
rate and in this way charged against the product. This method has
been prescribed in the case of some utilities in England but is not
much used here. Under this method two depreciation estimates of
probable life are necessary, viz.: (1) maximum life brought about by
an inclusion of repairs, renewals, etc., and (2) minimum life without
such repairs. By this it is not meant that other methods of calculating
the depreciation rates fail to take cognizance of the repairs factor,
but that this method specifically calls attention to it and includes
it in the charge made. It seems best for regulatory boards to make a
separate book record of repairs and depreciation, thus insuring against
any oversight of the factors of depreciation and also insuring the
correctness of a statement of condition.
CHAPTER IX
DEPRECIATION—METHODS OF CALCULATING
Methods of Calculation
Many methods of reckoning depreciation have been devised; some good,
some bad, and some too theoretical and involved ever to serve the
practical needs of business. It is proposed here to explain those
methods which have found most favor and, in Chapter X, to discuss
their effects from the standpoint of the true purpose of any scheme of
depreciation.
There are several ways in which the depreciation calculation can be
made, and the methods may be classified broadly, though with some
overlapping, under four heads. These classes are:
1. Proportional Methods
2. Variable Percentage Methods
3. Compound Interest Methods
4. Miscellaneous Methods
Factors of Calculation
The factors which must be known under most methods of calculation are:
1. Original cost of the asset
2. Scrap or residual value
3. Estimated service life
4. Under some methods, an arbitrary interest rate
By original cost is meant full cost of the asset in position ready for
use. By scrap value is meant the estimated value of the asset at the
time of its discard, when removed from position and ready for sale or
other mode of disposal. This is sometimes called its salvage value as
distinguished from its value while still in position to render service
but awaiting discard or break-up. By estimated service life is meant
the time during which the asset will be used for service. This may be
expressed in ordinary units of calendar time, such as the year; or in
units of service time, such as working hours; or finally in units of
output, such as tons, cubic feet, kilowatt hours, etc.
Symbols to be Used
For purposes of notation and reference the following symbols will be
used:
V = original cost
V₁ = depreciated value at end of first period
V₂ = ” ” ” ” ” second period
Vₙ = ” ” ” ” ” last period, i.e., scrap value
n = length of service life
d = rate of depreciation per period
D = total amount of depreciation, i.e., V - Vₙ
D₁ = amount of depreciation during first period
Dₙ = ” ” ” ” last ”
r = rate of interest
R = 1 + r, i.e., 100% plus the rate
1 - r = 100% minus the rate
A = annual amount to be paid under the compound interest methods
It should be noted that the foregoing factors are all estimates, with
the exception of original cost, and that when making these estimates
the principles of depreciation as discussed in preceding chapters
must be taken into consideration. Thus, a decision must be made as to
whether physical or functional depreciation is the controlling factor
in determining service life. In the determination of service life, the
policy as to repairs, renewals, and maintenance has a very important
bearing. In fixing the scrap value, the relation of inadequacy,
obsolescence, wear and tear, and age to the values remaining in the
asset must be considered.
1. PROPORTIONAL METHODS
Proportional methods include all those in which the periodic
depreciation is calculated as a proportional part of some fixed basic
value. These may be grouped under the following subclass titles, each
of which will be separately considered:
(a) Straight Line
(b) Working Hours
(c) Composite Life
(d) Service Output
(a) Straight Line Method
The “Straight Line” method, so called because its graphical
representation is a straight line, is perhaps the simplest of all
methods for calculating the periodic depreciation charge and is
therefore the most widely used. Under it the loss of value for each
period is proportioned to the length of service life. Thus, an asset
whose service life is reckoned as 10 years will have depreciated
one-tenth by the end of the first year, two-tenths by the end of the
second year, and so on. The depreciation for each year is the same.
Shown by formula, using the notation above, this will be:
(V - Vₙ) D
(1) D₁ = ------- or --- and, evidently,
n n
V₁ = V - D₁; V₂ = V₁ - D₂; etc.
From these formulas a schedule of appraisal for a given asset may be
made up showing its values as at the end of each year of its estimated
life. For an asset costing $150, of which the service life is 5 periods
and the scrap value, due to inadequacy, is $50, such an appraisal
schedule would work out as follows:
==========+==============+==================+==================
Age in | Periodic | Depreciated or | Total Accumulated
Periods | Depreciation | Appraised Value | Depreciation
----------+--------------+------------------+------------------
0 | $..... | $150.00 | $.....
1 | 20.00 | 130.00 | 20.00
2 | 20.00 | 110.00 | 40.00
3 | 20.00 | 90.00 | 60.00
4 | 20.00 | 70.00 | 80.00
5 | 20.00 | 50.00 | 100.00
----------+--------------+------------------+------------------
Here, the fixed depreciation base, i.e., the amount to be written off
over the 5 periods, is $100 ($150-$50). Graphically presented below, we
have the straight line AB representing the periodic appraised values,
and the line OC, the accumulating depreciation.
[Illustration: _Graphic Chart—Straight Line Method_]
(b) Working Hours Method
Where the “Working Hours” method is used, the life of the asset,
instead of being estimated in calendar units of time, is given in
service units as so many working hours. Thus, if it is estimated that
a machine will stand 12,000 hours of operation, its service life is
stated as 12,000 working hours. Record is kept of the number of hours
the machine is operated during each fiscal period and compared with
the estimated length of service life (also in working hours) to give
the proportion of the total depreciation which must be charged to a
given period. Using the same example—an asset costing $150, with scrap
value of $50, and service life of 12,000 working hours—the appraisal
schedule will be as shown below, assuming that during the first fiscal
period the asset was used 3,000 hours, during the second 4,500 hours,
the third 2,700, the fourth 1,200, and that it was scrapped some time
during the fifth fiscal period after another 600 hours of operation.
=========+=========+==============+=================+=============
| | | | Total
Age in | Service | Depreciation | Depreciated or | Accumulated
Periods | Hours | Rate % | Appraised Value | Depreciation
---------+---------+--------------+-----------------+-------------
0 | ..... | ..... | $150.00 | $......
1 | 3,000 | 25 | 125.00 | 25.00
2 | 4,500 | 37½ | 87.50 | 62.50
3 | 2,700 | 22½ | 65.00 | 85.00
4 | 1,200 | 10 | 55.00 | 95.00
5 | 600 | 5 | 50.00 | 100.00
| ------ | ------- | |
| 12,000 | 100 | |
---------+---------+--------------+-----------------+-------------
The following chart shows graphically the appraised values and the
accumulated depreciation as at the end of successive fiscal periods.
The character of the curves here has no relation to the lapse of
calendar time, i.e., fiscal periods, but depends entirely on the
degree of intensity of operation of the asset, i.e., its service
life in working hours. The above curves are true, therefore, only
for the particular data assumed and do not, in any way, indicate a
characteristic tendency of this method. Were the bottom line of the
chart, the abscissa, laid off proportionately on the basis of working
hours instead of fiscal periods, both graphs would, of course, become
straight lines. It is only because information as to values is desired
at the close of each fiscal period that the curves representing values
become broken lines.
[Illustration: _Graphic Chart—Working Hours Method_]
(c) Composite Life Method
Another proportional method, which in its operation is similar to
the straight line method, is known as the “Composite Life” method.
Its feature is the calculation of depreciation on the plant as a
whole, rather than on each individual asset. Under it what is known
as the _mean_ life of the plant is calculated. Depreciation may then
be estimated, on the straight line or other basis, for the entire
plant. To determine mean life it is necessary to “weight” the life of
each individual asset with its value and so get a common basis, the
dollar-year, for all assets. The process of calculating mean life will
be explained in Chapter XI where also its use and adaptability are
discussed. Aside from the determination of mean life, the method does
not differ from others which have been or will be discussed.
(d) Service Output Method
A fourth type of proportional method is known as the “Service Output”
method. Under it, the life of the asset is reckoned in terms of
_quantity_ of output. This is very similar to the working hours method
but differs in the unit of measurement for service life. The life of
the asset is measured by its product. Thus, the life of a water filter
may be given in terms of gallons or cubic feet of water run through
it; that of a rock crusher in terms of the cubic feet of rock handled;
that of a freight car or engine in terms of car miles; and so on. If,
therefore, record is kept of the performance of such an asset for
the fiscal period, the amount of depreciation to be charged off is
readily calculated, being such a portion of the total depreciation as
the units of output for the current period bear to the total units of
life output. It is thus a straight proportional method. Its appraisal
schedule and graphical representation are exactly similar to those of
the working hours method. It should be said, however, that sometimes
the service output method is operated on a sinking fund basis instead
of on a total depreciation basis. When the sinking fund basis is used,
the total payments into the fund, excluding all interest accretions,
constitute the total amount of depreciation to be distributed over the
service output.
2. VARIABLE PERCENTAGE METHODS
The second main classification of methods, called for want of a better
title, “Variable Percentage” methods, differs from the proportional
methods in that either the base or the percentage rate varies for each
estimate of depreciation. The various proportional methods can all be
expressed as percentages but their base remains fixed and is always
the total amount of depreciation to be charged off. Under the variable
percentage methods, if the percentage is fixed, the base varies; and if
the base is fixed, the percentage varies. The subclasses here are:
(a) Fixed Percentage of Diminishing Value Method
(b) “Changing Percentage of Cost Less Scrap” Method
(sometimes known as the “Sum of Expected
Life-Periods” Method)
(c) Arbitrary with Increasing Amounts
(d) Arbitrary with Decreasing Amounts
(a) Fixed Percentage of Diminishing Value Method
The “Fixed Percentage of Diminishing Value” method estimates the
periodic depreciation as a fixed percentage of the appraised or book
value of the asset as at the time of the last appraisal. Thus, if the
asset cost $1,000 and the fixed rate is 10%, the first depreciation
estimate is $100 (10% of $1,000) giving an appraised value of $900; the
second depreciation estimate is $90 (10% of $900), with a new appraised
value of $810; the third estimate is $81 (10% of $810), with an
appraisal of $729 for the asset; and so on. It is evident that a final
zero valuation can never be reached (although it may be approximated)
as the series becomes an indefinite or indeterminate series. If
there is any scrap value, and there usually is, the series becomes
determinate. From the standpoint of calculation the problem here is the
determination of the fixed rate necessary to reduce the asset value
to residual or scrap value in the given life-term. Using the standard
notation, we may formulate the following equations:
V₁ = V(1 - d); V₂ = V₁(1 - d) = V(1 - d)(1 - d);
V₃ = V₂(1 - d) = V(1 - d)(1 - d)(1 - d); whence
Vₙ = V(1 - d)ⁿ, which solved for 1 - d gives
______
1 - d = ⁿ√Vₙ/V) , and, solving for d, we get
_____
(2) d = 1 - ⁿ√(Vₙ/V)
While complex, the formula is readily solvable by means of logarithms.
For an asset costing $150 with a service life of 5 years and a
scrap value of $50, the rate is found by the above formula to be
approximately 19.726%.
_______
d = 1 - ⁵√(50/150) = .19726
The appraisal schedule is, therefore, as follows:
=======+==============+============+=================+==============
| Fixed | | | Total
Age in | Depreciation | Periodic | Depreciated or | Accumulated
Periods| Rate % |Depreciation| Appraised Value | Depreciation
-------+--------------+------------+-----------------+--------------
0 | ..... | $ ..... | $150.00 | $ .....
1 | 19.726 | 29.59 | 120.41 | 29.59
2 | 19.726 | 23.75 | 96.66 | 53.34
3 | 19.726 | 19.07 | 77.59 | 72.41
4 | 19.726 | 15.32 | 62.27 | 87.73
5 | 19.726 | 12.27 | 50.00 | 100.00
| | ------ | |
| | 100.00 | |
-------+--------------+------------+-----------------+--------------
The following chart shows graphically the appraised values and the
accumulated depreciation:
[Illustration: _Graphic Chart—Fixed Percentage of Diminishing Value
Method_]
(b) Changing Percentage of Cost Less Scrap Method
Similar in effect to the method just explained is the “Changing
Percentage of Cost Less Scrap” or the “Sum of Expected Life-Periods”
method. Here, the base remains fixed, but the periodic depreciation
rates change. Each depreciation rate is a fraction the common
denominator of which is the sum of the expected life-periods as viewed
from the beginning of each successive period, and the numerator of
which is the expected life for the period in question. For example, an
asset of which the expected life is 5 periods has at the beginning of
each successive period expected life-terms of 4, 3, 2, and 1 periods
respectively, making a total of 15 which becomes the common denominator
of the fractions whose numerators are 5, 4, 3, 2, and 1 respectively;
i.e., the changing depreciation rates are ⁵/₁₅, ⁴/₁₅, ³/₁₅, ²/₁₅, and
¹/₁₅. For an asset costing $150 with expected life of 5 periods and
scrap value of $50, the appraisal schedule would be as follows:
=========+==============+==============+==============+=============
Age | Changing | | Depreciated | Total
in | Depreciation | Periodic | or Appraised | Accumulated
Periods | Rate % | Depreciation | Value | Depreciation
---------+--------------+--------------+--------------+-------------
0 | ..... | $ ..... | $150.00 | $ .....
1 | 33⅓ | 33.33 | 116.67 | 33.33
2 | 26⅔ | 26.67 | 90.00 | 60.00
3 | 20 | 20.00 | 70.00 | 80.00
4 | 13⅓ | 13.33 | 56.67 | 93.33
5 | 6⅔ | 6.67 | 50.00 | 100.00
---------+--------------+--------------+--------------+-------------
A comparison of this appraisal schedule with that of the fixed
percentage of diminishing value method shows that this method charges
more depreciation during the early life-periods and less during the
later periods. The general effect of this method and its significance
are discussed in Chapter X where the relative merits of the various
methods are considered. The graph for the sum of expected life-periods
method is not shown as it differs little from that of the fixed
percentage of diminishing value method on page 158.
(c, d) Arbitrary Methods
The two other arbitrary types of this variable percentage method
are hardly to be classed as methods as they do not rest on any law
according to which they may be operated. Under them arbitrary amounts
are charged to depreciation each period, the only controlling principle
being that in the one case these periodic amounts increase from period
to period, while in the other case they decrease. In the one case,
therefore, the appraisal schedule would be similar as to its “Periodic
Depreciation” column to those of the two methods just explained,
excepting that the column must be reversed, i.e., read from the bottom
upward. In the other case, the appraisal schedule would be exactly
similar to those just shown. Within the restriction that they must be
increasing or decreasing amounts for succeeding periods and that the
total depreciation must be charged off within the estimated life-period
of the asset, the periodic depreciation charges are, under these
methods, purely arbitrary, neither based on fact nor logic.
3. COMPOUND INTEREST METHODS
The third general type of methods for making the depreciation estimate
may be called the “Compound Interest” type. This differs radically
from any of the others in that it uses the compound interest principle
to determine the amount of periodic depreciation. In the practical
application of some of these methods, not only is depreciation
estimated on this basis but an actual fund of cash or other assets is
set aside for accumulation on the compound interest principle so as to
provide ready funds for financing the replacement when the old asset
is discarded. The setting aside of the fund is not an essential part
of the method, and its discussion is therefore deferred to Chapter XXV
where the subject of funds and their treatment is fully considered.
Under this type there are three methods:
(a) Sinking Fund
(b) Annuity
(c) Unit Cost
(a) Sinking Fund Method
The problem under the “Sinking Fund” method is the calculation of
the amount of a sum of money which placed at compound interest at
the end of successive periods will accumulate to the amount of the
total depreciation of the asset during its life-term. At the end of
each period, this amount plus any accumulated interest on the amounts
previously set aside becomes the depreciation estimate for this
period. Unless a fund is actually established, there can, of course,
be no accumulation of interest. Under this method the amount of such
theoretically accumulated interest is, nevertheless, made a part of the
periodic depreciation charge.
The method thus becomes simply a mathematical device for making the
estimate. The calculation of the fixed periodic amount is in accordance
with the following mathematical formula, using the notation given on
page 151. The development of this formula is given in full in Chapter
XXV, “The Sinking Fund”:
(V - Vₙ)r Dr
(3) A = --------- = ------
Rⁿ - 1 Rⁿ - 1
For the asset used in the other illustrations, i.e., for an asset with
a full valuation at the beginning of its life of $150 and a residual
value of $50 after a service life of five years, this periodic amount
is $18.10, if interest is reckoned at 5%. Any other rate of interest
within reason would, of course, be equally appropriate.
The following appraisal schedule may be set up:
=======+==================================+============+============
|Periodic Depreciation Composed of:| |
Age in +-----------+----------+-----------+Depreciated | Total
Periods| Periodic | Interest | Total |or Appraised|Accumulated
| Amount | | | Value |Depreciation
-------+-----------+----------+-----------+------------+------------
0 | $ ..... | $ .... | $ ...... | $150.00 | $ ......
1 | 18.10 | .... | 18.10 | 131.90 | 18.10
2 | 18.10 | .90 | 19.00 | 112.90 | 37.10
3 | 18.10 | 1.85 | 19.95 | 92.95 | 57.05
4 | 18.10 | 2.85 | 20.95 | 72.00 | 78.00
5 | 18.10 | 3.90 | 22.00 | 50.00 | 100.00
| | | ------- | |
| | | $100.00 | |
-------+-----------+----------+-----------+------------+------------
The following chart shows graphically the appraised values, the
accumulating depreciation and the elements which compose it, the curve
OD representing the fixed periodic amounts, and EF the theoretical
interest accumulations. The curve OD is a straight line inasmuch as
it represents fixed periodic amounts. The depreciation and interest
curves, OC and EF, representing gradually increasing amounts, are both
slightly concave and would become increasingly so the longer the period
covered. The appraisal curve AB is slightly convex and its convexity is
accelerated by lapse of time.
[Illustration: _Graphic Chart—Sinking Fund Method_]
(b) Annuity Method
The “Annuity” method also makes use of the compound interest principle,
but in addition to the method of the sinking fund it adds to the
periodic depreciation charge as determined thereunder interest on
the successive appraised values of the asset. The effect of this is
to charge to the product, by way of Profit and Loss, interest on the
capital invested in each asset used in manufacture. The appraised
values of the asset are exactly the same as under the sinking fund
method, but the expense charge to depreciation is larger under the
annuity method by the interest on the appraised value of the asset.
This charging of interest to the product under the title “depreciation”
makes it necessary to capitalize the interest charge by adding it to
the value of the asset. If the amount to be charged off, i.e., V-Vₙ
is the same under both methods, for both to arrive at the same scrap
value, Vₙ, the interest under the annuity method must be added to the
value of the asset each time before deducting the depreciation charge,
a part of which is this same interest. The annuity method thus makes a
larger periodic charge than the sinking fund method.
The problem involved in the calculation of the periodic depreciation
charge by the annuity method is sometimes stated as the method of
finding a fixed or constantly equal periodic charge sufficient to
charge off not only depreciation as such but also the interest which
has been added to the value of the asset. The mathematical formula may
be derived as follows, using the standard notation:
VR = V(1 + r), or the asset with interest added to it
VR - D₁ = V₁, appraised value at end of first period
V₁R - D₁[31] = VR² - D₁R - D₁ = V₂, appraised value at end of
second period
V₂R - D₁[32] = VR³ - D₁R² - D₁R - D₁ = VR³ - D₁(R² + R + 1)
= V₃, appraised value at end of
third period, etc.
[31] Inasmuch as by hypothesis the periodic depreciation charges are
the same D₁ = D₂ = D₃ etc., hence, D₁ is used to represent the fixed
depreciation charge per period.
[32] Inasmuch as by hypothesis the periodic depreciation charges are
the same D₁ = D₂ = D₃ etc., hence, D₁ is used to represent the fixed
depreciation charge per period.
Generalizing, we have:
Vₙ₋₁R - D₁ = VRⁿ - D₁(Rⁿ⁻¹ + Rⁿ⁻² ... + R² + R + 1) = Vₙ,
scrap value. Whence
Rⁿ - 1
VRⁿ - Vₙ = D₁ -------. Solving for D₁; we have:
R - 1
(VRⁿ - Vₙ)(R - 1) (VRⁿ - Vₙ)r
(4) D₁ = ----------------- = ------------,
Rⁿ - 1 Rⁿ - 1
= periodic depreciation charge
That this is the same as the amount of the periodic depreciation charge
by the sinking fund method plus interest on the investment, is seen by
comparing formula (4) with formula (3). Formula (4) may be written as
(VRⁿ - Vₙ)r + Vr - Vr
---------------------- ,
Rⁿ - 1
i.e., the quantity Vr-Vr = 0 is put into the numerator. Adding zero
(Vr-Vr = 0) cannot change its value. Performing the multiplication
indicated by the parentheses, we have
VRⁿr - Vₙr + Vr - Vr
--------------------- .
Rⁿ - 1
Rearranging the terms, we have
(Vr - Vₙr) + (VRⁿr - Vr)
------------------------,
Rⁿ - 1
which factored in each group becomes
(V - Vₙ)r Vr(Rⁿ - 1)
-------- + ---------- .
Rⁿ - 1 Rⁿ - 1
By reducing the second fraction, this may be written as:
(V - Vₙ)r
(5) --------- + Vr
Rⁿ - 1
which is seen to be identical with formula (3) for the sinking fund
except for the addition of Vr, which represents interest at r% on
the investment V. The identity of the annuity formula (4) with the
sinking fund formula (3) plus interest on investment can be established
similarly for any of the periods.
It will be noted that by the annuity method the whole original value of
the investment is always earning interest either in the sinking fund
or in the diminishing appraised value. Thus, the portion of original
value deducted each period earns interest in the sinking fund, while
what is left as appraised value earns interest outside the fund. Thus,
the annuity method of charging depreciation may be said to consist
of two parts, viz., the fixed periodic amount and interest on the
original investment. This will be seen from the appraisal schedule
which follows. The same illustrative data are used as before, including
interest at 5%.
=========+==========================================+
| Periodic Depreciation Charge |
| Composed of: |
+--------+----------+------------+---------+
| | | | |
Age in | | Interest | Interest | |
Periods | Fixed | on | on | Total |
| Amount | Fixed | Investment | Charge |
| | Amount | | |
| | | | |
| (a) | (b) | (c) | (d) |
---------+--------+----------+------------+---------+
| | | | |
0 | $..... | $.... | $..... | $...... |
1 | 18.10 | | 7.50 | 25.60 |
2 | 18.10 | .90 | 6.60 | 25.60 |
3 | 18.10 | 1.85 | 5.65 | 25.60 |
4 | 18.10 | 2.85 | 4.65 | 25.60 |
5 | 18.10 | 3.90 | 3.60 | 25.60 |
+--------+----------+------------+---------+
| $90.50 | $9.50 | $28.00 | $128.00 |
---------+--------+----------+------------+---------+
=========+===========+==============+=========================
| | | Accumulated
| | | Depreciation
| | +-----------+-------------
| Appraised | Depreciated | |
Age in | Value | or Appraised | |
Periods | Plus | Value | Including | True
| Interest | | Interest | Depreciation
| | | |
| | | |
| (e) | (f) | (g) | (h)
---------+-----------+--------------+-----------+-------------
| | | |
0 | $...... | $150.00 | $...... | $......
1 | 157.50 | 131.90 | 25.60 | 18.10
2 | 138.50 | 112.90 | 51.20 | 37.10
3 | 118.55 | 92.95 | 76.80 | 57.05
4 | 97.60 | 72.00 | 102.40 | 78.00
5 | 75.60 | 50.00 | 128.00 | 100.00
| | | |
| | | |
---------+-----------+--------------+-----------+-------------
It will be noted, as stated above, that the sum of the two interest
items in columns (b) and (c) is the same for each period, viz., $7.50,
interest on the _original_ investment. The total of column (d), total
charge for periodic depreciation, minus the total of column (c),
interest on the diminishing appraised values, gives $100, the true
depreciation as shown by column (h). _True_ depreciation under the
annuity method is the same as under the sinking fund method. The
periodic depreciation charge differs, however.
A graphical illustration of the main items of the appraisal schedule is
shown below:
[Illustration: _Graphic Chart—Annuity Method_]
In the above chart the points A¹, A², etc., represent the appraised
values plus interest, the segments, A¹I¹, A²I², etc., representing
interest on each period’s investment. It is to write down these
increases in value that the additional $28 of periodic depreciation
charges is needed. The curve OC is a straight line since each period’s
depreciation charge is the same. Curves AB and OD are identical with
those of the sinking fund method. Curve OE represents the accumulating
interest on investment as shown by the segments A¹I¹, A²I², etc. Curve
OC is the sum or resultant of curves OD and OE.
The annuity method is termed the “Equal Annual Payment” method in a
preliminary report of the Valuation Committee of the American Society
of Civil Engineers. As here illustrated it does bring about an equal
periodic charge but only because the assumed rate of interest for the
sinking fund accumulations is taken also as the rate for interest on
the investment. If these two rates differ, the periodic charges will
also differ. For example, if the sinking fund rate is taken as 5% and
the rate applicable to the appraised values is 8%, the sum of these
two interest amounts will not be constant because the bases on which
they are calculated are changing each period. Because of this fact
the Committee above referred to called this the “Compound Interest”
method in its final report. To distinguish this from the sinking fund
method which also uses the compound interest principle, the title here
adopted, i.e., the “Annuity” method seems to accomplish that purpose.
(c) Unit Cost Method
A third method which uses the compound interest principle is called
the “Unit Cost” method. Because of the involved mathematical processes
required for the calculation of the amount of its periodic charge,
and the doubtful practical value of the method, only a description of
its main features will be given here.[33] The aim of this method is
to equalize over each unit of product three costs, viz.: the cost of
interest on investment, the cost of operation and repairs, and the true
depreciation cost, all of these to be included in a periodic charge
under the title of “depreciation.”
[33] The interested student is referred to Proceedings—American Society
of Civil Engineers—December, 1916, in which will be found the Valuation
Committee’s report, and to Salier’s “Principles of Depreciation,” in
both of which the formula is developed.
The calculation of the true depreciation cost by the sinking fund
principle is the reason for including this method in the compound
interest type. The problem to be solved is the determination of the
price to be paid for an asset at a given time so that the cost of each
unit of product turned out during its remaining service life shall be
the same as the cost of each unit of product turned out during the
spent portion of its service life. The difference between the original
cost of the asset and the price determined as above will be the
depreciation of the asset for the elapsed period. A symbolic showing of
the problem will make the matter clear. The following notation will be
used:
V = original cost of the asset installed ready for use
V₁ = price that could be paid for it at the end of the
period as above explained
O = estimated average operating costs per period,
including repairs, for V
o = estimated average operating costs per period,
including repairs, for V₁
D[34] = true depreciation rate or multiplier under
the sinking fund method, for V
d[35] = true depreciation rate or multiplier under
the sinking fund method, for V₁
U = units of output for V during one period
u = units of output for V₁ during one period
r = rate of interest on the investment
[34] D and d may be expressed as the respective periodic
amount-multipliers necessary to create sinking funds of one dollar
each under the conditions as to time and rate for V and V₁. VD and V₁d
become, therefore, the periodic amounts of true depreciation, i.e.,
decrement in value.
[35] D and d may be expressed as the respective periodic
amount-multipliers necessary to create sinking funds of one dollar
each under the conditions as to time and rate for V and V₁. VD and V₁d
become, therefore, the periodic amounts of true depreciation, i.e.,
decrement in value.
Then:
O + DV + Vr
------------ = the cost per unit of output for V,
U
o + dV₁ + V₁r
-------------- = the cost per unit of output for V₁.
u
Since, by hypothesis, these two costs are to be equal, we may form the
equation
O + DV + Vr o + dV₁ + V₁r
------------- = -------------,
U u
which solved for V₁, the price to be paid, gives
u ( )
--- ( O + DV + Vr ) - o
U ( )
V₁ = ------------------------ .
(d + r)
Evidently, V-V₁ is the amount of the depreciation charge. The values
for D and d, as indicated in the footnote, may be substituted and the
amount of V₁ determined. The process is somewhat complicated in its
practical application and will not be carried further here.
4. MISCELLANEOUS METHODS
Other methods of calculating the depreciation charge are used, but they
cannot be classified under any of the three groups discussed so far.
They are a miscellaneous, mongrel breed, scarcely to be dignified in
some instances as methods. Among these may be mentioned the following:
(a) Maintenance Method
(b) Replacement Method
(c) Fifty Per Cent Method
(d) Appraisal Method
(e) Insurance Method
(f) Gross Earnings Method
(a) Maintenance Method
In this case a periodic charge for depreciation is made, equal in
amount to the cost of maintenance of the asset for the period. It is
thus a definite but variable amount, depending upon the maintenance
policy.
(b) Replacement Method
This is hardly a method of _calculating_ the depreciation charge,
but rather of recognizing the fact of depreciation by charging all
renewals and replacements to revenue. It is argued that in a large,
widely extended plant after depreciation has reached the point where
renewals are necessary, the charging of all renewals and replacements
as expenses will take care of all accruing depreciation and secure a
fairly uniform charge to product from period to period. Under this plan
depreciation as such does not appear on the books but is taken care of
under other titles.
(c) The Fifty Per Cent Method
This is somewhat similar to the replacement method in that it is
applicable only after depreciation has reached the renewals stage. It
is claimed for it that, in a property or class of asset consisting of
many similar parts, as railroad ties, for example, after the stage of
normal repairs has been reached so that the parts are in all degrees of
repair from 0% to 100%, the normal maintenance and renewals policy will
maintain the property or asset always in about 50% condition. Therefore
the total depreciation for the asset or class is the other 50%, which
never reaches a larger amount because of a constant renewal of parts.
This 50% depreciation may or may not be carried on the books but it
exists nevertheless. For the conditions under which it is applicable as
above, the law of averages doubtless applies and makes the estimate a
fairly good one.
(d) Appraisal Method
Here a physical appraisal of the asset or property is taken at the
close of every fiscal period. The difference in value between the two
appraisals for successive fiscal periods represents the depreciation
for the period and would be brought on the books as such.
(e) Insurance Method
This is applicable only to large properties with assets widely
distributed. Its operation “involves the actuarial principles
of ordinary insurance. This means that the fund accumulated by
depreciation charges should not be reserved as an accumulation until
it can be spent for the purpose of replacing the identical property
upon which the fund accumulated when such property is abandoned;
and furthermore, that this fund should be expended, in whole or in
part, during the year in which it is created, in the replacement of
equipment.”
(f) Gross Earnings Method
Here the depreciation estimate is based on the gross earnings for the
period. This does not necessarily mean that the depreciation estimate
will be large when profits are large, and small or nothing when profits
are small, although it may be made to apply in that way in individual
cases. The policy of making ample reserves for depreciation in good
years and scant reserves in poor years is not to be wholly condemned.
Depreciation, however, has no relation to, or dependence upon, profits.
Rather, profits depend on depreciation in the sense that they cannot
exist until after charges for depreciation have been taken care of.
Depreciation considered as a fixed per cent of gross earnings is almost
the same in effect as the service output method, and has much to
commend it.
Condition Per Cent
Before leaving the topic of method, it may be well to explain a term
used in connection with the depreciation estimate, viz., condition
per cent. The condition per cent of an asset is found by subtracting
from 100%, the fraction which represents the ratio of the present
accumulated depreciation to the total estimated depreciation. Thus,
if an asset has depreciated in value one-quarter, its condition
per cent is said to be 75 (100%-25%). Hence, condition per cent is
easily calculated if depreciation has been estimated by any of the
proportional methods. If, in addition to the standard notation used, we
assume that:
Dₘ = total amount of depreciation for m periods
Vₘ = value of the asset at end of m’th period
then, in general, condition per cent may be expressed by the formula:
Dₘ
(6) 100% - ----
D
Evidently, therefore,
( Dₘ )
Vₘ = V(100% - ----).
( D )
Under the proportional methods Dₘ/D = nd. Therefore, condition per cent
is 100%-nd.
Under the sinking fund method, the calculation is more complex. Dₘ,
the total amount of depreciation accumulated to date, i.e., after m
periods, is the amount of the annuity A for m periods. From formula
(3), Chapter XV, page 272, the amount of an annuity A is seen to be
A(Rⁿ - 1)
---------- .
r
A(Rᵐ - 1)
Therefore, Dₘ = ---------,
r
A(Rⁿ - 1)
and D = ---------,
r
from which the ratio
A(Rᵐ - 1)
---------
Dₘ r Rᵐ - 1
--- = --------------- = -------- .
D A(Rⁿ - 1) Rⁿ - 1
---------
r
Accordingly, condition per cent under the sinking fund method is:
Rᵐ - 1
(7) 100% - -------- .
Rⁿ - 1
CHAPTER X
DEPRECIATION—APPRAISEMENT OF THE VARIOUS METHODS
General Considerations
No method of estimating depreciation will ever be devised which will
be applicable under all conditions and to all kinds of property. Such
a panacea for the ills of wasting assets can obviously never be found,
for the very good reason that the same medicine will not suit all
patients. What gives good results in one case may not be applicable or
not equally so, in another case. In discussing the relative merits of
the various methods, therefore, no dogmatic rules for their use can
be laid down; furthermore, without a detailed knowledge of operating
conditions, only their main points of strength and weakness can be
pointed out, and this is all that will be attempted here.
In a critical discussion of methods and their effects, the fact of
depreciation may be considered from either the viewpoint of time or
service. Depreciation when viewed from the aspect of time may be said
to be due to:
1. Decrepitude, which is merely the lapse of time.
2. Inadequacy, which is lack of capacity to do the
work which increasing markets demand (a condition
the essence of which is also time).
3. Obsolescence, which represents the inability to
perform efficiently as compared with the service
secured from more modern equipment, and which
may be a condition brought about by lapse of
time and the developments of an art or science.
When viewed from the aspect of service, depreciation may be due
primarily to wear and tear, which is a condition directly dependent
upon the service rendered.
It has been pointed out that these elements of depreciation, viz.,
wear and tear, inadequacy, obsolescence, etc., are single and isolated
in their action and not cumulative. One of them, therefore, is the
controlling element in any estimate of depreciation. Accordingly, in
judging the merits of a method the kind of depreciation must be taken
into account; i.e., depreciation must be viewed from a time and service
standpoint.
Ideal Basis for Distribution of Depreciation Charge
Regardless of the actual progress of depreciation, the theoretically
ideal method of distributing the charge, from the standpoint of a
going concern, is so that each unit of output shall bear its just
proportion of the burden. Any other attitude is inconsistent. Thus,
assuming that actual depreciation does not progress uniformly, that,
as some maintain, the rate of depreciation is heaviest towards the
end of the service life of an asset, it would not be equitable to
charge the product of those years with a much higher burden than that
of the earlier years. Just as it is a misfortune to be born under
some conditions, so here it would be a misfortune to a commodity to
be produced during the latter years of the service life of an asset.
The life-period of an asset must be viewed as a whole and its total
depreciation should be distributed evenly over its output, if equity
is to be secured—other conditions, of course, remaining the same. This
principle does not apply alone to the depreciation charge but equally
to all other charges in connection with the asset, such as repairs,
maintenance, etc. The author does not believe that these other costs
should include a charge for an assumed rate of interest on the money
invested in the asset. For a full consideration of the question of
interest on capital as an item of cost of production, the student is
referred to Chapter XXVI. Any method of distributing the depreciation
cost must take cognizance of the other costs as well.
1. PROPORTIONAL METHODS
(a) Straight Line Method
The straight line method is, first of all, simple in application
and can easily be adapted to any asset under almost any conditions.
Partly because of the ease of calculation and application, it has been
designated as an official method by many regulatory boards. Its basis
is a time basis and it spreads the charge evenly over the periods of
the service life of the asset. Accordingly, where the time elements of
depreciation, viz., decrepitude, inadequacy, or obsolescence, control
and where the output does not fluctuate much from period to period, the
straight line method should give satisfactory results for its intended
purpose, i.e., for allocating the real depreciation charge.
Its effect, however, must be considered also in conjunction with
the distribution of the other costs connected with the asset. Many
engineers maintain that repairs are light during the early life of an
asset and heavy during the later years. If this is true and these costs
are charged to the period in which they are incurred, the combined
depreciation and up-keep costs place an unjustly heavy burden on the
output of the later years. Almost equally good authority maintains that
the cost of repairs is in no sense uniformly graduated as implied above
but can be counted upon in practice to be extremely irregular. If this
is true and up-keep costs are charged as above, then many periods are
apt to be underburdened and others loaded too heavily.
While, however, these considerations must be given weight when a
single asset is under view, in a large plant after operation has
continued to the point where a normal and fairly regular cost of
up-keep has become established, the inequalities of the individual
up-keep charges may merge into fairly equal charges for the up-keep
of the plant as a whole. This the law of averages accomplishes to a
greater or less degree. But in a small plant with few assets subject
to depreciation, the equality of the whole might not result from the
individual inequalities. After all, this magic rule of averages which
is invoked to cover up many troublesome and embarrassing situations is
obnoxious to scientific accounting; it is a makeshift which carries
with it a shiftless trust in the happy outcome of things—a trust which
has been so often betrayed as to carry little weight.
If depreciation costs can be predetermined with a satisfactory degree
of accuracy—and an estimate of them is all that can ever be made—with
equal accuracy and satisfaction can up-keep costs be predetermined.
The one is no more difficult than the other and equal reason exists
for predetermination in both cases, viz., the securing of an equitable
distribution of costs. With both estimates made at the beginning of the
service life of the asset, all costs in connection with the asset can
thus be prorated over the years of its service life.
If, as stated above, the output is fairly regular as between periods,
fair and equitable results will be obtained. If the output fluctuates
violently, unsatisfactory costs and an inequitable burdening of
product will be the result. The proper treatment of overtime and
“beyond-capacity” work, i.e., abnormal operations, requires care. It
is expected that such work will have a higher unit cost than normal
output, and it is proper that a sliding scale of depreciation be
applied in such a case.
(b) Working Hours Method
Most of the considerations taken into account for the straight line
method are equally applicable to the working hours method. Here,
with the service life expressed in terms of working hours instead
of fiscal periods, a far step has been made towards securing an
equitable distribution of depreciation costs over product. The rate
per working hour can in this way be applied directly to the product.
The machine-hour and sold-hour methods of costing distribute the
depreciation along with all other costs on this basis of “rate per
working hour.”
Where a machine or other asset is limited in its use to a few
operations equally wearing in their effect, this method should give
satisfactory results. Where, however, one asset can be used for
many different processes, involving inequalities in wear and tear,
if the service rendered is the controlling factor, an inequitable
distribution will result. Similarly, beyond-capacity operation, i.e.,
operation beyond the normal speed at which depreciation cost has
been predetermined, will not be taken care of automatically by this
method. Adjustment is necessary and, though arbitrarily made, must be
attempted. Thus, ten articles might be turned out in one working hour,
whereas an estimated output of six formed the basis for determining
the rate of depreciation per working hour. As with the straight line
method, so here equal care must be exercised in securing an equitable
distribution of up-keep costs.
(c) Composite Life Method
This is not a working method for estimating individual depreciation
costs, but rather a method of proof or check, which proves very
valuable in some cases. The method is discussed in detail on page 197
where the uses to which it may be turned are pointed out.
(d) Service Output Method
The service output method bases the depreciation cost not on years of
life nor on life in terms of working hours of service. Here an attempt
is made to predetermine the output of the asset in terms of units of
product, and so burden every unit with its fair share of depreciation.
To secure full equality of charges, up-keep costs must be reckoned on
the same basis, rather than on a time basis of service hours or length
of life. If conditions are uniform and normal, this method, where
applicable, secures perhaps the most satisfactory of all allocations
of depreciation costs. To an individual machine performing several
different processes the method would scarcely be applicable. To a group
or battery of machines, turning out a uniform product in finished form
or in the same degree of partly finished condition, the method could
be well applied. The estimated total output of the group would then be
taken as the basis for calculating the service output of each machine
in the group. When calculating service life in whatever units, that
speed of operation which secures the highest efficiency is taken as the
figure of normal operation.
From the foregoing it follows that the service output method of
calculating the depreciation charge per unit of output is well adapted
to an inherently wasting asset, such as a mine, a quarry, and timber
lands, and is almost invariably applied in such cases.
2. VARIABLE PERCENTAGE METHODS
(a) Fixed Per Cent of Diminishing Value Method
The chief merit of the variable percentage methods, in the eyes of
their advocates, is the way they are automatically adjusted to the
up-keep charges. The reader should study the graphs of these various
methods as a means of comparing results.
On the graph, page 158, it is shown that under the fixed per cent
of diminishing value method the periodic depreciation charges are
heavy in the beginning and decrease toward the end. It is argued
that, inasmuch as up-keep costs increase as the depreciation charge
decreases, this method automatically equalizes these two costs. This
argument was examined in detail under the previous discussion of the
straight line method. What was there set down applies equally here. The
fixed per cent method is also based on service life by periods—a time
basis rather than a service or output basis. Furthermore, it involves
a complex calculation and is perhaps never applied with any degree
of accuracy. Lawrence R. Dicksee prefers this method for handling
depreciation on machinery.
(b) Sum of Expected Life-Periods Method
The objection of complexity of calculation to the method just discussed
is overcome largely in the sum of expected life-periods method. Here
the rate of decrease is more marked, but the method has the same
general effect as the fixed per cent method. If the repair charges are
handled, as suggested, by means, of pre-estimates, the results will
not be equitable. If repairs increase with uniform regularity as the
depreciation costs decrease, fair equality is secured. Otherwise the
method has little to commend it.
(c, d) Arbitrary Methods
The two other methods under this main group, viz.: arbitrary with
increasing amounts in the one case and decreasing amounts in the other,
are not based on any orderly scheme of calculation and, having little
logic behind them, are not to be relied upon. Ease of calculation is
perhaps their only merit.
3. COMPOUND INTEREST METHODS
General Considerations
In a discussion of compound interest methods the basic feature, that
of the compound interest principle, requires consideration. The
thought of progression on a compound interest basis is fascinating to
many. It is a powerful instrument of accumulation and its charm seems
to lie in the fact that through its instrumentality small sums can be
made to grow into large sums. Whether the principle is applied to the
creation of a fund or simply as a method of _calculating_ periodic
amounts, the remarks of P. D. Leake,[36] an English authority, are
equally appropriate. He says: “May I impress upon you that these
devices are dangerous expedients in any but the most skillful hands....
It (the sinking fund) is apt to give a sense of false security,
because its whole virtue depends upon its obligations being faithfully
carried out over the whole period, and this condition is not always
fulfilled.... It is probable that in many cases the use of a sinking
fund is an altogether unwarrantable draft upon the future, because
there is no reasonable certainty that the fund, whether it be state,
municipal or commercial, will not be raided before it attains its
object.”
[36] In “Depreciation and Wasting Assets.”
Over short periods the difference between the periodic amounts under
this method and the straight line method is slight, as will be apparent
from a comparison of the two charts on pages 153 and 162, giving
graphic illustration of the two methods. There the period is for five
years. When the period is extended to, say, twenty or fifty years, the
difference in burden, due to interest accumulations, between the early
years and the later years is very marked. “Thus, a 10-year unit having
no salvage value, loses half its value in 5 years under the straight
line theory, regardless of the rate of interest, and at 5% under the
compound interest theory it loses nearly as much—about 44% of its value
in the same time; ... but a 50-year unit, losing half its value in 25
years, under the straight line theory, loses only 22.8% of its value,
at 5%, under the compound interest theory.”
(a) Sinking Fund Method
The sinking fund method as an orderly scheme for estimating the
periodic depreciation charge _will_ make the estimate, and, if adhered
to faithfully, the entire depreciation will be written off by the
end of the service life of the asset. In this respect it is to be
preferred to any arbitrary or haphazard method. That it secures an
equitable distribution of depreciation costs over the product of the
various periods, or that it effects a correct valuation of the asset at
intermediate periods of its life is open to serious questioning. The
periodic charge under the sinking fund method perhaps bears no relation
to the fact of depreciation. The method is, at the best, simply a
mathematical device for an orderly calculation of periodic amounts. In
the valuation work of public service companies or in regulation work
where, as in California, actual funds must be set aside to accumulate
at compound interest, there is no serious objection to the method.
Although it rests on false or doubtful assumptions of fact and results
in an inequitable burden on the product as viewed from the standpoint
of individual assets, these are minor considerations; for the method
does by the end of its service life take care of the loss in value.
Judged from the standpoint of its relation to up-keep costs, the method
lays an increasingly heavy burden on the later years of the life of the
asset.
(b) Annuity Method
All that has been said with regard to the sinking fund method applies
with equal point to the annuity method. As previously indicated, in
the explanation of its essential features, this method automatically
secures a charge for interest on the investment as a part of the
depreciation charge. Not only is the charging of interest of doubtful
propriety in itself, but certainly its inclusion under the title of
depreciation is misleading and indefensible. The courage of one’s
convictions with regard to interest as a part of cost should not allow
interest to shelter itself under the cloak of “depreciation.” By
referring to the appraisal schedule and chart, it is seen that the real
depreciation charge is exactly the same under the annuity as under the
sinking fund method.
(c) Unit Cost Method
The unit cost method represents an attempt to secure an equal burdening
of each unit of product with interest, depreciation, and operating
costs. In the language of its proponents, “this theory is probably the
soundest theory of depreciation, and when applied with intelligence,
probably furnishes the truest measure of accrued depreciation.” While
the end sought by the unit cost method is commendable, it is a compound
interest method and it mixes interest, up-keep, and depreciation under
the one title “depreciation.”
4. MISCELLANEOUS METHODS
Criticisms of the miscellaneous theories can be brief.
(a) Maintenance Method
This method is irregular in its incidence, and under it the
depreciation charge fluctuates violently between periods. Just as
maintenance is subordinated to the requirements and demands of the
trade, so also are depreciation costs made to depend on the same
conditions. The charging of depreciation thus becomes a matter of
business convenience instead of an inexorable fact of production. Just
as repairs are postponed to a slack period during which maintenance
charges are in consequence heavy, so does the depreciation charge
increase even though actual wear and tear has decreased. Presumably
the method makes charges light during the early years and heavy
during the later years of the life of the asset. In a large plant
with various kinds of assets, after a normal up-keep charge has been
established, the maintenance method of estimating the periodic charge
for depreciation for the plant as a whole may work out fairly well on
the theory of averages or by accident; for maintenance is not a measure
of depreciation.
(b) Replacement Method
This is not a method of measuring depreciation but rather of
financing it, i.e., of making good the loss. It also is based on
the law of averages, and in a large plant after the point of normal
replacements has been reached it may prove a satisfactory method of
accomplishing its purpose. It does not serve as a means whereby a
periodic depreciation charge can be brought on the books. Furthermore,
it disregards the depreciation accrued up to the point of normal
replacements.
(c) Fifty Per Cent Method
This method is also based on the law of averages. Here the law is very
apt to work out satisfactorily. When the point of normal replacement of
the assets, to which the 50% method is applicable, has been reached,
the amount of depreciation is approximately 50% of the original value
of the group of assets. This amount may be booked at that time and
will remain without change thereafter, for the assets are maintained
constantly in that condition. As a means of valuation, the method may
serve well; as a measure of periodic depreciation or as a means of
distributing the depreciation cost over the product, it is inadequate.
(d) Appraisal Method
This method is also inadequate as a means of measuring the periodic
cost of depreciation. The physical facts of depreciation are not
usually discernible at such short intervals. A judgment of values
must, therefore, almost invariably make use, consciously or
unconsciously, of some of the other methods of estimating the amount
of depreciation by periods. After all, all methods of measuring
depreciation are appraisals. Under the appraisal method confusion
between original cost and reproduction cost is almost certain to
occur, for present market values usually control physical appraisals.
A discussion of the relative merits of original cost and reproduction
cost as a proper basis for estimating depreciation will be presented in
Chapter XI.
(e) Insurance Method
This method of carrying the depreciation charge is analogous to the
policy practiced by some concerns of taking care of their fire losses
by carrying their own insurance. If physical conditions are such
as to make such a policy advisable or prudent, it should work out
satisfactorily. It should be noted, however, that the insurance method
is a means of providing funds for financing replacements and renewals
rather than a method of insuring an equitable distribution of the
depreciation cost over the product. The method of providing funds does
not need to be the same as the method of measuring the periodic cost of
depreciation. The insurance method serves the former purpose but is not
well adapted to the latter. Much of the criticism of the sinking fund
method is here applicable.
(f) Percentage of Gross Earnings Method
Measuring periodic depreciation as a percentage of the period’s gross
earnings is a convenient and fairly satisfactory method under some
conditions. If the principal element is wear and tear—a service factor
rather than a time factor—output may have a very direct relation to
gross earnings. If the commodity dealt in is a standardized product
and its price does not fluctuate to any extent or, better still, is
fixed, gross earnings will be a very fair measure of output. It is
true that the estimate is based on a sales valuation of output rather
than its cost of manufacture, but under some conditions this is a good
measure of relative output as between periods. A depreciation charge
based on gross earnings may thus give an equitable distribution of the
depreciation burden. In the case of public utilities, when the price of
the commodity or service dealt in is fixed, an estimate based on gross
earnings usually gives satisfactory results where used. In applying
the method, the expected earnings during the composite life-period
of the plant are estimated and depreciation costs are then prorated
over periods on the basis of earnings for the period as compared with
total earnings for the composite life-period; or more simply, a fixed
percentage based on past experience can be applied to the earnings
of each period. Some objections to the method, arising in some cases
from a misunderstanding of its operation, were pointed out when an
explanation of its working was given.
In some cases gross earnings bear no relation, or only the remotest, to
the quantity of output or the units of service rendered. A depreciation
estimate based on earnings would not in that case be logical and could
not give satisfactory results.
From the above discussion of some of the merits and shortcomings of
the various methods, the cogency of the introductory remarks, to the
effect that no method of measuring depreciation can serve as a panacea,
should be appreciated. Every depreciation problem is more or less an
individual problem; sweeping generalities will not serve.
Effect on Return on Investment
Many interesting studies have been made of the effect of some of the
above methods on stability of income as between periods and their
effect on the return of the investment, using hypothetical data as
to the earnings of the depreciating asset. Except for the purpose of
fixing rates in the case of public service corporations, where the
public has an interest because of the monopoly granted, stability of
income should be subordinated to the fact of depreciation and not serve
as a test of the merit or demerit of a method.
CHAPTER XI
RECORDING DEPRECIATION ON THE BOOKS
Methods Commonly Employed
Two methods of booking depreciation in the ledger are commonly
employed. The periodic adjusting entry on account of depreciation has
as its basic purpose the separation of the mixed account under asset
title into its two elements—the one to show the expense element, the
other to set up the true valuation of the asset. The expense element
is set up under the one title “Depreciation” for all the assets. The
deduction from the values as shown in the unadjusted asset account
may be made either by credit entry direct to the asset account or by
entry to a separate “Depreciation Reserve” account, each one of these
reserves distinguished by the name of the asset to which it applies.
The latter method is preferred because thus the asset account at any
time shows the original cost of the property—information of value for
many purposes and worth the effort needed to maintain it distinct
from other items. Under this method every wasting asset account is
immediately followed by its particular depreciation reserve account,
called its “valuation” account. The depreciation reserve is as much a
part of the record of the asset as is the asset account itself. The two
accounts are complementary, neither giving reliable information without
the other. The reserve account is thus always and only a balance sheet
account.
The above statement indicates the most satisfactory method of handling
the various depreciation reserve accounts on the balance sheet.
Although appearing on the credit side of the ledger, they are in no
sense liability accounts, being interpreted always as credits to the
asset account, held in suspense, as it were, in the reserve account,
pending full determination of their accuracy, which governs their
ultimate disposition. Thus, on the balance sheet, either only the
net present value of the asset should be shown, or preferably its
original cost with its value extended short, its depreciation reserve
deducted, and the present value, thus determined, full-extended.
Further information of some value is given if besides the amount of
the reserve the rate of depreciation is shown, though this is not
often done. Occasionally an entirely incorrect showing, from the
viewpoint of strict form, is seen when not only are the depreciation
reserves—usually in one item—shown on the right side of the balance
sheet but are set up in the Net Worth section, seemingly as a part of
the surplus or other true profit reserves. This practice cannot be
justified on any ground except that the sheet is kept in balance—a
consideration which is far removed from real essentials.
Renewals and Replacements
_First Method._ As to the handling of the reserve at the time of
renewal of parts and replacement of the entire asset, here also two
methods are met. Under the one, the original cost of the part (or
whole) retired is transferred from the asset account, its salvage value
as defined above being carried to a Salvage account, and the cost less
salvage portion being charged to the reserve account of the asset.
This clears the asset account of all capital charges on account of the
part (or whole) retired. The new part (or whole) replacing it is now
charged to the asset account which then represents true cost of the new
asset. If it is a whole which is replaced, theoretically the charging
of it against the reserve should just clear that account of all values.
Practically the preliminary estimate or forecast of the amount and time
of depreciation never coincides exactly with the fact of depreciation.
A credit balance in the reserve indicates an overallowance for
depreciation and is an item of true reserved profits, i.e., surplus;
whereas a debit balance indicates an insufficient allowance and is an
expense item chargeable against surplus and not _current_ profits. This
matter is treated at greater length on page 205. When the whole asset
is replaced, the depreciation reserve should always be cleared of any
remaining balance, as indicated above, so that the new asset and its
depreciation allowance may be handled and watched unobscured by the
record of any inherited sins or virtues from the past.
_Second Method._ The other method of handling the reserve at the time
of replacement requires a comparison of the cost of the displaced
asset and the cost of the new asset. The old asset account is allowed
to stand untouched, but any betterment, i.e., excess of reproduction
cost over original cost, is charged to it so that the asset account
may show cost of the new asset. This cost, except for its betterment
portion, if any, is now charged against the reserve. Both methods thus
accomplish the same purpose, but the first is more direct and simpler
of operation. It may be interesting to note that, in early instructions
to railway accounting officers, the Interstate Commerce Commission
prescribed the second method, which emphasizes the betterment feature.
The present regulation is in accord with the first method.
Occasionally one finds a practice which, though based on the second
method, differs in that no determination of betterment values is
made, the original asset values remaining undisturbed and the entire
reproduction cost being charged against the reserve account. This
practice, of course, is due to a lack of understanding of the nature
and purpose of the depreciation charge and its offsetting reserve, and
is counter to correct principles. There is, however, seeming judicial
support for it in cases of the valuation of utility properties for rate
purposes. The problem is discussed in full on page 202. The entries on
the general books thus present no difficulties.
Subsidiary Records
Subsidiary records should usually be kept to show the detail of the
group asset accounts carried on the general ledger. Not only is this
necessary to maintain an adequate check on the inventory of the group
asset and control over it, but without a detailed record of items it is
impossible to keep careful watch over the operation of the forces of
decay and depreciation and, therefore, equally impossible to build up
reliable experience data concerning each group of assets. The amount of
detail necessary in the record of the plant assets is dependent upon
the information desired and capable of being obtained within a limit of
cost low enough to make it worth the cost. This is a matter of policy
which the management must determine. It may be desirable to carry the
records in much greater detail for a period than would be justifiable
as a permanent policy. It may be worth while to make more or less
frequent studies of particular groups of assets in order to check up
the effect of the depreciation rates.
As is pointed out elsewhere, while the preliminary estimate of expected
life, and determination therefrom of the depreciation rate, are of
great importance and the utmost skill and judgment possible should be
employed, only a policy of everlasting vigilance and readjustment, in
the light of new data available with the increasing age of the asset,
will bring satisfactory results. To predetermine a rate and then to
expect it without supervision to work out to a successful conclusion
is, to say the least, foolish. Only by means of a complete record of
life histories can a mass of reliable data be built up which can be
made to serve as a guide for the future. The depreciation problem is
an individual problem and must, from the nature of things, remain so
to a marked degree. Until conditions under which the lives of assets
are to be lived become more or less standardized, or so long as each
concern must carry its own depreciation insurance, standard rates of
depreciation will not have a controlling significance.
Grouping and Classification of Plant Assets
From what has been said it is evident that the assets of a plant must
be divided into groups for the sake of simplicity and convenience
in keeping record of them. The basis of grouping should be physical
similarity, process, or product. Thus, all tram cars might be carried
in a group, as also all machines doing the same work or process. Groups
of machines performing different processes on the same product could
well be treated as a depreciation unit, and likewise all buildings used
for the same purpose, if of a similar type of construction. If the
latter are of different types it might be desirable to keep separate
records. As stated above, the information desired must govern the
groups under which record of behavior and performance are kept.
A numerical or an alphabetic numeric system of classification and
identification is advantageous. Each machine, piece of equipment, or
other asset should be marked or tagged when installed so that any
particular piece of equipment can be identified at any time. The tag
should carry date of installation and the name of the maker or vendor,
as well as its own identification number. By the use of a combined
alphabetical and decimal numerical system, almost any possible grouping
can be made according to main and auxiliary groups, processes, or
products.
Form of Plant Ledger
The form of the plant register or ledger need not be elaborate.
Its main subdivisions should correspond with the subdivisions of
plant and equipment carried on the general ledger. Thus, if we find
therein accounts with buildings (factory, store, office, etc.),
machinery, furniture and fixtures for factory, store, and office,
delivery equipment, etc., subsidiary records should show corresponding
subdivisions. It should be a matter of fixed policy to require a
periodic proof of these subsidiary records against their respective
controlling accounts on the general ledger. Only thus can the inclusion
of all items in both records be made certain. The control established
must cover both the items of the assets record—the original cost as
shown by the asset account—and the accumulated depreciation as shown by
the reserve account.
Asset Record
Aside from the title and classification and identification number, the
plant register should provide a record of the asset under the heads of:
1. Date of installation or adjustment.
2. Estimate of life in periods, working hours, service
output, etc.
3. Original value, including installation costs.
4. Periodic depreciation burden.
5. Periodic appraisal value.
On the form shown below, provision is made for adjustment of the
original estimate of depreciation. Where there is a realizable scrap
value, additional columns to show scrap value and total depreciation
to be written off should be provided. The form shown would have to
be adapted to the method of depreciation decided upon as applicable
to a particular asset. Thus, if working hours or service output are
the basis, provision should be made to show the basis of calculation
of each period’s depreciation burden. The following form is well
adapted to make record of the asset under the straight line method of
depreciation.
[Illustration: From “Principles of Depreciation” by Earl A. Saliers.
_Plant Ledger (showing adjustment of value)_]
Periodic Revision of Rates
In Chapter VIII where the problems in connection with depreciation
rates were discussed, a periodic testing of the effects of the
particular rate employed was laid down as an essential for the
application of any rate. The determination of the rate in the first
place is a problem requiring expert knowledge and the most careful
consideration of many factors. Hardly less important, however, for the
successful operation of any depreciation scheme is the attention given
to the manner of its operation and a modification and readjustment of
rates to bring the theoretical expectation of the wasting of the asset
into accord with its actual wasting to date.
At the beginning, when the asset is first installed the depreciation
rate must be based, so far as this particular asset is concerned,
entirely on contingencies. None of its life has been lived; none of
its actions and behavior have yet become a matter of record. What it
is apt to do can be forecast only by a study of its ancestors—heredity
as modified by a reasonable expectation of change due to different
environment. However, at the end of five years, say, there is available
a record of service and behavior in the light of which not only can the
accuracy of the forecast be judged, but also a more reliable forecast
for the remainder of its service life can be made.
Frequency of Revision of Rates
Because of the conditions stated above, a periodic testing of rates
should be made. How frequently this should be done depends largely
on local conditions. Certainly sufficient time should be allowed to
pass to secure a really worthwhile test. What constitutes a sufficient
time depends largely on the expected length of life. Long-lived assets
obviously need not be tested so frequently as short-lived assets;
and the periods should be shortened when the asset has been serving
under supernormal conditions; the intensity of its life would be a
controlling factor. It is usually stated that this testing of rates and
conditions should be made at least every five years in the form of an
appraisal. In the physical appraisal care should be used not to allow
present market prices to enter into it, else the element of fluctuation
may easily be brought in to nullify or exaggerate the real results of
depreciation.
Test of Condition Per Cent
At the time of reappraisal the estimated condition per cent or the
expectancy as to remaining service life are the points most to be
considered. C. E. Grunsky has made an interesting contribution to the
study of expectancy—theoretical, it is true, in the sense that it is
based on assumed hypotheses, but nevertheless of value as calling
attention to a phase of the subject that presents large possibilities.
He takes 10,000 similar articles, all of probable life-terms of 10
years, and all simultaneously installed. Assuming that of these 10,000,
100 will fail or go out of service at the end of the first year, 200
at the end of the second year, that the largest numbers will fail in
the years just before and just after the expected life-term of 10
years, and from then on, that there will be a gradual decrease in the
number of failures until the 20th year, beyond which time (double
the estimated life-period) none will remain in service—the following
table is shown, which gives in the last column at the right the life
expectancy of all remaining articles as at the beginning of a given
year.
It will thus be seen that an article which has survived its 5th year,
has at the beginning of its 6th an expectancy, not of 5 years but of
6.12 years; an article which has lived its allotted 10 years has an
expectancy of 3.67 years; and so on. Certainly Mr. Grunsky’s study,
if it serves no other purpose, at least draws attention to possible
lines of development and, read in connection with facts as to the
known length of life of many assets which have outlived their expected
terms, it draws strong attention to the need of very careful use of any
so-called mortality tables. These life history tables for assets are
similar to the mortality tables used by life insurance companies.
TABLE OF EXPECTANCY[37]
The probable life of each article is 10 years or
periods. For terms other than 10 years, each year
in the table may be regarded as a period equal to
one-tenth of the probable life-term.
(Based on the special hypothesis of failures as
explained in the text)
========+==========================================+===============
| FOR 10,000 ARTICLES | SINGLE ARTICLE
+----------+------------------+------------+---------------
Year or | | Remaining Number | Remaining |
Period | Number | of Articles at | Service at | Expectancy at
| of | Beginning of | Beginning | Beginning of
| Failures | Year | of Year | Year or Period
--------+----------+------------------+------------+---------------
1 | 100 | 10,000 | 100,000 | 10.00
2 | 200 | 9,900 | 90,000 | 9.00
3 | 300 | 9,700 | 80,100 | 8.27
4 | 400 | 9,400 | 70,400 | 7.46
5 | 500 | 9,000 | 61,000 | 6.77
6 | 600 | 8,500 | 52,000 | 6.12
7 | 700 | 7,900 | 43,500 | 5.51
8 | 800 | 7,200 | 35,600 | 4.95
9 | 900 | 6,400 | 28,400 | 4.44
10 | 1,000 | 5,500 | 22,000 | 4.00
11 | 900 | 4,500 | 16,500 | 3.67
12 | 800 | 3,600 | 12,000 | 3.33
13 | 700 | 2,800 | 8,400 | 3.00
14 | 600 | 2,100 | 5,600 | 2.67
15 | 500 | 1,500 | 3,500 | 2.33
16 | 400 | 1,000 | 2,000 | 2.00
17 | 300 | 600 | 1,000 | 1.67
18 | 200 | 300 | 400 | 1.33
19 | 100 | 100 | 100 | 1.00
20 | 0 | 0 | 0 | 0
--------+----------+------------------+------------+---------------
[37] From “Valuation, Depreciation and the Rate-Base,” by C. E.
Grunsky.
Composite and Group Rates
In the practical application of the depreciation rate in a large
plant, every separate piece of property is not, of course, considered
by itself. The plant is divided into groups of similar assets,
determined roughly on the basis of life expectancy, conditions of
service, etc. Using these groups it is possible to find the rate of
composite depreciation—a figure which serves as a check over the group
depreciation. This is also sometimes called the “mean life” of the
plant. It is determined by two methods—one called the direct, the other
the dollar-year method. Assuming groups of assets of varying life
lengths and costs, the following examples show the manner of estimating
the amount of depreciation for the whole plant and also composite life;
that is, the mean average life of the individual assets when viewed not
as units but as a composite whole:
MEAN LIFE
DIRECT METHOD
======+=========+================+==============+=============
Group | Life | Value | Rate | Amount of
| in | to be | of | Periodic
| Periods | Depreciated[38]| Depreciation | Depreciation
------+---------+----------------+--------------+-------------
A | 5 | $100,000 | 20 | $20,000
B | 10 | 75,000 | 10 | 7,500
C | 15 | 60,000 | 6⅔ | 4,000
D | 20 | 120,000 | 5 | 6,000
| | -------- | | --------
| | $355,000 | | $37,500
------+---------+----------------+--------------+-------------
[38] That is, cost less salvage.
Mean life is $355,000 ÷ $37,500, or 9⁷/₁₅ periods.
Under the dollar-year method, the invested values are weighted by the
length of their investment term and thus all investments are reduced to
the common basis of one dollar for one year:
MEAN LIFE
DOLLAR-YEAR (OR WEIGHTED RATIO) METHOD
=====+====+===========+=============+================+============
| | Values |Turnover Rate|Total Investment|
Group|Life| to be | in Longest | During Longest |Dollar-Years
| |Depreciated| Life-Period | Life-Period |
(a) |(b) | (c) | (d)[39] | (e) | (f)[40]
-----+----+-----------+-------------+----------------+------------
A | 5 | $100,000 | 4 | $400,000 | $2,000,000
B | 10 | 75,000 | 2 | 150,000 | 1,500,000
C | 15 | 60,000 | 1⅓ | 80,000 | 1,200,000
D | 20 | 120,000 | 1 | 120,000 | 2,400,000
| | -------- | | -------- | ----------
| | $355,000 | | $750,000 | $7,100,000
-----+----+-----------+-------------+----------------+-------------
[39] That is, the number of times renewal of the asset will be required
during the longest life-period of any of the assets.
[40] Dollar-years, column (f), is the product of the total invested
values as shown in column (e), and the life of each group as shown by
column (b). Thus, $400,000 invested for 5 years is the equivalent of
$2,000,000 invested for 1 year.
Column (f) ÷ column (e), (7,100,000 ÷ 750,000 = 9⁷/₁₅) gives the mean
life.
Column (e) ÷ the longest life-period, 20 years, (750,000 ÷ 20 = 37,500)
gives an annual charge for the whole plant.
What is known as “mean” age or plant expectancy as to remaining life
may be found similarly. Assume a physical appraisal made after 12
years’ life of the above assets:
MEAN AGE (LIFE EXPECTANCY)
DIRECT METHOD
=====+====+==============+=========+============+===============
| | Unexpired or |Condition|Values to be| Values Already
Group|Life|Remainder Life| % |Depreciated | Depreciated
(a) |(b) | (c) | (d)[41] | (e) | (f)
-----+----+--------------+---------+------------+---------------
A | 5 | 3 | 60 | $100,000 | $40,000
B | 10 | 8 | 80 | 75,000 | 15,000
C | 15 | 3 | 20 | 60,000 | 48,000
D | 20 | 8 | 40 | 120,000 | 72,000
| | | | -------- | --------
| | | | $355,000 | $175,000
-----+----+--------------+---------+------------+---------------
[41] (d) = (c) ÷ (b).
Group A assets, having been twice renewed, would be in 60% condition;
Group B, 80%; Group C, 20%; and Group D, 40%.
Column (f) ÷ column (e), (175,000 ÷ 355,000 = 49²¹/₇₁%) gives the per
cent of composite depreciation already taken effect.
The mean life, as determined above, multiplied by per cent of composite
depreciation gives the mean age or portion of the mean life already
lived (9⁷/₁₅ × 49²¹/₇₁% = 4⅔).
The figure of mean or composite life may serve two purposes. First, it
forms the basis for comparison with other similar plants and is about
the only fair basis for comparison. Second, it gives the basis for
estimating the amount of annual depreciation of the plant as a whole.
This statement does not mean that individual depreciation reserves are
not to be carried for each group of assets and those charged with the
value of the asset as soon as it is discarded and renewed. But the use
of the estimated mean or composite life figure does give a control
over the amounts which should always be found in the individual group
reserve accounts, i.e., at any given time the sum of the individual
reserve account balances should be approximately equal to the amount as
shown by the reserve when calculated on the mean life basis.
The Reserve as an Index of Financial Condition
The statement is often made that a balance sheet showing depreciation
reserves points to a conservative policy in the treatment of plant
properties. Usually such a balance sheet affords little or no basis for
expressing a judgment as to conservatism or the lack of it. All that it
does show is that recognition is made of the _fact_ of depreciation.
As to its _adequacy_ or _inadequacy_, a knowledge of other factors is
necessary.
_Fluctuating Reserve._ According to successive balance sheets a
reserve may vary little from year to year, or it may show considerable
increase or decrease, and any of these conditions may be entirely
normal and express adequacy of reserve requirements. In the first case,
stability of the reserve may result because the asset is short-lived
and hence is more or less frequently replaced; or different units of
the property may have been installed at somewhat regular intervals so
that retirements from service are also somewhat regular. Under either
supposition, the charges against the reserve for the units displaced
would just about keep pace with the regular credits to reserve for
replacement purposes. In other words, that condition of the reserve for
that class of asset is the normal condition—except perhaps in the case
of a rapidly expanding plant, or other conditions not counted as normal
when the reserve requirements were put into operation—and any other
condition should lead to inquiry and investigation.
_Increasing Reserve._ In the second case where the reserve is showing
a considerable increase from year to year, that also may be a normal
condition. Long-lived assets are seldom replaced with any degree of
regularity in the annual charge against the reserve, except in the case
of very large plants where the number of such assets is correspondingly
large in proportion to their size. Here more or less regular
installations may take place as a result of an expanding business,
covering a period of approximately the same length as that of the life
of the asset. So here, too, any other than a regularly increasing
reserve must incite inquiry.
_Decreasing Reserve._ As to the third case, that of a somewhat
regularly decreasing reserve, the condition is not usually normal but
may occasionally be met in a plant where one type of equipment is being
retired and not replaced, due perhaps to a changing line of activity;
as when, for instance, a stock furniture manufacturer works gradually
into the exclusive manufacture of automobile and carriage bodies.
Some types of equipment will thus be gradually retired and their
reserves will constantly diminish, their place being taken by other
reserves covering the new type of equipment. However, this condition of
decreasing reserves, while entirely normal under certain circumstances,
being unusual, should always receive careful investigation. It is here
that mean life and mean age or composite plant depreciation are of
assistance in forming a judgment as to the general adequacy of reserves.
The Reserve in Relation to Expanding Plant
In the case of a plant the development of which is stationary, the
problem of judging the adequacy of the reserves is simple in comparison
with a plant which is expanding, resulting not only in the installation
of more of the same kind of equipment but also of equipment of other
kinds. A disturbing element is thus introduced and careful oversight of
the depreciation policy must be exercised. In all cases, intelligent
reading of the reserve and its sufficiency are internal problems based
on intimate knowledge of conditions. Lacking this knowledge no true
judgment can be made. The character of the asset, number of units in
use, dates of installation, a comparison of the assumed conditions at
date of installation with the actual conditions of the present—all are
factors to be taken into account.
Reserve as Related to Efficiency
The general relation of efficiency to depreciation has already been
discussed. As to whether the condition of the reserve is any index of
the efficiency of the service rendered by the plant unit, attention is
briefly directed to a misinterpretation of individual reserves. Experts
state that many types of equipment cannot deteriorate actually more
than a fixed per cent of their cost and continue to give efficient
service. If, say, 30% is the limit in the case of one type, this does
not, of course, indicate that, as soon as the depreciation reserve
shows an amount equal to 30% of the cost, the approach of inefficient
operation and the time of discard are at hand. It must be borne in
mind that the reserve is a device based on financial considerations
and, if properly calculated and handled, no asset should be ready for
retirement until its reserve approaches in amount the value at which
the asset is carried in its account. Nor is the point of approaching
inefficiency shown until that condition of the reserve is found.
Reserve not Based on Cost of Replacement
The question is sometimes raised as to whether reserve requirements
should be based on original cost or cost of replacement new. The
question usually reveals a lack of understanding both of the purpose
of the depreciation charge and the means of financing depreciation.
It is usually said that the reserves carried on the books are for the
purpose of providing the means of financing the replacement. It is
not the purpose here to go into the question of original cost versus
cost of reproduction new, either as a basis for valuation of public
utility properties or from the viewpoint as to where the incidence of
the burden of replacement properly should rest—whether on the users of
the service given by the asset to be replaced or on those using the new
asset. In the private enterprise where the rights of the public are
not so apparent, under present-day tenets of political and economic
philosophy, only internal policies and purposes to be accomplished need
be considered.
As stated above, the basic purpose of the creation of the reserve is
to burden the product with depreciation charge as a real part of the
cost of production. If we are concerned with real and actual costs of
production, by no stretch of the imagination can replacement cost—what
it might cost to replace the asset at some more or less distant
time—enter into the question. It might, with equal obscurity of logic,
be said that, because the labor cost is bound to be higher 10 years
from now than at present, in order to get the true _present_ cost of
the product the estimated future labor cost should be taken in place of
the actual present cost.
The Financing of Replacements
If one purpose of the depreciation reserve is that of financing
depreciation, this can mean only that the reserve must insure provision
being made so that the capital invested will not be lessened or
encroached upon by the wasting of the assets in which it is invested.
It is no necessary or proper purpose of the reserve to provide for
increasing the invested capital. _Financing_ the _replacement_ of
the retired asset is a separate financial problem and only concerns
accountancy, so far as the records may reflect that policy. The
reserve, in itself, does not furnish the means of financing any part
of replacement, as was fully shown above. If the new asset is expected
to cost more than the old, certainly business prudence would dictate
provision for the added cost as well as ready funds of an amount equal
to the original cost. The actual capital provided originally need be
sufficient only for the time being; to provide more than that, if
remaining idle, would be folly. If there is evidence of expansion,
or if it is recognized that more will be needed—due to change in
markets—for replacement purposes than was originally needed at the
inception of the enterprise, provision must be made therefor.
_Methods of Financing Replacements._ In the financing of replacements,
three courses are open:
1. Capital stock may be increased.
2. Funds may be borrowed.
3. Profits of the past may be reserved in the business
and the actual value of the holdings of the owners
thus be enhanced.
In the third case present dividends may be sacrificed for the sake of
the future. Such reserve profits must be kept and used for the intended
purpose, the purpose dictating their form as liquid or fixed. It cannot
be too strongly emphasized that these are reserves of _profits_—not
valuation or offset accounts under the title of reserves. Depreciation
reserves, except they become secret reserves in the sense referred to
below, have no right to serve any other purpose than that intended,
viz., to provide insurance that none of the originally invested capital
shall be dissipated and that the current product shall be burdened with
its just share of _all_ the materials and costs of production.
Secret Reserve
A great deal has been said about inaccuracies in the depreciation
charge; the need of periodic readjustments has been emphasized. Now it
is purposed to look into the effects of inaccurate charges remaining
unadjusted on the books. In a desire to be on the safe side, some
concerns, notably financial institutions, make very liberal provision
for depreciation. Such a policy is not entirely to be condemned and is
decidedly refreshing in comparison with the parsimonious allowances,
begrudgingly made in some quarters. The effect of such a policy,
if operated without check, is to create what is known as a “secret
reserve.” The value of the asset is charged more rapidly against
operation than the asset actually wastes. Hence the books show a
reserve sufficient to cover the cost of asset while there are still
values remaining in the asset. In other words, the business possesses
an asset of value which is carried on the books as of no value. Were
the real present value of the asset brought on the books, the contra
credit would appear in some surplus or _profits_ reserved account. Such
would constitute a true record of the item, openly stated. So long as
the asset remains concealed, i.e., without record on the books, its
contra credit is also latent and constitutes a _secret_ reserve of
profits.
A too liberal depreciation policy, if recognized and adjusted at the
time of a reappraisal, will require a separation from the depreciation
reserve of the portion brought about by the overallowance, and its
showing as a part of the surplus. When so handled, an overcharge for
depreciation has no permanently bad effect except as it may show, for
purposes of comparison, too high costs of production for the period
overburdened. However it may be and sometimes is, used for purposes
of fraud and therefore, as a fixed policy, the practice of the secret
reserve is to be condemned.
Insufficient Charge
On the other side is the parsimonious policy of too low a charge or
none at all. This results, whether consciously or not, in a charge
against capital instead of revenue. At the close of the fiscal period
the books are supposed to be brought into accord with the facts of
true condition as then existing. Therefore, if the full portion of the
accrued expenses is not separated from the wasting asset accounts,
but is allowed to stand on the books under the title of assets, then
these true expense items will still be carried hidden under the cloak
of asset titles. The depreciation is thus carried as a charge against
capital. The depreciation of a _going_ concern should never be so
treated; it is an operating charge, and no flight of fancy or shuffling
of figures can make anything else of it.
In the case of a property, showing inflated values because of too
low depreciation charges in the past, which is taken over and
rehabilitated, the sums spent on the property previous to operation to
put it in condition are properly capital charges. This is allowed on
the theory—unfortunately, not always a fact—that the difference between
the book value of the property and what was paid for it represents
the estimated expenditures necessary to bring the property up to its
book value. If such is not the case and full book value was given for
the property, the charge is still allowed, being looked upon as in the
nature of an organization expense, representing in an instance of this
sort the measure of the bad bargain made. This will, of course, result
in a penalty in the form of an added depreciation burden on all product
from the property taken over and rehabilitated.
Appreciation as an Offset to Depreciation
If depreciation is so inevitable and the necessity of its charge so
absolute, can anything be said in support of the proposal to offset
depreciation against appreciation? By appreciation is meant an increase
in value due to the passing of time. Judicial authority can be found
in support of it in cases of valuation for rate purposes.[42] There
is no question but that a _realized_ increment in land or any other
asset offsets a depreciation or any other expense charge in just the
same way that any other item of income offsets an expense. There is,
however, this marked difference between depreciation and appreciation:
the former is an inexorable reality advancing day by day entirely
independent of market fluctuations, whereas the latter is dependent on
the market and usually cannot be realized until the asset is sold.
[42] See Consolidated Gas Co. v. City of New York, 157 Fed. Rep. 855,
and 20 I. C. C. Rep. 344.
When, however, as is too often the case, the proposal to offset
depreciation by appreciation is meant to justify a policy which takes
no cognizance of depreciation on the books because it is offset by
appreciation, no support can be found for that view. In itself it
reveals an entire lack of knowledge of the purpose of the depreciation
charge or a disregard of the fundamental and obvious requirements of
prudence. Depreciation is one of the costs of production and without it
true cost cannot be shown. Failure to show depreciation on the books
would justify also the omission of a cash income item because the cash
was to be spent immediately in payment of salaries—a cancellation
outside the business records of income against expense which can under
no circumstances be justified.
Appreciation Due to Physical Changes
There is a kind of appreciation which is not dependent on fluctuations
of the market and which as surely accrues, up to a certain point, day
by day as does depreciation. Properties the value of which has been
enhanced by earth construction work done on them are susceptible of
this kind of appreciation. “Appreciation is generally restricted to
physical items, and measures their gain in value due to age, use, and
properly directed labor.... It results from work not specifically
charged to capital account ... and covers items not represented ... in
connection with a valuation.”[43] It is found in connection with such
items as roadbeds, solidification and grassing of slopes, drainage,
dams, embankments, etc.
[43] Valuation Committee of the American Society of Civil Engineers.
Its two forms are called solidification and seasoning, and adaptation.
By the first is meant a settling and compacting of loose earth and
its protection from wasting and washing away, as by the grassing of
slopes, and the planting of trees and shrubs to hold the snows. When
a roadbed is turned over to the operating division, it frequently is
far from complete in the sense of being in a high state of efficiency,
and the cost of its maintenance and up-keep during the early years of
its life is much higher than during later years. This appreciation due
to seasoning is difficult of valuation, but perhaps the difference in
up-keep between early and later years is the best measure of it.
Appreciation Due to Adaptation to Use
“Adaptation” is a term used to cover that class of expenditures
needed for the better adaptation of the property to its use. In the
early stages of the development of a property many things cannot be
foreseen nor can a proper basis be settled upon for a determination
of the charges as between capital and revenue. The proper handling
of such expenditures as those incurred for drainage requirements,
better adaptation of the roadway to the surrounding topography of the
country, etc., are difficult. If these costs have not originally been
charged against capital, the properties may truly be said to have
appreciated in value by reason of them. Items of this kind require a
wise discrimination between costs of operation and capital charges.
The effect of such changes is almost always lost sight of so far
as physical appearance shows, and the appreciation due to them is
difficult of valuation at a later time. In the case of railroads,
perhaps the difference in maintenance cost as between the early and
later years of the roadbed is the best index.
In the case of industrial concerns, the cost of a rearrangement of
machinery and working facilities for the better and more economical
handling of the product frequently results in an appreciation in value
due to adaptation to use. This has already been discussed in Chapter V.
As stated above, appreciation has judicial sanction and its valuation,
although fraught with many difficulties and uncertainties, has been
made and the results accepted. The generally haphazard method of
roughly estimating the value of an appreciation when its determination
becomes necessary suggests that it were better, by far, to attempt
the proper segregation of the charge between capital and revenue
at the time of its incurrence, rather than to take cognizance of
an appreciation in value at a later time. There are undoubtedly
circumstances in which appreciation in value can be properly recognized
and should be taken into the accounts not only of public utility
properties but also of industrial concerns.
Unearned Increment
Appreciation in value due to so-called unearned increment is entirely
a matter of market value. By this is not meant that the monetary value
of this kind of appreciation fluctuates with the market; it accrues
from day to day and is just as real as depreciation. Although very
real, it does not become _realized_ until the property is disposed of,
a thing which is determined by business policy and does not rest on
any principles of accountancy. It is not good practice to bring such
unrealized values on the books. For a fuller consideration of this
phase of the subject, see Chapter XVII where the problem is treated in
connection with land and real estate.
Depreciation Policy and Stockholders
A final consideration concerns the relation of the depreciation policy
to the stockholder. As stated above, a too liberal depreciation
policy results in the creation of secret reserves which may be used
to the prejudice of the stockholder by an unscrupulous managing
clique desirous of buying minority holdings at a depreciated value or
of manipulating the stock for speculative purposes. An insufficient
depreciation allowance results in a false optimism, a payment of
dividends out of capital, and perhaps finally in a wrecking of the
property. Except for the transient, speculative shareholder, a fixed
depreciation policy based on a conservatively accurate allowance is
always for the best interest of the property and its owners.
CHAPTER XII
CASH AND MERCANTILE CREDITS
Introduction
In Chapter V an effort was made to establish the general principles
of valuation as applicable to the main classes of assets found on
the average balance sheet. In doing so, the fundamental distinctions
between capital and revenue charges were set forth. In the six
chapters on depreciation the general principles of depreciation and
their application to problems in accounting have been developed, with
particular emphasis on the problems of valuation and true costs. It
is purposed now to consider in detail the various problems met in the
valuation of the individual items found on the commercial balance
sheet. It will be necessary also to consider the method of showing
these items so as to indicate the basis of valuation and something of
the financial policy employed. The various assets will be considered
in the order of their appearance on the balance sheet, the arrangement
being based on degree of liquidity, beginning with the most liquid.
What Cash Includes
There is little to be said about the _valuation_ of an asset of such
evident and definite value as cash. The problem here is rather one
of showing the nature of the asset, although certain principles of
valuation under given conditions need also to be considered.
The term cash as an item in the balance sheet usually includes all
money and whatever serves as money. Thus, all legal tender of the
realm, bank notes, checks, bankers’ drafts, postal and express money
orders, and occasionally postage stamps and even “IOU’s” are classed
as cash. Not all items, however, that may be carried on the books as
cash should appear under this caption on the balance sheet. There only
the current asset cash should be listed in the group of current assets.
All other cash, including that held for specific purposes under deed
of trust or otherwise, should, unless it is readily applicable for the
cancellation of current liabilities, be shown in some other group.
Where the petty cash or working funds of all sorts are operated on the
imprest system, the funds should be replenished before the books are
closed and should thus be truly valued at their ledger figures. The
bank account should be reconciled with the cash book, and the figure
should represent the amount at which the item is to be taken into the
balance sheet. This means, of course, that all properly authorized
claims against cash in bank are to be treated as cash disbursed if
they have been regularly issued, whether presented for redemption at
the bank or not. Checks written but not yet mailed are not usually
treated as cash disbursed because they are still under control.
Similarly, items left at the bank for collection and deposit may be
counted as cash on hand. If, however, as might happen in exceptional
cases, a comparatively large amount represented dishonored items and a
second attempt was being made to collect these dishonored items, the
better procedure would be to omit them from the cash total and include
them with the receivable items. In this connection attention should
be called to the practice occasionally met with of holding the cash
open for a few days after the closing date for the purpose of making
a better showing as to balance on hand by means of new collections.
This, of course, is a practice which cannot be countenanced under
any circumstances as it is simply an effort to mislead, even though
the effect may not always be bad. A balance sheet is a statement of
financial condition purporting to be true as on a certain named date.
The values shown therein are therefore to be those applicable to, and
true on, that date and no other.
Stamps Remitted as Cash
Some concerns dealing in commodities of small value sold through the
mails allow, and even encourage, payment by means of postage stamps,
these in turn being used for their own correspondence and parcels post
expense. The proper place to record the value of this item at the close
of the fiscal period is in the inventory of office supplies or other
similar heading instead of treating it as a part of the cash. This
necessitates a transfer from cash to office supplies. The transfer can
be accomplished in either of two ways without interfering with the
usual handling of the cash whereby it is checked against the bank’s
record of deposits and checks as explained in Volume I, Chapter XXXV.
The customary method is to use the cash book as the place of record for
the receipt of stamps and then transfer them to the stamp drawer for
office use. All other “cash” being deposited in the bank, the record
of cash receipts as shown by the cash book does not thus check against
the record of deposits as shown by the bank. To secure this agreement,
a check may be made out payable to “Cash,” “Ourselves,” or “Postage,”
and passed through the bank periodically as a deposit and so secure
the proper agreement between the bank’s record and the concern’s. The
record of the check among the cash disbursements thus secures the
proper charge to Postage or Office Supplies and also effects the proper
agreement between the bank’s record and the concern’s. The use of a
“postage” journal, operated on the same lines as the cash book and
recording all receipts and disbursements of postage, would accomplish
the same purpose and in some circumstances would be advisable.
Temporary Cash Disbursements
The practice of allowing proprietor, cashier, or others to take
cash from the cash drawer and leave a memo of some sort to show
responsibility or purpose is to be deprecated. Only where the principle
is strictly adhered to of depositing all cash and disbursing only by
check and by means of a petty cash fund handled under the imprest
method, can adequate control over cash even be approximated. Where,
however, such is not the practice, the problem is not that of the
valuation of cash, for the memos are not cash, but of the valuation of
claims receivable—a subject to be treated later in this chapter.
Disposition of Cash Funds
In the showing of cash for purposes of management, it is essential to
indicate the present disposition made of the various cash funds or to
show the immediacy of the control over them. Thus cash should be listed
as:
1. Safe or drawer
2. Various working funds
3. Petty cash fund
4. Bank
Under “Bank” should be indicated how much is held on “current” account
and how much is restricted to special purposes. Of the current balance
it is desirable to show the portion subject to check for immediate
needs and the portion representing surplus funds not immediately needed
and therefore held to earn interest. These amounts subject to interest
are almost always available on short notice, but usually only with the
sacrifice of interest earnings to date.
Cash from the sale of capital stock or bond issues, or from the sale
of old plant or any portion of it, under authorization from the
stockholders that it be held for purchase or construction of new
plant, or for other capital purposes, comprises that held for specific
purposes. Sometimes even cash in the sinking funds might be included
in the list. As it is usually of importance to keep the management
informed as to the amounts of cash available for the various purposes
stated above, an effort should be made to give this information,
without too much detail, in the balance sheet if it is drawn up for
internal use.
Cash Held Abroad
There remains to consider moneys held in a foreign branch and thus
subject to fluctuations of exchange. In Chapter XXXI, where the subject
of the foreign branch is treated, a full discussion of the problem of
exchange in its relation to the accounting records will be given. Here
it is sufficient to say that as between countries where exchange rates
vary little, the general practice is to use an arbitrary conversion
figure for incorporating the results of the foreign branch with those
of the head office. This conversion figure applies to cash as well
as to all other items. The use of such an arbitrary basis will give
substantially correct results under the conditions named.
The assets of the foreign branch are the properties, usually and for
the most part, of proprietors and stockholders residing in the country
of the home office, who are concerned merely with the distribution of
the earnings of the foreign branch. Profits are made in one currency
to be distributed as dividends in another currency. Hence, the rate
of exchange prevailing at the time of closing the books would usually
give the most accurate results and should, of course, be used when
exchange is not fairly stable between the two countries. It may even
be conservative and advisable to set up a reserve for fluctuations in
exchange, with the object of absorbing what might otherwise be too
great a charge or credit to the current period’s profit and loss if a
particularly unfavorable or favorable rate were prevailing on the date
of conversion.
Accounts and Notes Receivable
In the valuation of accounts and notes receivable the problem is
largely one of appraising the uncollectible items. The book account
and note are intermediate stages in the conversion of merchandise into
cash. Were they always worth their face value there would usually be
no problem in their valuation except for the element of theoretical
interest which is not commonly taken into account by commercial
enterprises. In considering this problem of valuation, the question
of the correct use of terms arises. For the sake of clearness, when
showing the items on the balance sheet, attention will be first
directed to this latter phase of the subject.
Objection to the Title, Accounts Receivable
The governing principle here is that only current items can be included
in this group of assets when shown on the balance sheet. In accounting,
as in economics, there is no distinctive scientific terminology. The
economist makes use, for the most part, of every-day words and phrases.
These are often open to misunderstanding and are sometimes capable
of being used even for wilful misrepresentation. Recognition of this
fact has made necessary a more careful definition of some terms. In
the language of the street, almost any claim against outsiders may be
spoken of as an “account receivable.” The term is thus so broad as not
only to include current claims against customers in regular course
of trade, and accrued income, such as rents, commissions, interest,
dividends, etc., earned but not yet received, but also to serve as a
cloak covering many other kinds of claims and deposits. Among these may
be enumerated:
1. Cash deposited to cover breakage or damage to
equipment in use, to guarantee the payment of
prospective expense, or to guarantee good faith
in the performance of a contract.
2. Moneys advanced to subsidiaries, salesmen, and other
employees on account of expenses and salaries.
3. Claims against creditors for returned or damaged
goods, against railroads for lost or damaged
goods, and against governments for rebates,
drawbacks, and the like.
4. Prepayments on purchase or expense contracts, as
payments made to bind a bargain or before
delivery of goods; and expenses paid in advance,
such as royalties, rents, interest, etc.
5. Unpaid calls or instalments on stock subscription
contracts.
6. Claims against absconding officers for property
appropriated or trusts violated.
It is necessary, therefore, to employ a term of more definite meaning
which cannot be misused. The word “Customer” is sometimes used and is
not objectionable. However, the term “Trade Debtors” is more generally
employed and will be so used here as denoting all claims against
customers, clients, etc., in regular course of business. Its appearance
in a balance sheet is usually evidence of a careful discrimination
among the various classes of claims and is not therefore a misleading
term.
Risk from Credit Losses
As stated above, the chief problem in valuing accounts and notes
receivable is that of estimating bad debts. It is a matter of general
experience that some of those to whom credit is extended do not pay
their bills. Hence, at the close of the fiscal period it is necessary,
so as not to overstate the asset, to estimate the amount which
probably cannot be collected. The necessity for this is recognized in
a decision of the United States Supreme Court in Providence Rubber Co.
v. Goodyear, 9 Wall. 788, and has the sanction of conservative business
policy.
The effect of such an estimate is that the period in which the sale is
effected is made to stand the loss, and not the one in which failure to
secure collection is experienced. There is a close relationship between
the actual loss from bad debts and the credit policy of a concern.
Where the sales force is allowed to grant credit, the loss from bad
debts is almost invariably large. Where the extension of credit is
controlled by a credit department, the loss is less than in the other
case but depends on thoroughness of information and investigation
of the risk. However much care may be exercised, there will be
nevertheless some loss, but a live credit supervision should keep the
loss at a minimum.
Risk and Length of Credit Period
The amount of loss, or rather the percentage of loss, is not the same
for different lines of business nor even for different concerns in
the same line. The normal credit period for a particular business has
some relation to the loss. Thus if credit supervision and collection
effort are the same for two concerns, the one with the shorter credit
period will usually have the smaller loss. In a business, for example,
where the credit term is 60 days, we would expect fewer uncollectible
accounts than in one whose credit period extends for a year or more. As
between two concerns in the same line of business, _where conditions
are fairly uniform_, however, there should be little variation in the
loss from bad debts. As pointed out in Volume I, Chapter XXXVI, the
sales discount policy is for the most part a device for overcoming the
element of risk in the extension of credit.
Analysis of Customers’ Accounts as the Basis for Estimate of Bad Debts
In estimating the amount of bad debts, experience within the particular
business is the only safe guide. Oftentimes, however, the manager or
proprietor is not the most competent person for the task. The auditor,
in consultation with the manager, may often arrive at a better estimate
than could someone closely connected with the business. In making the
estimate, it is an aid to analyze the accounts according to the length
of time they are past due. Thus, there would be, after analysis, the
amount of those overdue not more than 30 days, the amount of those
overdue not more than 60 days, the amount of the 60 to 90 days overdue
items, those 90 days to six months, those six months to a year, and
all those more than a year overdue. The total amount outstanding minus
the sum of these overdue classes represents the portion not yet due.
Some part of the not-yet-due portion is, of course, still subject to
discount if paid within the discount term. With the claims against
customers thus analyzed, a much better basis is afforded for testing
the adequacy of the provision for bad debts. The various methods of
estimating this provision are discussed on page 219.
It may here be noted that when making up the estimate of bad debts it
is by no means always necessary to analyze the outstanding items as
suggested above. Such an analysis is of value in three cases:
1. In the case of a new concern where there is no past
experience on which to base the estimate.
2. In the case of an outsider—a professional auditor
or other party—being called upon to make the
estimate.
3. Periodically, in any business, as a check on the
work of the collection department.
The value of the analysis in cases (1) and (2) is based on the
principle that the longer an item is overdue, the greater is its
likelihood of proving uncollectible. The need of an increasing rate
for the different classes as analyzed above is apparent. In case (3)
its value lies in the fact that it reveals the general effect of the
collection policy and incidentally points out any change in policy.
Any additional factors which may have wrought a change in the general
financial situation must, of course, be taken into account.
Basis of Estimate of Bad Debts
Three methods of making an estimate of bad debts are found, in all of
which a percentage of some given base is used. The various bases are
respectively:
1. The amount of outstanding trade debt at the time
of the balance sheet.
2. The amount of sales on credit made during the
present fiscal period.
3. The total sales, both cash and credit, for the present
period.
_Trade Debtors as the Basis._ The use of trade debtors as a base is
obvious because it represents the uncollected charges from which alone
can any loss from bad debts arise. The use of such a base seems correct
in principle. This is so in cases where a balance sheet is made up
only once a year, so that conditions as to the periodicity of the
sales are practically the same from year to year. The amount of loss
from uncollectible items is then somewhat nearly proportional to the
amount of claims outstanding at the close of the fiscal year. But where
it is necessary to make the estimate monthly, or oftener than once a
year, it is very probable that at some of the intermediate periods
the amount of outstanding claims will bear no logical relation to
the loss from bad debts. Thus, in the garment industry the sales for
practically the whole year are made within a few months, and during the
other months the processes of manufacture and collection are carried
on. For these reasons the amount of bad debts is not proportional to
the outstanding claims at the end of each month, nor does such a base
properly allocate the losses to the periods in which the sales are
made. Accordingly one of the two other methods previously mentioned is
used.
_Sales as the Basis._ Inasmuch as there cannot be any loss from bad
debts in the cash sales, theoretically the credit sales provide the
proper base for making the estimate. Practically, total sales, either
gross or net, furnish the base most frequently employed because the
total is always available without the necessity for analysis. So long
as the ratio of the two kinds of sales remains fairly constant, the
loss from bad debts does bear a direct relation to total sales.
_Summary._ It may be said with respect to the use of trade debtors as a
base, that it gives satisfactory results where conditions are uniform
from period to period. In its use, however, cognizance must be taken
of any change in the credit policy of the business whereby the term
of credit is shortened or lengthened as that in itself would tend to
change the ratio of the base to the estimated loss from uncollectible
items. As between credit and total sales, theory favors the former but
practical considerations the latter. If for any reason the ratio of
cash to credit sales should change, the change would have to be taken
into consideration when making a comparison between periods of the
loss from bad debts. No justification can be found for a fourth method
sometimes met with, which makes the provision for bad debts bear some
relation to the net profits—large if profits are large, and small or
none if profits are small.
In handling the estimate of bad debts on the books, the same
considerations are to be observed as in booking depreciation. Care
must be exercised not to allow the reserve to grow beyond liberally
estimated requirements and so create a secret reserve, nor to fall
below such requirements. This must be watched closely and, if need be,
the rate changed to accomplish the desired result.
Discounts and Collection Costs
In connection with the valuation of trade debtors, the problem
of collection costs and cash discounts must be considered. Some
authorities connect these costs directly with sales and make provision
for them in the valuation of the current trade debtors; i.e., an
estimate of the cost of collecting the outstanding claims and of the
probable amount of loss from discounts on the amounts outstanding is
deducted by means of reserves from trade debtors and so shown on the
balance sheet. Where such a practice is followed, strict consistency
would require that a similar credit provision be made for discounts on
purchases—a practice not often advocated. The weight of opinion is in
favor of taking all such costs and credits into account only when they
are actually met. This accords with the treatment of these items as
financial management items (explained in Volume I, Chapter XXXVI) and
as therefore bearing no direct relation to sales. If, however, unusual
costs of this or any other kind are anticipated, prudence demands that
provision, by means of reserves, be made for them. Usually the costs
average up pretty well from period to period.
Valuation of Other Receivable Items on Open Account
The problem of valuing the other classes of receivable items previously
mentioned on page 215, does not differ in the main from that of trade
debtors just discussed. If they are worth their face value they should
be so shown. If worth less, the necessary valuation reserves should be
set up. With these items the _chief_ problem, however, is their proper
showing on the balance sheet; i.e., their correct classification and
a suitable nomenclature. Most of the items are not strictly current,
but even their inclusion under this head is not misleading if they
are carefully earmarked to show their true nature. Some of them are
decidedly fixed, some are in no sense assets. In some cases even trade
debtor balances as carried on the books are not strictly current.
In concerns where sales are made on an instalment basis, usually
the payments extend over several months and oftentimes years. The
customer is charged with the whole amount and credited with the regular
instalment payments as made. The portion of the outstanding balance
covered by the more remote payments is thus not current. In concerns
where both regular and instalment sales take place, a separation of
the customers’ balances on the basis of the sales contract gives the
necessary information for balance sheet purposes. The accounts of
instalment trade debtors normally require a much more liberal valuation
reserve than those of regular credit customers.
Loss on Notes Receivable
In some cases the expected loss because of uncollectible notes may be
less than that from open accounts, due to the greater formality of
the note as an instrument of credit and the probably greater loss of
credit to the maker in case of dishonor. However, in making provision
for bad debts, the practice is almost universal to class the two
receivable items together. Such practice is undoubtedly sound. In the
case of notes, the request for payment is more forceable because of the
definitely stated due date and the loss of standing if unpaid after
such date. In some cases the payment of notes is not pressed, nor is
any extraordinary provision made for past-due items—as in industries
allied with farming when an unusually bad season makes impossible the
payment of notes given by farmers. Again, the practice is sometimes
made of taking notes for a long overdue, open account. These have
usually no better value than the accounts and must be treated
accordingly.
The usual method of handling overdue notes receivable is given in
Volume I, Chapter XXXVIII. As there stated, where payment is allowed
to lapse, it is generally advisable to insist on the giving of new
notes in place of the old. There may be circumstances in which this is
not advisable, but the proper method will usually be apparent in each
case.
Interest on Notes Receivable
The valuation of notes receivable—using the term to include all
written promises to pay, i.e., promissory notes, accepted drafts, and
the like, requires a consideration of interest. By far the larger
number of notes given in trade are non-interest bearing and are not
therefore worth their face value until they become due. The interest
problem in the valuation of notes is thus whether the notes should
be shown at their face value or present, i.e., discounted, value.
Notes which are interest bearing from their date of issue are, of
course, worth their face, on the assumption that the interest takes
care of the discount. Where non-interest bearing notes form a very
considerable item it is well to value them on a discounted basis; if
their amount is small, theoretical principles of valuation give place
to practical considerations and they may be valued at their face. Where
notes bearing interest are valued on a discounted basis, care must
be exercised not to include the interest accrued both in their face
valuation and also under the head of accrued income.
Balance Sheet Titles for Notes Receivable
The problem of terminology is also met in handling notes receivable.
Under the balance sheet caption “Notes Receivable” should usually be
included only notes received from trade debtors, and certainly it
should never represent any but current asset items. Notes received from
officers and employees, of indefinite term and the payment of which
will not be pressed, should be recorded under some such title as “Notes
Receivable Special.” Long-term notes and those representing loans or
advances of any sort should be properly earmarked, as should also loans
carried on open account, salary overdrafts, and the like. The latter
should be shown under Deferred Charges. These nicer points of valuation
cannot be presented on a condensed balance sheet, but care should at
all times be taken to make such a showing as will not be misleading and
will serve the purpose for which the statement is to be used.
CHAPTER XIII
MERCHANDISE STOCK-IN-TRADE
Definition and Scope of Term
Stock-in-trade, as the term is usually understood, comprises all
commodities purchased for resale. Thus, assets, which in one concern
belong to the fixed asset group, may be the stock-in-trade of other
concerns. In stating the principles of valuation for these assets, it
is definitely to be understood that they apply only to such as are
used as stock-in-trade, and not to the same items when used as fixed
assets. Oftentimes the process of manufacture intervenes between the
purchase of a commodity and its sale. In such a case the commodity, at
the time of valuation, may be in different stages of completion. It is
then usually so listed on the balance sheet under suitable titles, such
as Raw Material, Goods in Process, and Finished Goods, all of which
are treated as current assets. Included in the problem of valuation
of stock-in-trade is the treatment of goods out on consignment, goods
of others held for sale on a commission basis, and scrap material.
Finally, some points to be observed in taking the physical inventory
will be considered.
Valuation at Market or Cost Price
Inasmuch as stock-in-trade is purchased solely for resale or ultimate
conversion into cash, it is desirable for the balance sheet to reflect
the proper value of what remains on hand unsold. Such goods may have a
realizable value higher or lower than cost value, from the standpoint
of the market in which they were purchased, and will usually have a
higher value in the market where they are to be sold. The value of all
current assets to be shown on balance sheet is usually stated at the
present realizable value. As applied to stock-in-trade, that must not
be understood to mean sale or retail value. To value the stock-in-trade
on such a basis would result in taking into the current period the
profits on sales not effected until the next period; furthermore,
these profits would not even be offset by the costs of making the
sale. It may be laid down as a principle of business practice based
on sound reason, that the period in which the sale is made should
be given credit for it. Stock-in-trade must therefore be valued on
the basis of its purchase or wholesale market price and according to
well-established practice, either at cost or market, whichever is
the lower. This principle has the support of conservative practice
throughout the world.
Objections to Valuation at Less than Cost
The effect of valuing the stock-in-trade at a lower market than cost is
to bring into the period’s results a loss which may never be realized,
either because the change in the purchase market may not be reflected
in the sale market, or because, if so reflected, the market may swing
back before actual sale of the stock is made. If valuation is to be
at the market when that is lower than cost, consistency would seem
to demand that, when the market is higher than cost at the time of
preparing the balance sheet, market value should be used and the profit
occasioned thereby be credited to the current period. The answer to
this argument is that operation would thus be placed on a speculative
basis.
Again, it is sometimes argued that good buying is just as essential to
profit-making as good selling. Accordingly, the purchasing department,
with the foresight to buy in a favorable market, should receive the
credit for it; if conditions are reversed, it should bear the blame,
i.e., the loss. In other words, the period in which the purchase effort
is expended should be credited or charged with the gain or the loss
brought about by a favorable or unfavorable condition of the current
market as compared with its condition at the time the purchase was made.
Anticipation of Profits or Losses Undesirable
In answer to these various contentions, it may be stated that though
good buying is an essential factor in profit-making, no refinement of
logic can obscure the obvious fact that goods are bought to be sold and
that no profit arises until the sale takes place. All effort before
the sale, whether directed towards good buying, careful storing and
display, the placing of advertising, or the selection of a sales force,
will come to naught unless sales are made. It would seem, therefore,
that potential profit or loss on any or all effort preliminary to the
actual sale has no place in the current record. From the standpoint
of the profit and loss statement, this conclusion as to the policy
of valuation of stock-in-trade at cost can be stated without fear
of contradiction. In support of this is a direction of the Treasury
Department in connection with the federal income tax returns. This
reads, as revised in October, 1916: “In case the annual gain or loss is
determined by inventory, merchandise must be inventoried at the cost
price, as any loss in salable value will ultimately be reflected in the
sales during the year when the goods are disposed of.”
From the viewpoint of the balance sheet, objection is sometimes
raised—and supported by conservative practice and legal requirement as
indicated above—that a balance sheet showing stock-in-trade at cost may
thus very obviously under-or over-value the item, a situation not at
all desirable. In this discussion, the whole problem of valuation is
being treated from the point of view always of a going concern and not
of one facing dissolution and the forced sale of its properties. Under
these circumstances, such a balance sheet must frequently be used as
the basis for asking credit, and credit extended on inflated values of
current assets is not properly extended.
Method of Treatment and Summary
To meet this situation, particularly in the case of large fluctuations
in the market, the true status of affairs is disclosed by appending
to the balance sheet a footnote in which is stated the present market
value of the inventory. Without this information, oftentimes, when the
market is showing steadily rising values, as much harm and financial
ruin may result through the extension of insufficient credit, as
under other conditions might arise from an ill-advised inflation of
credit. Sometimes the present market value is indicated by setting up
a reserve out of _profits_, called “Reserve for Market Fluctuations in
Merchandise”—or other similar title—when the market is lower than cost.
This method retains the inventory on the books at cost value and so
does not burden the current profit and loss, although it does lessen
the amount of profits available for dividend distribution. Without
doubt the policy is good in cases of extreme and somewhat permanent
changes in the market.
To sum up, therefore, the valuation formula of cost or market,
whichever is the lower, while based on conservatism may unnecessarily
and improperly burden the current income account. Valuation at cost, on
the other hand, while placing the profit or the loss in the period when
realized may cause the balance sheet to present an entirely inadequate
and even misleading story as the basis for credit. To remedy this,
three courses are open, viz.:
1. Carry the market valuation, whether more or less
than cost, in a footnote to the balance sheet.
2. In case market value is less than cost, set up a reserve
out of profits equal in amount to the difference.
3. Carry in an inner column in the body of the balance
sheet the present market value.
It would seem, therefore, that valuation at cost with the present
market value shown on the face of the balance sheet, is the most
desirable practice from every viewpoint.
Depreciation of Stock-in-Trade
Quite apart from this discussion of the proper basis for valuation,
which concerns itself with marketable merchandise, is the problem of
the method of handling deterioration or depreciation of stock-in-trade
as distinguished from fluctuations in value. Such deterioration may
result from shelf wear, use of goods for display purposes, changes in
style and shape, overstocking which causes an accumulation of goods
which soon are out of date or of sizes and qualities seldom used,
broken lots where such will injure the sale value, and so on. Many
devices, such as the “spiff” or the offer of a premium to salesmen,
are employed by up-to-date merchants to keep their stocks free from
these items of deterioration; but in spite of all that can be done, it
usually proves impossible to keep the stock live in every particular.
A valuation at cost under these circumstances would be an obvious
inflation of values. If the concern had purchased that quality of goods
originally with the expectation of resale, valuation at cost, under the
limitations suggested above, would be the correct basis for showing.
Since, however, such is not usually the case, the proper basis of
valuation is now the market price—the present price at which goods of
similar kinds and qualities can be bought.
It may be objected that the effect here also is unduly to burden the
current period with unrealized losses, but this is not the case.
The deterioration in value is a very real loss which is entirely
independent of any fluctuations in the market. If goods are shelf-and
window-worn from display usage, the deterioration is just as much an
expense incurred for advertising as a display advertisement in a daily
paper. The deterioration due to overstocking is a penalty which the
current period should bear because of its poor buying effort or its
inadequate sales efficiency. Thus, valuation of the inventory of any
stock of goods must have regard to the effect of its present condition
on its marketability. Any deterioration which renders the stock less
salable is an expense to be borne by the present period and not the
period in which the sale is made.
Full Costs of Stock-in-Trade
Cost having been established as the basis for valuing a stock of
marketable merchandise, there must next be considered the elements
of cost and their application to different classes of goods. By cost
of goods is meant full cost, i.e., not only invoice price but all
additional costs, needed to place them ready for sale. All costs,
therefore, up to the point where goods are ready to create income are
proper charges against the stock-in-trade. Customary costs of this
kind are freight, drayage, insurance during transit and storage, duty,
seasoning or aging costs, warehouse charges, and all similar items. The
information as to these costs is usually recorded separately, but at a
summary period they are loaded on the invoice cost of stock-in-trade.
In connection with this question of the proper composition of
cost, attention is called to two other items sometimes requiring
consideration. The first deals with the handling of cash discounts. The
point at issue is as to whether the invoice figure should be recorded
at the price quoted on a cash basis or on a credit basis. This point
is discussed at length in Chapter XXXVI of the first volume where the
conclusion reached is that the _credit_ policy of each concern must
govern the manner of making the record. If the concern has a fixed
policy of buying at a cash price, that price should be the price of
record; whereas if all financial and other related policies are based
on a 30-or 60-day credit term, the credit price for that term should
be the price of record. Particularly is this true when viewed from
the sales standpoint where the fixing of the selling price is a part
of the financial policy. The second point requiring consideration in
connection with cost is the item of interest on the money invested in
stock. At the close of the fiscal period should the stock sold and
that left on hand be burdened with interest on the average amount of
capital tied up in it during the period? The student is referred to
Chapter XXVI of this book, where a full presentation of the case for
and against the inclusion of interest is made.
The Distribution of Costs Over Stock-in-Trade
It should be said that, due to the particular method of handling
purchasing, delivery, and storage, it frequently is not practicable
to take cognizance of all items which theoretically are constituents
of cost. Each concern must establish a policy relative thereto and
hold to it. Having done this, it is faced at inventory time with the
problem of determining the cost figure applicable to each unit of
the stock remaining unsold. Certain of the costs, such as freight
and cartage, have probably been incurred by different lots of
miscellaneous merchandise, and to distribute the proper charges to each
unit comprising the lot is difficult. Usually a certain percentage
sufficient to cover that particular item of cost is spread evenly
over all units remaining on hand. Occasionally, especially where the
stock is homogeneous and only a few varieties are dealt in, an effort
is made to prorate these costs on a more accurate basis. In loading
on the freight cost, for example, a combined weight and value record
might bemused or, where possible, the official freight tariff might
govern. Such minute accuracy is not often needed or desirable, the flat
percentage rate on value giving in most cases sufficiently correct
results.
The Pricing of the Inventory
A rule-of-thumb method of valuation requires that the purchase price
as carried on the last invoice of the article shall be used for
pricing the inventory. This usually proves a good working rule, but
often raises perplexing problems and is subject to abuse and misuse.
If several purchases have been made during the period at different
prices, should the last price paid govern the valuation of the portion
unsold? The argument for so doing is that the portions unsold probably
belong to the last lot purchased, good merchandising requiring that
the old stock be sold out before the new is brought forward. That, of
course, is not always the case. If it is made an inflexible rule that
the price of the last lot bought shall be the price of the inventory,
a dangerous tool is placed in the hands of the unscrupulous. A manager
needing or desiring to make a better showing of profits might in this
way make an insignificant purchase at a high price near the end of the
fiscal period and so secure a much higher valuation than the cost for
the whole inventory. Where the inventory is likely to contain remnants
of the various lots purchased during the period, or where the condition
as to an insignificant final purchase may exist, the policy of using an
average price for the inventory will be more accurate in its results.
The weighted average, whereby each purchase price is weighted with the
volume or quantities purchased, is fairer, though more complicated
than the straight average. Thus 10 units bought at $100 per unit, 15
at $90, and 3 at $110, would give a straight average of $100 but a
weighted average of $95.71, (1,000 + 1,350 + 330) ÷ (10 + 15 + 3).
In manufacturing establishments where the fiscal period is short,
say one month, and it is desirable to keep the raw material cost as
nearly uniform as possible, the method of the weighted average is to be
recommended.
As mentioned above, each concern must fix its own policy as to what
items shall be included in the cost of goods purchased. Whatever that
policy may be, care must be exercised to make sure that the same
items and no others form part of the value of the inventory. In the
case of any doubtful items, instead of trusting to memory, a house
classification of accounts or an accounting guide book should be drawn
up so as to secure from period to period a similar handling of all
items.
Valuation of Manufacturing Inventory
The whole of the foregoing discussion concerns the valuation of goods
bought for resale, i.e., the inventory of a trading business. Some
points in the application of the same principles to a manufacturing
concern will now be considered.
_Finished Goods._ So far as finished goods are concerned, the principle
of valuation at cost applies. What constitutes the cost of manufacture
was discussed in Chapter III, from which it is evident that many other
elements in addition to those which must be considered in a trading
concern must be taken into account. The manufacturing cost formula
comprises the three items of: (1) raw material consumed, (2) direct
labor applied, and (3) factory expenses incurred, this latter item
sometimes called overhead expenses. When a concern operates a detailed
cost system, the valuation of the finished product is not difficult,
being the goal towards which the system works. Where no cost system
is used, great care must be exercised to make sure that every item of
cost is calculated as accurately as possible and that a proportionate
share of such costs is applied to the finished product still on hand
unsold. It is sometimes urged that instead of this cost-to-manufacture
price, the price at which the article could be bought on the open
market should govern; or, alternatively, that the article should be
valued at least sufficiently above cost to give a theoretical profit to
the factory. Just as in the case of the discussion of “cost or market
price” for the trading concern, the same conclusion is reached here,
viz., that cost should govern, because while good manufacturing is
an element in profit-making, yet no profit is made until the sale is
effected. It is true that if cost to manufacture is lower than cost to
buy in the open market, a real _saving_ has been made by the policy
of manufacturing rather than of buying, but a saving is quite another
thing from a profit. This differentiation between a saving and a profit
will be fully discussed presently. Correct accounting, therefore,
requires a valuation of finished goods at cost to manufacture.
_Raw Material._ The valuation of the inventory or raw material is on
the same basis as that of a stock of goods bought for resale, i.e.,
raw material is to be valued at full cost up to the point of its
consumption.
_Goods in Process._ The valuation of partially completed goods, i.e.,
“goods in process,” is a much more difficult problem. To simplify
the discussion these will be divided into two groups, first, goods
manufactured for stock, and secondly, those made on a specific contract
or for special order. To the first group the principle of cost applies
without any qualification. The problem involved is that of determining
what has constituted cost up to that particular stage of completion.
Where a detailed cost system is in use and a production schedule forms
part of the system, it is possible at almost any moment to ascertain
exactly the values accumulated on any article at each stage or process
of manufacture. Where definite costs are not possible, a careful
estimate based on full knowledge of conditions is the best that can be
done. Where parts are first manufactured for assembly into a completed
whole, they should be treated as finished goods and valued at full cost
up to that point.
_Contracts._ The second group of goods in process, viz., those
manufactured to fill specific orders, or, in large construction work,
contracts taken but not completed, may be valued on a somewhat
different basis from that applicable to the first group. Here a sale
has actually taken place and only the intervention of the closing of
the books raises the question of valuation. In a case of this sort it
is customary to make a careful estimate of the costs of the work or
contract, up to its present state, due weight being given to remaining
costs necessary to complete it and to any provision for possible
contingencies. When handled in this way, the estimated profit on the
work already done is said to be applicable to the current period and is
therefore taken into account. In other words, the portion completed is
treated as sold, after making the provisions indicated above, and is
charged off the books against a corresponding part of the sale price.
Hence, the valuation involved here does not concern the inventory, but
the cost of goods sold.
It may be objected that, in the case of large contracts, perhaps
running over a period of years, many unforeseen things may happen
to wipe out any seeming profits on the completed portion, and that
conservatism would demand that no profits be taken until the contract
is completed or in a sufficiently advanced stage as to be reasonably
sure of results. In such a case it frequently happens, however,
that not only are stockholders impatient of delay, but very serious
injustice may result to any who might be forced to give up their
holdings before the completion of the contract. Moreover, a fair
method of making payment on the contract is usually in force, the sale
price often being on the basis of units of work accomplished, so that
the contingencies giving rise to the objection mentioned are greatly
minimized. Thus, some contracts may be on a fixed price per cubic yard
of earth removed, per unit of goods manufactured, or other similar
basis for periodic payment, a certain per cent being retained as a
guarantee for the satisfactory completion of the whole. Again, where
the price is for a lump sum, engineers representing the contracting
parties may agree on the amount completed and periodical payment may be
made on that basis.
This topic of uncompleted contracts will come up again for treatment
when considering the profit and loss summary for the year. It is
sufficient to note here that some share of the profit on the completed
portion of a contract may be taken as indicated above, in which case
the inventory problem may be disposed of either by adding the amount of
estimated profit to the cost value of the uncompleted contract, or by
treating the payments made as sales.
Contracts and Length of Cost Period
In some lines of business, orders are booked several months ahead of
delivery date, the factory operations depending somewhat closely on
the contracts entered into. During the period of manufacture there
may be few deliveries of the product, and therefore no actual profit.
Obviously, the easiest method of handling such a situation is to make
the fiscal period long enough to include the greater part of the
deliveries, and so leave the inventory comparatively free of goods in
process. Where this method is adopted, there is no serious objection
to valuing the goods still in process at the close of the period so as
to take a fair portion of the profit, although conservative practice
usually values them at cost. The difference in the amount of profit
under the two methods is insignificant under the condition named. Under
other conditions valuation at cost is the rule.
Valuation of Scrap
Raw materials are never completely used up in manufacture; portions
too small for the main product, corners, odd-shaped pieces, defective
pieces, etc., are usually thrown into scrap. This scrap is frequently
utilized in the manufacture of side lines if a market can be developed;
otherwise it may be valueless. The problem of the valuation not only of
the scrap but of any product that may be made from it presents some
interesting features. If the entire cost of the raw material is charged
to the main product, the scrap material used in the side line costs
nothing, and to charge anything for it, either on the basis of cost or
some arbitrary estimate, would result in inflation. Furthermore, the
cost figures of a side line which is not charged for material might
at some time be made the basis for a bid on a contract too large to
be filled entirely out of scrap material, and so result in a loss. On
the other hand, if the main product is charged only for the material
actually consumed, and the side line is compelled to bear the cost
value of the material it consumes, the cost of the side line may so
increase that it cannot be marketed at a profit. The lowered cost
of the main product might lead, in the face of keen competition, to
the cutting of its price below real cost, unless, of course, all the
scrap is being utilized in the side line which is also being sold at
a profit. If such is the case, the valuation of the main product, the
side line, and the scrap should be on a cost basis. This is not usually
the case, however. No basis for valuation can be found which will prove
entirely satisfactory under all circumstances.
In the light of the conditions involved, particularly as to whether
there is a constant market for the utilization of all the scrap
material in the manufacture of the side line, each concern must
adopt whatever policy best suits its peculiar needs. At all times
the application of materials costs to the product should provide an
intelligent basis for entering into future contracts. A _blind_ use of
cost figures frequently invites disaster. In cases where scrap is not
utilized in a side line, it has only scrap value. The thing to guard
against is the double charge for the same material, i.e., a charge to
the main product and also to the side line, resulting in an inflation
of values.
Inventory-Taking
There remains, as a corollary to the problem of valuation, a
consideration of the method of taking the inventory, for if the count
is wrong the most careful valuation per unit will not give true total
value. In connection with the count of the inventory, two fundamental
rules must be observed. These are: (1) make sure that everything, i.e.,
all stock-in-trade, belonging to the business is included; and (2) be
careful that there is no duplication of count nor inclusion of any
stock belonging to others.
In accordance with the first fundamental rule, care should be exercised
to include all goods out for sale in other markets—these to be valued
at full cost in those markets—and all goods not yet received into stock
but belonging to the business. These latter include goods invoiced but
not received, and goods received but not unloaded prior to the close of
the period.
In accordance with the second fundamental rule, any goods of others
held for sale on a commission basis must be carefully excluded from
the count, as should also goods received before the close of the
period but with invoices dated some time in the future. Furthermore,
all goods inventoried from their invoices, i.e., all goods not taken
into stock, must be earmarked so as not to be charged into the next
period’s purchases. This is best accomplished by stamping the invoices
as “Included in the 19.... Inventory.”
_Inventory Methods._ The careful organization of the physical stock to
be inventoried, sorting any misplaced items, and separating them into
classes, and an equally careful organization of the clerical force,
acting under explicit directions based on a well-thought-out plan,
are fundamentally essential to accuracy and to the prevention of any
duplication of count. In some cases the use of duplicate or coupon tags
proves very valuable. On these tags provision is made for recording
in duplicate the number of units and condition as to salability, and
they are ruled with two money columns. The tags are numbered on both
parts consecutively and are charged out to the various departments,
as many being issued as there are classes or compartments of goods. As
the count is made of a certain class of goods, a tag is attached to the
compartment or other storage place as evidence that the count has been
made, after which the lower portion is torn off and sent to the office.
Any missing numbers indicate omissions in the count. If the card
has been lost, the duplicate still attached to its compartment will
indicate the count. After all cards are accounted for, the duplicates
are detached and the goods covered by them are then released for sale
or other use. In taking the inventory it is especially important that
where goods are below normal as to salability, their estimated per cent
of normal condition be noted on the tag. This gives a basis for valuing
and should show the amount of deterioration and its cause.
Perpetual Inventory
The use of a perpetual inventory system is quite general in some
lines. Its operation requires almost as careful a record of stock as
is made of cash, i.e., not only must all receipts be recorded but all
disbursements as well. In a trading concern this record usually takes
the form of a stock book of some sort, to which entry is made, as to
quantities only, from the purchase and sales invoices, the balance
shown at any time being the stock remaining on hand. The application
of the unit value gives the value of the entire stock and so makes
possible monthly statements of approximate condition. In a factory, a
separate stores ledger may be operated, carrying an account with every
kind of material used. This ledger is controlled by the Raw Material
or Stores account on the general ledger. Entry to the stores ledger
accounts is made from the purchase invoices for receipts, and from
formal requisitions drawn on the stores-keeper for disbursements, i.e.,
for the issuance of material. The stores ledger may record not only
quantities but also values, so that its balance should be the value of
the stores on hand. This is possible because the material is drawn out
at cost price.
Oftentimes, for retail concerns, instead of the stock book method, the
percentage method of book inventories described in Volume I, page 506,
gives more satisfactory results when sufficient past experience can be
drawn from.
_Necessity of Physical Count._ It must not be assumed that a perpetual
inventory system obviates the necessity of taking a physical inventory,
for it does not. All that it accomplishes is to secure a closer
supervision over stock between inventory times and to make possible the
showing of approximate results at interim periods. Where operated, it
is possible to take the physical inventory piecemeal, although there
is a marked advantage in taking a complete inventory periodically. The
piecemeal method means that any department can do its stock-taking
during a slack time without regard to the time when other departments
take theirs. Thus there is less interference with the regular conduct
of business. It must be borne in mind, however, that the physical
inventory is just as essential as ever because of the many inaccuracies
that tend to creep into the perpetual inventory system, and furthermore
because of loss, theft, over-measure, and so on, which throw the book
record out of agreement with the actual count.
CHAPTER XIV
TEMPORARY INVESTMENTS; ACCRUED AND DEFERRED ITEMS
TEMPORARY INVESTMENTS
Nature of Temporary Investments
The next item to be considered for valuation in the current assets
section of the balance sheet is temporary investments. These are
assets, such as stocks and bonds of ready marketability, in which
current funds are tied up temporarily. Investments in stocks and bonds
for purposes of securing business connections and privileges essential
to the most efficient conduct of the business do not belong to this
category. The term usually covers only those assets representing the
investment of temporarily surplus cash or those acquired in settlement
with debtors with the expectation of early realization. As A. L.
Dickinson[44] so well says, “such investments have no relation whatever
to the business and can be disposed of without in any way interfering
with its earning capacity, other than the loss of the dividends
thereon.”
[44] In “Accounting Practice and Procedure.”
In the case of concerns affected by seasonal changes in volume of
business, there are periods when sums of surplus cash lie unemployed,
unless the concern depends upon borrowed money to take care of seasonal
increases. Business policy, therefore, demands that the surplus cash
be put where it will earn something. Such investments are frequently
of a somewhat speculative character. In fact, other things being
equal, business acumen demands that the investment be made in those
securities in which there is a chance of gain in addition to the
regular income therefrom. It cannot be stated too strongly, however,
that safety, freedom from great fluctuations, and ready marketability
are always prime essentials to be observed in securing stocks and bonds
for temporary investment. While the procedure is unusual, there may at
times be circumstances under which such investments may be bought on a
margin basis.
Valuation of Temporary Investments
The usual rule for valuing temporary investments at the time of drawing
up a balance sheet is at cost or market, whichever is the lower.
Inasmuch as they may be needed on short notice, the information desired
is what they will be likely to realize. This is particularly true
in the case of a concern with a rapidly expanding market, for which
provision may need to be made by increasing the plant as well as the
working assets. Where reserved profits have become tied up in fixed
plant, the need for ready funds is apparent.
It may be argued that inasmuch as realizable value is the information
desired, valuation at market, whether lower or higher than cost, is the
only proper basis. The rule stated is, however, held to be the correct
one from the standpoint of conservatism and the further fundamental
objection to bringing unrealized profits into the current period, as
would result from a market valuation higher than cost. Of course, a
lower valuation than cost brings unrealized loss into the period’s
operations, but this is not regarded with the same disfavor. Where
the market price is fluctuating from day to day, as is normally the
case, the market valuation on the date of the balance sheet is perhaps
no nearer to the amount that will be actually realized than the cost
value, since cost value merely represents one of the many changing
points in the market. If a distinct market tendency in one direction or
the other were likely to continue until the time of realization on the
investments, there might be good reason for taking the profit or loss
accrued to the date of the balance sheet. However, these considerations
are of too speculative and uncertain a character to be given any weight.
There is some valid objection, on theoretical grounds at least, to
the results of the period being affected by the unrealized profits
or losses caused by taking the market valuation of temporary
investments onto the balance sheet. Valuation at cost, with a
footnote to show market value, gives all the information essential to
a full understanding of the exact condition of the investment. The
habit of adding footnotes to the balance sheet may, however, become
objectionable and the practice is to be avoided wherever possible.
Also, really essential information usually carries greater weight when
incorporated in the balance sheet figures.
Reserve for Investment Fluctuations
To meet the foregoing objection and, at the same time, that of allowing
unrealized items to affect the period’s profit and loss, use may be
made of an account called, say, “Reserve for Investment Fluctuations.”
The account should be operated in the same way as the Reserve for
Market Valuation of Merchandise discussed in the preceding chapter.
That is, if market is lower than cost, at the close of a fiscal period,
surplus is charged and the reserve credited for the difference. On the
balance sheet the reserve is treated as an offset to the investment
account carried at cost. This incorporates the market valuation as a
significant figure of the balance sheet and shows the cost for purposes
of information. The charge to surplus avoids fluctuation in the current
profit and loss results because of an unrealized item and so makes
it more useful for comparative purposes. In case market is higher
than cost, the difference is charged to the asset and credited to
the reserve. On the balance sheet, cost is thus the effective figure
and the market price is given for informational purposes. When the
investment is sold, the entry creating the reserve should be reversed
in either case. This brings on the books in the period when the sale
takes place, the actual profit or loss realized, being the difference
between cost and sale prices. The adjusting entries on account of
valuation do not thus permanently affect surplus, while the actual
profit or loss reaches surplus in the usual way—a valuable desideratum.
“Stock Rights” on Investments
It may occasionally happen that while stocks are held for purposes of
temporary investment, stock rights arise. Such a “right” is a privilege
of subscription to a new issue of stock, granted holders of stock
on a certain date, at a rate below the market quotation of the old
stock. The stock records are closed temporarily to any transfers of
stock in order to determine those entitled to these rights. Up to the
date of closing the records, the market value of the stock carries an
increased value to cover the value of the rights belonging to it, and
the stock is quoted “rights-on.” After this date the rights are dealt
in separately and quoted separately on the exchange. Stock then sells
“ex-rights.” Should the end of the fiscal period of a concern holding
stocks subject to rights fall after their issue, the stock and rights
may be booked separately, though often shown together.
An illustration will show the theoretical method of valuation of
rights. Take a corporation whose stock now sells at 125, issuing the
right to subscribe at par for additional stock to the extent of 10% of
present holdings. The case of a stockholder with fifty shares would
work out as follows:
50 shares at $125 $6,250.00
5 ” at 100 500.00
-- ---------
55 ” at a cost of $6,750.00
The average cost of one share is $122.73. Based on the former quotation
of $125, the right is seen to be worth theoretically the difference, or
$2.27. The quoted market price will usually be less.
Cost of Investments
In connection with the cost of temporary investments it may be well
to point out that cost means full cost to the purchaser, including
brokerage and other costs in connection with the purchase or subsequent
thereto. If the investment is being carried on margin, the customary
practice is to charge to the investment account the interest on the
funds borrowed by the broker to finance the transaction and to credit
thereto any dividends or interest received. The difference between
the asset account kept with the investment and the liability account
with the broker thus shows at any time the original equity in the
investment. A credit to the investment account when the stocks are
sold develops the net profit or loss on the entire transaction. There
may be circumstances under which it will be desirable to separate from
the asset account all charges and credits subsequent to the original
purchase, carrying them in a suitable expense and income account.
Valuation of Bonds
In the case where bonds are held for temporary investment, purchased
either at a premium or discount, it is not customary to take account
of amortization, because the investment is temporary. The problem
of amortization is postponed to Chapter XV, in which permanent or
long-term investments are treated.
In brokerage firms, where stocks and bonds comprise the stock-in-trade,
the same principle of valuation applies as with a merchandise stock
except that the rule of valuation at cost or market, whichever is the
lower, is applied to each _individual_ holding. In this way, decreases
in the value of one stock are not offset by increases in the value
of others as would be the case if total market and cost values for
the entire lot were first determined and then the valuation formula
applied. In this chapter the principle of valuation of stocks and bonds
as stock-in-trade is mentioned only by way of contrast.
Valuation of Unissued Stock
Under the head of temporary investments, the company’s unissued and
treasury stocks or bonds are sometimes included. Such unissued stocks
or bonds manifestly represent an inflation of asset values, offset, it
is true, by an equal inflation of capital stock. In the first place,
conceding for the sake of argument that the inclusion of unissued
stocks among the assets is legitimate, the principle of equilibrium
requires that they be valued at par on the balance sheet, a figure
which is not cost and which may be very far from market. Again,
the company’s unissued stocks may be in no sense current assets.
Furthermore, stocks which have never been issued have no owners and
so can command no proprietorship in the enterprise. The most that can
be said about them is that they are contingent assets, showing that
certain legal formalities have been met which authorize their issue if
so desired. The remaining necessary procedure, viz., that the stock be
placed on the market and sold, is, however, the condition which must
be met to create a real asset and to create proprietorship. Until that
has been done there is neither proprietorship nor asset. Reference
to Volume I, Chapter XLIX, where the various methods of opening the
books of a corporation are illustrated, will show that the method to
be preferred is one which eliminates the account Unissued Stock from
the books. However, where it is set up, correct classification would
seem to require that it be treated as of the nature of a valuation or
offset account for capital stock. In other words, the two accounts,
Capital Stock and Unissued Capital Stock, must be read together to show
the true status of the proprietorship stockholdings. The correct method
of presentation on the balance sheet is here only indicated but will be
illustrated in Chapter XXI where the problem of valuation of capital
stock is treated.
Valuation of Treasury Stock
The case against the inclusion of treasury stock in temporary
investments is not quite so apparent, but equally convincing upon
examination. Treasury stock differs from unissued stock only in that it
has once been issued but has, through various channels, found its way
back into the possession and control of the company. While outstanding
in the hands of stockholders and under their individual control, the
increased stock proprietorship is reflected in increased assets. If
the stock comes back into the treasury through donation, the decrease
in proprietorship stockholdings is compensated by a new proprietorship
element under donated surplus. Thus, while there are not so many shares
outstanding, the value of each is enhanced by a combined or common
proprietorship in donated surplus, which reflects exactly the status
of the treasury stock. Whereas formerly there was individual control
over the stock, now that it is in the treasury, control is common or
combined. Stock proprietorship has been diminished and the balance
sheet should show it by treating Treasury Stock as an offset account
and not as a part of current assets under Temporary Investments.
As to the valuation of treasury stock at some other figure than par,
the same argument holds as in the case of unissued stock. If the
treasury stock has been acquired by purchase on the open market, its
price may be a good and sufficient basis for valuation; but even here
individual ownership and control has been exchanged for common and
combined ownership. The individual stockholdings are decreased, and
the decrease is reflected on the assets by the amount paid for the
stock. It would seem, therefore, that a showing more in accord with
the facts would require treasury stock to be treated as a deduction
from the capital stock authorized. Thus the best practice eliminates a
company’s own stocks from the list of its assets. Where such holdings
are small and insignificant, they may without any serious impropriety
be included among the assets and even under the caption “Temporary
Investment” so long as substantial accuracy obtains.
Summary of Valuation Formula
To sum up, then, the valuation formula for current investments requires
their showing at cost or market, whichever is the lower. The most
satisfactory method of applying the formula is by means of the Reserve
for Investment Fluctuations which makes possible the incorporation of
market value whether lower or higher than cost, with the differences
between market and cost carried in the reserve account. Thus the
conservatism of the valuation formula is made effective and at the
same time information is given as to the present market values of the
investment.
ACCRUED AND DEFERRED ITEMS
Nature of Accrued Income
Income derived from many different sources is never fully received at
the close of the fiscal period. For instance, of the sales made many
will still be outstanding as charges to various customers; interest
will have accrued on notes receivable and on investments held; rental
income is earned day by day but is received only periodically;
royalties based on the use of some machine or process are accumulating
where the device or process is being used but settlement is made
only periodically; and dividends on stocks or other investments may
have been declared during the current period but are not payable and
therefore will not be received until the next period.
Inadequacy of Cash Method of Handling Accruals
All these accrued items give rise to claims which must find expression
in the accounts either currently or ultimately. In the case of sales
of merchandise the customary practice is to set up the claim on the
books when the sale is made. In the case of the other items usually
no record is made until the income is actually received. Under this
method—called the cash method—it is evident that the true income cannot
be shown in the period in which it is earned and that the period in
which it is received secures the credit for it. This means not only
that the current period may at its beginning receive credit for items
of income mostly earned during an earlier period, but at its end it
will be deprived of similar earnings accruing from day to day up to its
close but not credited because their time of payment overlaps into the
next period. This method is defended as being substantially correct on
the principle of averages, i.e., those earnings which do not entirely
belong to the current period but for which credit is taken will in
the long run just about offset the earnings accrued at the end of the
period which are not taken account of.
The statement may be true and, if so, can be easily tested; but,
whether true or not, modern practice requires the _accurate_ accounting
of all claims. It is therefore required that these accrued earnings be
brought onto the books if reliable results are desired.
Correct Method of Handling Accruals
To show all earnings in the period in which they actually accrue is
called the “accrual method.” Under this method the income earned but
not received during the current period is set up among the assets, just
as in the case of sales, with this difference, however: the claim for
the broken portion belonging to this fiscal period need not be recorded
day by day but only at the end of the period. Most income items of
this sort are due, either by contract or by custom, at the end of
certain definite periods. The setting up of a claim for a broken, i.e.,
an uncompleted portion, does not mean that such a claim is on that date
legally enforceable, but that it is a claim equitably belonging to the
current period.
Showing of Accrued Items on Balance Sheet
As to the section of the balance sheet in which these accrued income
items should be shown, usually they are true current assets and should
be so listed. They frequently arise in connection with current assets,
e.g., the interest accruing on notes, stocks, and bonds held, and
are therefore just as current as the assets themselves, or even more
so. Where not so arising, as in the cases of rents, royalties, etc.,
usually the contract or customary period of settlement is so short as
to make the claims under them true current assets. Occasionally the
accrued earning is added to the value of the particular asset and so
shown in the balance sheet. A better practice, because more definite,
is to list them separately under the title, Accrued Income, Accrued
Accounts Receivable, or other similar title.
Valuation of Accrued Items
The principle of valuation of accrued income items is apparent. On the
supposition that the concern will continue in business, the accrued
income is proportioned between the two periods on the basis of the
portion of the time belonging to each period. However, this does not
mean that the portion so taken shall be valued at its face. The accrued
portion is worth as a portion neither more nor less than the whole
is worth as a whole. If there is doubt as to the ability to collect
it when it falls due, certainly the valuation placed on the accrued
portion should express that doubt. In other words, unless the claim is
fully secured by collateral or other pledges, valuation should be on
exactly the same basis as for the other receivable items, such as the
claims against trade debtors, other open accounts receivable, notes
receivable of various kinds, etc.
Accounting for Accrued Income
The accounting for accrued income presents no particular difficulties.
In addition to the two methods discussed in Volume I, pages 116 to 119,
a third which is considerably more laborious than either of them is
frequently employed, and is as follows: At the time of adjusting and
before closing the books, for every item of accrued income a separate
asset account is set up. Thus, for royalties an account, Accrued
Royalties Receivable, would record the claim on account of royalties at
the same time the accrued income from royalties is being recorded in a
suitable income account. Thus there is distinct separation of the asset
and income elements.
From this point two methods are in use for handling the subsequent
record of the item. Under the first method, the income when actually
received or legally due is recorded in the regular income account.
This thus shows an inflated figure because it is not offset by the
portion credited to the previous period, the asset account covering
this, remaining unchanged throughout the current period. At its close,
however, proper adjustment is made by adding to, or subtracting from,
the amount held over from the close of the previous period such an
amount as will make its new balance show the correct amount of accrued
income as at the close of the current period. The contra credit or
debit to the above entry, as the case may be, is of course to the
particular income account, causing it to reflect the true income for
the current period.
Under the second method, the first entries for the new year consist in
transferring all accrued income asset balances to their respective
income accounts, where they serve the purpose of automatically
adjusting the full receipt of income a portion of which was credited in
the previous period, to the amount properly belonging to the current
period. At the close of the period any adjustment on account of accrued
income is handled by debiting the asset account and crediting the
income account exactly as before.
An illustration will show the differences between the two methods.
Illustration of Different Methods of Recording Accrued Items
_Problem._ The royalties income accrued December 31, 1916, amounted to
$5,000. During 1917 payments were received on account of royalties to
the amount of $35,000. On December 31, 1917, accrued royalties were
$5,250.
_Solution—Method 1_
ACCRUED ROYALTIES RECEIVABLE
=======================================================
1916 |
Dec. 31 $5,000.00 |
1917 |
Dec. 31 (A) 250.00 |
|
ROYALTIES INCOME
=======================================================
| 1917
| $35,000.00
| Dec. 31 (A) 250.00
|
_Method 2_
ACCRUED ROYALTIES RECEIVABLE
=======================================================
1916 | 1917
Dec. 31 $5,000.00 | Jan. 1 (A) $5,000.00
--------- | ---------
1917 |
Dec. 31 (B) $5,250.00 |
|
ROYALTIES INCOME
=======================================================
1917 | 1917
Jan. 1 (A) $5,000.00 | $35,000.00
| Dec. 31 (B) 5,250.00
|
Of the two methods, the second is somewhat fuller and probably presents
the facts more consistently, although involving a little more book
work. From a practical standpoint where regard is had to the amount
of book work required, the method used in Volume I, pages 116 to 119,
sometimes known as the inventory method, serves all the purposes of
either of the above methods and requires much less work. By it the
above problem would appear as follows:
ROYALTIES INCOME
=============================================================
1916 | 1917
Dec. 31 Accr. $5,000.00 | $35,000.00
1917 | Dec. 31 Accr. 5,250.00
Dec. 31 P. & L. 35,250.00 |
$40,250.00 | $40,250.00
======== ========== | ======== ==========
1918 |
Jan. 1 Accr. $5,250.00 |
An objection, not at all serious, is that under this last method the
ledger will show, as on the date of the balance sheet, the current
assets in two places, viz., the current assets section and the income
section, instead of altogether as under the other methods. This
objection is more than offset by the saving in clerical labor. There is
in some quarters an all too prevalent tendency to multiply the number
of accounts and increase the bookkeeper’s work without any adequate
return in results.
Prepaid Items—Definitions and Kinds
Closely related to current assets, because through an overexpenditure
of current funds this period a lesser expenditure will be required next
period, is the class of items known as prepaid expenses or deferred
charges to operation. These items are not current in the sense that
they will be turned into cash shortly, but they are analogous in
that a saving in the expenditures of the next period will result.
Because of the ease with which they may be put to improper uses,
it is best to segregate them from current assets under a suitable
balance sheet caption, such as “Deferred Charges to Operation.” Where
the two captions, Current and Working Assets, are shown, items of
this class properly belong to the latter. Under this head will be
considered such items as supplies of all sorts—office, factory, power
house, stable—stationery, printing, postage, repair parts, insurance
unexpired, advertising contracts and material, rent, royalties,
interest and discounts paid in advance, salary overdrafts, premiums
on long-term investments and discounts of long-term obligations, and
sometimes organization expense, although this last item is perhaps best
handled with the intangible assets.
Valuation of Prepaid Items
The purpose in considering these items at the close of a fiscal period
is to secure a proper and accurate allocation of charges as between
the two periods, without which true results as to profit and loss are
not possible. The same argument as to these items averaging up fairly
well between periods applies here as for accrued income. The only
other point to be considered in connection with them is the basis for
their valuation. Realizable values, i.e., what the items would bring
under the hammer or at other forced sale, are manifestly inequitable.
A three-year insurance policy with one year expired is to a concern
which intends to avail itself of the remaining two years’ protection
worth more than the surrender value of the policy calculated on the
short-rate basis with perhaps the expenses of doing business also
subtracted by the insurance company. Evidently to a going concern the
protection enjoyed for the year just expired is worth neither more nor
less than a pro rata share of the entire cost, nor are the remaining
two years’ protection to be valued at a less rate because redeemable at
a less rate.
Hence, a valuation based on the going concern principle is to be used
for deferred charges. As indicated above, this means, when used in this
connection, a pro rata valuation based on the life of the supply and
the portion unused. In the case of tangible supplies the rule can be
most easily applied as a unit cost figure to the unused units still on
hand. That is, an inventory of supplies is taken and valued at full
cost. Although nearly related to current assets, deferred charges are
seldom influenced by market fluctuations after they are once purchased,
because if properly classed as deferred charges they are always held
for own use and never for outside sale.
Danger of Overvaluation
Care must always be exercised—even more than in handling the
stock-in-trade inventory—to see that there is no padding of this class
of items. To this end, before taking inventory, a general clean-up of
supply materials all over the plant is an exceedingly good policy.
This should result in discarding, or reducing to scrap value, all
obsolete and unusable supplies. Without such a clean-up it is easy,
even when motives are of the very best, to carry forward from year to
year as assets supply materials which will never be used and which
are therefore nothing but expense items and should be charged against
operation. Only a careful periodic appraisal of supply materials and an
equally careful inventory indicating their usability can give a correct
basis for applying the valuation formula.
Two or three items of deferred charges need a word of further
explanation. In some mining industries, notably coal and precious
metals, leasing is done on a royalty basis with a minimum amount to be
paid each period based on a minimum production of ore to be mined. If
less than the minimum is mined, a frequent provision in the terms of
the lease makes possible the application of any royalties overpaid one
period against a future production of more than the required minimum.
That is, no increased royalties are charged for a production over the
minimum until all accumulated royalties from periods of underproduction
are used up. In any period of underproduction such royalties may
properly be treated as deferred charges only on condition that there
is reasonable expectation that future production will increase to the
point where it will consume the overpaid royalties of earlier periods.
At times a company finds itself bound to such a contract, based on a
minimum production, without any hope of relief because the prospect
has not developed as anticipated. Under such conditions the entire
periodical royalty charge is a charge against operation and must be
absorbed entirely by the operations of each fiscal period.
Accounting for Deferred Debit and Other Items
The accounting for deferred debit items proceeds along the same lines
indicated for accrued income. Nothing further need here be said than
that such items as insurance, supplies of various sorts, etc., are
frequently recorded originally as asset items instead of as expenses.
At the close of the period so much of each of them as has been used is
transferred to suitably named expense accounts and is thus taken into
profit and loss. There is no objection to this and it usually works out
very satisfactorily, although the usual practice is to treat all items
of this class as expenses rather than as assets. This method is usually
prescribed by regulatory commissions in the case of public utility
companies.
The treatment of premiums paid on long-term investments and of
discounts arising through the marketing of long-term obligations at
a figure below par is reserved for consideration in the next chapter
where their relation to the interest account and the problem of
amortization will be considered.
CHAPTER XV
PERMANENT INVESTMENTS
Nature of Permanent Investments
As distinguished from the type of investment discussed in the
preceding chapter, investments of a more or less permanent character
will next claim our attention. These may be permanent in the sense
that at the date of the balance sheet they have a long term to run
before they mature and the expectation is they will be held for a
considerable period of time; or permanency may be indicated because
ownership of the investment is necessary or, at least, a valuable
requisite to operation. Ease of conversion into cash may or may
not be a characteristic of such investments, and certainly it is
not a determining test for valuation as is the case with temporary
investments, discussed in Chapter XIV.
The necessary test is always the condition in which the company would
be placed, viewed from the standpoint of efficient operation, if the
investment were disposed of. If its efficiency or its contracted or
moral obligations would not be impaired, the investment may be said
to be of a temporary character. Examples were given in the previous
chapter. If, however, its efficiency would be materially affected,
or its continuance as a business be hampered or threatened, then the
investment must be considered as of a permanent character. This latter
type of permanent investment will be discussed first, followed by a
consideration of the long-term securities (bonds, stocks, and land)
held as investments for certain funds (such as the building fund, bond
and redemption fund, etc.).
Permanent Investments as an Aid to Operation
These permanent investments may take the form of ownership of the stock
or bonds of other corporations, as in the case of the holding company.
They may represent interests, active or silent, in partnerships; or
they may take the form of advances of working capital or funds to
other concerns. Whatever the form may be, and whether evidenced by
formal securities, collateral, or merely by open book accounts, they
serve the purpose of securing some essential facility without which
operation could not be successfully carried on. A newspaper may secure
full or controlling interest in a paper mill to insure its supply of
print paper; a railway may become a heavy owner in a terminal company
in order to give it terminal facilities; a refinery may purchase a
controlling interest in an oil production company in order to give it a
sure supply of crude oil; etc. Thus, the permanent or fixed investment
is always a means of bringing about the efficient operation of a
business. It may be effected in any one of three ways, viz.:
1. By practically full ownership of the subsidiary
enterprise to secure complete control and so
direct its policies.
2. By only a controlling ownership.
3. Through the agency of advances, particularly when,
because of poor credit, the usual money markets
may be closed to the borrowing company.
Valuation of Permanent Investments
The problem of the valuation of investments under the three forms
mentioned presents some interesting features. It might seem that,
inasmuch as the investment is in the nature of a fixed asset, valuation
should always be at full cost; that market fluctuations should have no
effect. The last half of this statement is correct but the first part
needs modification. It is to be expected that a concern in purchasing
the stock of another will not pay more than it considers the stock to
be worth. The price may be more or less than the face value of the
stock, depending upon the existence of an element of good-will or the
overstatement of the assets on the books of the vendee company; or
again, where the stock is bought on the open market many other factors
may cause a variance of purchase price from par value of the stocks.
Were the investment simply an inanimate asset to be used, cost, perhaps
less depreciation, would be the proper basis for valuation. Since,
however, a corporation cannot remain stationary—it must usually record
a gain or a loss from year to year—ownership in that corporation must
accordingly suffer change from year to year. So many things can happen
to an operating corporation that cannot befall an inanimate asset held
for use that the proposal to value both on the same basis is hardly
tenable. Furthermore, if proper principles of valuation are applied
to the subsidiary concern, its true value can be determined with fair
accuracy. Accordingly, a true basis is secured for valuing it as an
investment on the books of the holding company. Any increase in value
over cost is due to the profits made by the subsidiary enterprise, and
in the case of its complete ownership by the holding company these
profits belong in full to the holding corporation. If all the profits
are disbursed as dividends to the holding company, the subsidiary
enterprise suffers no change in condition and therefore no change in
value. If, however, some of the profits are retained, this would result
in an increased value which should be reflected in the valuation of the
subsidiary enterprise on the books of the holding company. How this may
best be shown also requires consideration.
Holding Company and Subsidiary Enterprises
A holding company may have but few assets aside from its holdings in
subsidiary concerns. A balance sheet showing only these few assets and
its investments in the other concerns does not usually give much useful
information. Therefore, as the assets of the subsidiaries belong to
the holding company and really comprise its operating plant, a more
intelligent way of showing the investments of the holding company is
to combine or consolidate the balance sheets of the subsidiaries and
incorporate them in the balance sheet of the holding company in place
of the item of investments. This method is known as the “consolidated
balance sheet” and is given fuller treatment in a subsequent chapter.
Here attention is called to it merely as a device for showing the
valuation of permanent investments represented by substantially full
ownership of the subsidiary companies.
Controlling Investments
Where ownership is not complete but still controlling, the method of
the consolidated balance sheet is not so fully applicable and often
is not used. In this case the investment will appear as such on the
balance sheet with whatever adjustments in value may be necessary due
to the success or failure of the subsidiary’s operation for the past
period. Whatever profits are made enhance its value and in the enhanced
value the controlling company has a pro rata share, the effect of which
should be taken up in the valuation of its investment therein. The net
amount of the enhancement in value is the difference between the net
profit made by the subsidiary concern and that portion paid out in
dividends—in other words, the portion reinvested in the business.
This portion, i.e., such part of it as belongs to the controlling
company, may be taken up directly by charging the investment account
and crediting a proper income account; or the share of the entire net
profit belonging to the controlling company may be charged to the
investment and credited to an income account. In the event of dividends
being paid by the subsidiary company, these would be credited to the
_investment_ account of the controlling company, which account would
then show, as in the first method, the new value due to the profits
reinvested in the business. That this policy of increasing the value of
the investment is conservative and sound is apparent when one considers
that the holding company’s ownership of the subsidiary concern controls
the latter’s policies, including the dividend policy. The profit taken
onto the books of the holding company by the above method is a real,
not a book, profit.
Advances to Subsidiary Concerns
Where control is secured through the medium of advances made on open
account or by means of such advances together with ownership of stocks
and bonds, a valuation must be made of these claims separately from the
stocks owned. Where ownership is complete and valuation is shown by the
consolidated balance sheet method, intercompany accounts and claims
are, of course, eliminated and so do not show. In all cases, however,
where claims against a subsidiary arise on account of advances, or even
of sales, and these must be shown on the balance sheet of the owner of
the claims, more than average care must be taken in placing a value
on them. In the case of advances, frequently their exact status is
not known at the time when made. The record is carried in a suspense
account until its final status is determined, when record is made
accordingly. The advance may be temporary, for the purpose, say, of
enabling the subsidiary concern to take advantage of very favorable
market conditions in the purchase of raw materials, in which case,
of course, the claim is a current asset; or possibly the subsidiary
company is about to make additions to plant and equipment and is
financing the expansion temporarily by means of borrowings from the
parent company. Whatever method of permanent finance is finally settled
upon, this should convert the open-account claim of the parent company
on account of advances, into the regular securities or obligations of
the subsidiary concern. Again, it is unfortunately true that advances
to the subsidiary company often become necessary to recoup it because
of operation at a loss. This may continue with little hope of repayment
for years to come, if ever. The parent company may ultimately lose all
the funds advanced to the subsidiary company because of the latter’s
financial instability.
Rules for Valuation
Because of the many factors involved, it is apparent that no absolute
rule can be laid down for valuing the advances to a subsidiary
enterprise. Each case will require careful investigation and must be
settled on the basis thus established. If the investigation shows
the loan to be temporary with good expectation of its full return,
it should be shown at its face value among the current assets. If
the advance is to be converted into the securities of the subsidiary
concern and the latter is in good condition, the advance may be carried
at par among the fixed assets. When the securities are received they
should be valued as any other permanent stock investments, with due
regard to the basis of conversion in comparison with the value of the
securities given in settlement. If conditions upon examination are
found to be serious, it may be necessary to treat advances made as
expenses, i.e., they are of no realizable value. If the bankruptcy of
the subsidiary concern seems probable, a question of financial policy
and law arises, viz.: whether the interests of the parent company are
best conserved by allowing its claims to remain on open account and so
rank with other creditors, or to be converted into stock and rank with
those of other owners. It may be necessary to take that phase of the
matter into account when determining the value of claims against the
subsidiary concern.
Investments in Partial Holdings
For the sake of business connections, prestige, and good-will,
oftentimes more or less permanent investments are made of such a nature
or in such amounts as not to secure a controlling interest. Here,
because the reins of business control are not held by the investing
company, manifestly such an investment is on a very different basis
from those in companies whose control is held by the investor. In the
one case, business policy can be determined and made effective; in
the other case, success or failure is under the control of others.
Accordingly, the valuation of these partial holdings differs from
investments in companies entirely owned or controlled by the investor.
Where the holdings of these minor interests are not particularly
substantial in comparison with other properties owned, there is no
serious objection to valuing them at cost. They are held to secure
certain benefits, and so long as the real values of the companies
concerned are being maintained or enhanced, there is little probability
of the investment being disposed of. Market fluctuations, therefore,
should be given little or no consideration. Where, however, partial or
minor holdings form a comparatively large portion of the investments,
it may sometimes be wise to value them on the same basis as temporary
investments of a current nature. In this case the profit or loss
attendant upon bringing market values into the books should be handled
as with temporary investments.
Where investments of this kind are shown on the balance sheet at cost,
it is sound policy to call attention in a footnote or otherwise to
their market values, as oftentimes the market gives some indication of
the condition of the company. The savings banks of the State of New
York, in reporting to the State Department of Banking, must show the
market value of the securities held. Usually three values are shown,
viz.: market, par, and so-called investment value, to be explained
later. Where the securities held are not listed on any exchange or are
held closely and not traded in extensively, it is often difficult to
secure reliable market quotations for them. Here cost, unless known
conditions demand otherwise, seems the best basis for valuation.
Investments Producing No Income
Some investments may be of a permanent type and yet of themselves
produce no income. Such are memberships on stock and produce exchanges,
boards of trade, and the like, which are valuable for the privileges
and prestige accruing therefrom and the business associations secured
thereby. They should usually be valued at cost, thus allowing the
period in which they are sold, if disposal becomes necessary, to get
the profit or loss incident thereto.
Bond Values and Market Interest Rates
In connection with the valuation of bonds, some additional
considerations should be taken into account. Assuming that the margin
of security for the mortgage covering the bonds is ample, the value of
a bond, i.e., its price on the market, is largely dependent upon the
prevailing interest rate in the money market. Thus, if a bond bearing
5% interest is offered for sale in a market where the rate is 6%, it
can be sold only at a discount sufficient to provide approximately 6%
on the money invested. Similarly, a 6% bond offered in a 5% market
should bring something more than par. It is not intended to convey
the impression that whenever a bond sells below par it is because the
market is demanding a higher rate than that offered by the bond; nor
when a bond sells at a premium need the entire amount of the premium
be a reflection of money market conditions. An additional factor is
oftentimes the credit standing of the issuing company. Thus, even
though a bond may be amply protected, the poor credit rating of the
issuing concern will be reflected in a downward tendency of the price
of the bond, for under such circumstances foreclosure proceedings
preliminary to sale and conversion of the security always loom large in
the background. On the other hand, bonds of the United States are often
above par because of the government’s credit standing.
On the assumption that there is reasonable expectation that the bonds
will be paid at maturity, their valuation on the balance sheet during
the time they are held by an investor must have regard to the price
paid as determined by the bond interest rate and the money market
rate at the time of purchase. A bond bought at a discount and held
to maturity is redeemed at par. If the bond is carried at cost until
the period of redemption, that period would secure the credit for the
difference between cost and par. Similarly for a bond bought at a
premium, and carried at cost constantly, the period of redemption would
bear the loss between cost and redemption price.
Nature of Bond Discount or Premium
To bring out more clearly the real nature of bond discount or premium,
under the limitation stated above, consider a bond selling at 90 and
bearing 4½% interest. This should be interpreted to mean that the
issuing company, because of the low rate offered on the bond, will have
to pay at maturity $1,000 for every $900 now received. It is, as it
were, having to prepay $100 interest on every bond sold, in addition to
its promise to pay the stipulated bond rate of interest periodically.
It is selling a $1,000 security for $900 and is thus depriving itself
of $100 which it might have had by contracting to pay the present
market rate of interest. From the other (i.e., investor’s) point of
view, he is willing to lend money at the bond rate only because he
expects to be compensated by the $100 to be received in a lump sum at
the maturity of the bond.
The wisdom of fixing the bond interest rate so that the bond will
command either a premium or a discount hinges upon the soundness of
the forecast as to the money market in the future. It is, of course,
a speculative transaction. Since, then, discount on bonds is, from
the standpoint of the issuing concern, a prepayment of a portion of
the interest in amount sufficient to make the income rate on the bond
correspond with the rates prevailing in the market, this prepayment is
applicable to the whole period of the life of the bonds and should be
spread equitably over that period. To accomplish this it is necessary,
every time bond interest is paid, to transfer to the Bond Interest
account a portion of the Discount on Bonds account, thus gradually
wiping off the Discount account and making the Interest account
show every period the real amount (and real rate) of interest as
distinguished from the amount paid as indicated by the bond rate.
In the present discussion, the chief concern with the problem of bond
discount and premium is from the point of view of the investor. Having
established from the other point of view the true relation between
premium and discount and bond interest, there will be considered the
two additional problems as to the manner of carrying the record on the
investor’s books and as to the method of valuing the investment at each
balance sheet period. First, then, is the problem of making the record.
Record of Bond Investments
When bonds are purchased the record may be made in two ways. Accounts
may be kept with the bonds at par, separate valuation accounts being
carried for the discount or premium. An account with bond interest is
also opened and sometimes one with prepaid interest on bonds, where,
as is usually the case, the bonds are bought with accrued interest to
date of purchase. The accrued interest, however, is more conveniently
recorded as a charge in the bond interest account, thus automatically
adjusting the income from the bonds when the first coupon after date
of purchase is redeemed. As stated in Chapter XIV, the amount of the
discount or premium is to be spread equitably over the life of the
bond. The method of making an equitable distribution is a problem to
which consideration will be given in later pages of this chapter.
The entry to effect the distribution is a transfer entry between the
premium or discount account and the bond interest account for the
portion accrued as on the date of each payment on the coupons. The
result of the transfer is to establish with the bond account at par a
true valuation of the bonds held as on that date, and to secure the
correct amount of income from bond interest to be credited to the
current period.
The second method of making record of the bond investments is to
record the purchases at cost in the bond account, carrying there full
information as to premium or discount, no separate accounts with these
being opened. When the bond interest falls due, the bond account
itself is written up or down for the amount of the discount or premium
accrued during the current period. The contra entry is in the bond
interest account just as above. This latter method does not commend
itself when the only record kept of bonds is that mentioned above. If
the investments are so numerous as to require a subsidiary ledger for
their record, where with each kind of bond accounts will be kept with
its par, discount or premium, and interest, there is no objection to
handling the controlling account on the general ledger by making the
discount or premium adjustment directly to the bond account. Fuller
information is given and the record is less involved, however, when
handled by the first method.
Amortization of Bond Discount and Premium
The equitable distribution (technically known as “amortization”) of the
discount and premium on bond investments is the essence of the problem
of their valuation. There are two methods of making this distribution,
termed the “straight line” and the “scientific” method. Under the
straight line method the amount of the discount or premium is divided
by the interest periods the bond has yet to run, and the quotient is
made the amount of periodic amortization. Although not scientifically
accurate, the method commends itself because of its simplicity and
consequent ease of operation. Its use is allowed by the Department
of Banking of the State of New York for valuing the investments of
savings banks. The scientific method is based upon compound interest
calculations and will be best understood by means of examples. Under
this method the discount or premium is looked upon as the amount of an
annuity. The portion which must be written off for any period is the
present worth of the annuity on that date, taking into consideration
the rate of interest and the time in interest periods the bond has
still to run.
In practice, however, the amount of amortization is not found in that
way. To find the periodic amortization, it is necessary to know the
cost of the bond, its coupon interest rate, and the effective rate. By
effective rate is meant the real income rate on the basis of the price
paid for the bond. Assume that a 3% bond, interest payable January
and July, has 3 years (6 periods) to run and is bought for $971.99 so
as to yield 4% on the investment. At the end of the first semiannual
period the actual interest received will be $15, but the real income
on the investment is $19.44 because it was purchased on a 4% basis
for $971.99 (2% on $971.99). Of the total discount of $28.01, $4.44
(19.44-15.00) is to be credited to the current period. The adjustment
of discount brings about a new valuation of the bond, it being now
worth $976.43 (971.99 + 4.44), because nearer by six months to maturity
when it will be worth par or $1,000. So, for the next period the
coupon is $15 and the effective income, $19.53 (2% on $976.43), hence
the amortization is $4.53; and so on for the six periods, at the end
of which the discount will have been completely distributed, i.e.,
amortized.
The following schedule shows the periodic amortization and new values
of the bond:
3% bond, par $1,000; bought on a 4% basis for $971.99;
3 years to run; interest January and July.
============+=======+=========+============+========+=========
| | | | | Discount
|Nominal|Effective| Periodic |Value of| Adjusted
Date |Income | Income |Amortization| Bond | Amounts
------------+-------+---------+------------+--------+---------
Jan. 1, 1915|$..... | $..... | $..... | $971.99| $28.01
July 1, 1915| 15.00 | 19.44 | 4.44 | 976.43| 23.57
Jan. 1, 1916| 15.00 | 19.53 | 4.53 | 980.96| 19.04
July 1, 1916| 15.00 | 19.62 | 4.62 | 985.58| 14.42
Jan. 1, 1917| 15.00 | 19.71 | 4.71 | 990.29| 9.71
July 1, 1917| 15.00 | 19.81 | 4.81 | 995.10| 4.90
Jan. 1, 1918| 15.00 | 19.90 | 4.90 |1,000.00| .....
+------------+ |
Total discount amortized $28.01 | |
-------------------------------------------+--------+---------
A similar schedule for a bond bought at a premium immediately follows:
5% bond, par $1,000; bought on a 4% basis for $1,028.01;
3 years to run; interest May and November.
============+=======+=========+============+=========+=========
| | | | | Premium
|Nominal|Effective| Periodic |Value of | Adjusted
Date |Income | Income |Amortization| Bond | Amounts
------------+-------+---------+------------+---------+---------
May 1, 1917|$..... | $..... | $..... |$1,028.01| $28.01
Nov. 1, 1917| 25.00 | 20.56 | 4.44 | 1,023.57| 23.57
May 1, 1918| 25.00 | 20.47 | 4.53 | 1,019.04| 19.04
Nov. 1, 1918| 25.00 | 20.38 | 4.62 | 1,014.42| 14.42
May 1, 1919| 25.00 | 20.29 | 4.71 | 1,009.71| 9.71
Nov. 1, 1919| 25.00 | 20.19 | 4.81 | 1,004.90| 4.90
May 1, 1920| 25.00 | 20.10 | 4.90 | 1,000.00| .....
+------------+ |
Total premium amortized $28.01 | |
-------------------------------------------+---------+---------
The problem of amortization is thus seen to be comparatively simple
when the cost of the bond, its nominal rate, and effective rate are
known, and successive valuations of the bond are equally simple. The
crux of the whole calculation is thus seen to be the determination of
the original purchase price of the bond. At the time of the purchase of
the bond the following facts are known: the par of the bond, the time
it has to run, its rate of interest, and the rate of earning desired
on the investment. There are three methods or formulas by which this
price can be determined and they will be explained in turn. However,
the development of the formulas will be more easily understood if some
points in compound interest and annuity calculations applicable to the
three methods of valuing the bond are first explained.
Formulas for Compound Interest
In the determination of the present worth of a sum of money at compound
interest due a certain number of years hence, the following symbols
will be used:
A = the sum which placed at interest at the given rate will
accumulate to the given amount in the given time.
B = the given amount accumulated
r = given rate of interest per _period_
R = 1 + r
n = the given number of periods
The present worth of B is manifestly A, the sum which, when placed at
interest, amounts to B. At compound interest the amount to which A will
accumulate in n periods is given by the formula:
(1) B = A(1 + r)(1 + r) ... to n factors, which reduces to
= ARⁿ, whence solving the equation for A
B B
(2) A = ----, i.e., the present worth = ---- .
Rⁿ Rⁿ
1
From this, the present worth of $1 is seen to be ---- .
Rⁿ
Formulas for Annuities
An annuity is a given sum of money placed at interest usually at the
end of each successive year or period, and allowed to accumulate at
compound interest for a number of periods. For bond valuations it is
necessary to know the amount of an annuity and the present worth of
this amount. The following terminology will be used in the solution of
the problem:
A = the sum put at interest periodically
B = the amount to which A accumulates
r = the rate of interest per period
R = 1 + r
n = the number of periods
P. W. = the present worth of the annuity
The first sum, A, placed at interest at the end of the first period
will accumulate for n-1 periods and, according to formula (1) above,
will amount to ARⁿ⁻¹. The second sum, A, placed at interest at the end
of the second period will amount to ARⁿ⁻²; etc. The last sum, A, will
not accumulate and so is worth just A.
The amount of the annuity is thus seen to be the sum of the amounts of
the several periodic sums. Expressed as a formula:
B = ARⁿ⁻¹ + ARⁿ⁻² ... + AR + A
= A(Rⁿ⁻¹ + Rⁿ⁻² ... + R + 1), whence
Rⁿ⁻¹ Rⁿ⁻¹
(3) B = A------ or A-----
R - 1 r
The expression in parentheses is a geometric series
whose sum may be written in the fractional form shown.
The present worth of B, i.e., of
Rⁿ⁻¹
A-----,
r
is found from formula (2) above to be:
Rⁿ⁻¹
A----- divided by Rⁿ.
r
Expressed as a formula:
Rⁿ⁻¹
(4) P. W. = A-----
Rⁿr
Formulas for Bond Valuation
The method of valuing a bond makes use of the formulas (1) to (4) just
established. The symbols used in the bond formulas will be:
P = the par or face value of the bond
r = the effective rate
c = the nominal rate—the rate specified in the bond
C = Pc, i.e., the value or amount of a matured interest
coupon, the nominal yield of the bond
Pr = the interest yield on par at the effective rate
V = present worth or value of the bond
_First Method._ The present value of a bond may be looked upon as the
sum of two present worths, viz.: the present worth of the face of the
bond and the present worth of the annuity represented by the periodic
interest payments, i.e., the coupons. The present worth of the face is,
according to formula (2), P/Rⁿ. The present worth of the coupon annuity
is, from formula (4), seen to be
Rⁿ⁻¹
C-----.
Rⁿr
Hence the present value of the bond is the sum of these two present
worths, i.e.:
P C(Rⁿ⁻¹) Pr + C(Rⁿ⁻¹)
(5) V = --- + --------- or --------------
Rⁿ Rⁿr rRⁿ
_Second Method._ Here, the determination of the amount of premium or
discount which is fair payment for a bond is the point of attack.
That is, using par as a basis, how much above or below par is the
bond worth? The fair premium is based upon the difference between the
nominal yield of the bond and the interest return in the present money
market. Stated otherwise, in the case of a bond selling at a premium,
the nominal interest return may be looked upon as composed of two
parts, viz.: (1) a portion representing interest at the _effective_,
i.e., current money market rate on the par value of the bond, and (2) a
portion—the difference between the nominal yield and (1)—which is of
the nature of an annuity for the life of the bond. The present worth of
this annuity is the fair premium on the bond.
To illustrate: A 6% bond sold in a 5% market would have a nominal yield
annually of $60. All that can be secured, however, on the par value is
$50. Hence, on the basis of valuation at par there is a $10 excess of
nominal over market yield which would be received every period. The
present worth of this $10 annuity is the fair premium which the bond
will command. With the use of the previous symbols, this annuity is
expressed by the quantity (C-Pr) whose present worth, as determined by
formula (4) is
(C - Pr)(Rⁿ -1)
--------------- .
rRⁿ
Therefore, the value of the bond is the face or par of the bond plus
the present worth of this annuity, i.e.:
(C - Pr)(Rⁿ - 1)
(6) V = P + ----------------
rRⁿ
This formula when simplified reduces to
Pr + C(Rⁿ - 1)
--------------,
rRⁿ
which is identical with formula (5) and, of course, values the bond at
the same amount.
_Third Method._ Valuation by either of the methods above is rather
complex, requiring for easy solution the use of logarithm or compound
interest tables. A third method, requiring only the ordinary arithmetic
processes is sometimes used, although very burdensome when the periods
are numerous. This is sometimes called the periodic method because
working backwards from par, the value at the next preceding period is
determined, and from that the next is found, and so on till the value
at the desired period is reached. Reference to the second amortization
schedule shown on page 270 will help in understanding the process.
Using the same terminology as above and this additional:
P₁ = the first preceding value above par
($1,004.90 in the schedule)
P₂ = the second preceding value above
par ($1,009.71 in the schedule)
Etc.
formulas 7 to 9 below may be developed.
It was noted that any particular value of the bond is found by
subtracting from the next preceding value the difference between the
nominal and effective incomes. The nominal income is always based on
par, and the effective on the value at the last interest period. For
example, in the schedule referred to: $1,004.90-($25-$20.10) = $1,000,
the $20.10 being the effective income, 2% on $1,004.90. Using symbols
the above equation may be generalized as follows:
P + Pc
(7) P₁ - (Pc - P₁r) = P, whence P₁ = -------, and
1 + r
P₁ + Pc
(8) P₂ - (Pc - P₃r) = P₁, whence P₂ = --------, and generalized,
1 + r
Pₙ₋₁ + Pc
(9) Pₙ - (Pc - Pₙr) = Pₙ₋₁, whence Pₙ = --------
1 + r
This gives a working rule whereby it is possible to work back from the
known value, par, by successive operations until any desired value is
found. The calculation is somewhat as follows for the example used in
the schedule:
1,000 + (1,000 × .025) 1,025
----------------------- = ------ = 1,004.90
1.02 1.02
1,004.90 + (1,000 × .025) 1,029.90
------------------------- = -------- = 1,009.71
1.02 1.02
Similar calculations will develop the other values in the schedule. In
the case of a bond with, say, 30 periods still to run, the burdensome
nature of the calculation by this method is apparent.
While commercial houses rarely need to use the algebraic formulas
for calculating bond values, it is the only really correct method
of valuing bonds which are held for long-time investment, and the
accountant should be conversant with it. For the balance sheets of
savings banks, insurance companies, and other investment concerns,
scientific valuation of bonds with the attendant amortization up and
down of discounts and premiums is not only theoretically correct but
practical considerations, in a market such as prevails in a time of
marked but temporary depression, demand that it, or some approximation
to it, be used.
A discussion of the valuation of serial and short terminal bonds, or
those carrying more than one rate of interest, or those redeemable by
lot at various times, is beyond the scope of the present work.
Valuation of Sinking Funds
The section of the balance sheet under consideration usually includes
the various funds representing the investment of reserves. Sinking
funds, building funds, insurance, pension, endowment funds, and the
like, are examples of this class of asset. The use of the term fund
should be strictly limited to specific assets set aside for specific
purposes. The problem of valuation in connection with funds will be
considered under two sets of conditions, viz., when the funds are
invested in a concern’s own securities and when invested in outside
securities. The practical questions in connection with funds are those
of finance rather than of accounting.
The determination of a policy of investment as between the concern’s
own and outside securities depends on many considerations, some of
which do not come strictly in the purview of the accountant. It is
argued that for the sake of immediate availability, investment of funds
to be used for a specific purpose at a definite time should be in the
securities of other concerns over whom control does not extend. In
some cases, however, provision is made in the trust deed of a sinking
fund to the effect that the funds set aside shall be used to purchase
the bonds to retire which the funds have been created. These bonds
may be canceled or held for the sake of their income in the fund till
maturity. There would seem to be no choice between a concern’s own and
outside securities, provided the same standards of moral obligation
are observed in both cases. If the securities purchased for the funds
are the concern’s own bonds, they should as a rule be valued at cost
and the premium or discount amortized over the remaining life of the
security. They may, of course, be carried on the books at par and the
premium charged immediately against any income in the fund. The showing
on the balance sheet should be in exact accord with the facts. If the
bonds have been purchased and canceled together with their coupons,
the amount of such cancellations should be shown as a deduction from
the bond liability. The fund is thus serving its purpose _currently_
by reducing that liability. Any uninvested balance in the fund should,
of course, be shown among the assets. When the bonds are purchased and
held uncanceled for the sake of their income, it is probably better to
carry them among the assets, indicating, if the information should be
considered vital, that the securities in the fund are the concern’s own
securities.
If the funds are invested in outside securities, these should be valued
on the basis of long-time investments. If bonds, their premiums or
discounts should be amortized. If, however, the credit of the issuing
concern is such as to cast doubt on its ability to redeem them at
maturity, other bases for valuation should be taken. It might even
be necessary to set up special reserves to replenish the expected
shrinkage upon realization of the securities held in the fund. A final
injunction may not be out of place, to the effect that all funds should
be definitely labeled so as to show their purpose.
Valuation of Investments in Land
Investments of a more or less permanent nature sometimes take the form
of investments in land. This may be for the purpose of securing an
income; it may be of a speculative nature, as when land is held for
appreciation in value; it may be to secure room for future expansion;
or it may be for the purpose of preventing a competitor from securing
favorable holdings as to trade location or facilities. For whatever
purpose acquired, as here considered, the land is a permanent
investment and should be separated in the records from land held for
operating purposes. The manner of accounting for these investment
holdings is somewhat dependent on the purpose for which they are held.
In most cases, particularly if the land is income-producing, at least a
land expense and income account will be needed in addition to the asset
account or accounts with the land.
As to the valuation of these holdings, full cost with no account taken
of depreciation or appreciation in value is the correct basis. As
stated in Chapter XVII, page 307, under certain conditions the carrying
charges on non-income-producing lands may be added to the value of the
holdings. If lands are held over a long period to secure appreciation
in value, certainly all carrying costs should be loaded on to the asset
account, offset, as shown in Chapter XVII, by a suitable reserve. Care
must always be taken not to secure inflated values by these methods. If
any of these holdings are disposed of, the profit or loss then actually
realized must be taken into account; but no unrealized profit or loss
should be brought onto the books—except, perhaps, as a balance sheet
footnote.
CHAPTER XVI
MACHINERY AND TOOLS, FURNITURE AND FIXTURES, AND OTHER EQUIPMENT
General Considerations
The valuation of assets grouped under the head of equipment presents
nothing new in principle but requires consideration of many points in
the application of principles and of some features in accounting. Here
the principle of value as a going concern is particularly effective. As
in the valuation of prepaid expenses on a going concern basis, so here
forced sale or liquidation value has no place. The business is viewed
as established and as expecting to operate continuously. Capital has
become tied up in certain equipment essential to the undertaking, in
the sense that to dispose of it in its entirety would mean a break-up
of the business. It cannot therefore be freed or put to other uses
without a reconstruction of the present enterprise. Accordingly, the
possible market value, as second-hand property, should not in any way
influence the valuation at which this group of assets is carried on the
books. Only full cost at the time of installation and depreciation,
using the term in its broad sense, need be considered in the problem of
valuation.
Distinction between Personalty and Real Property
The present chapter deals with such fixed asset equipment as machinery
and tools, furniture and fixtures, delivery equipments, patterns,
lasts, dies, maps, drawings, electrotypes, ovens, furnaces, etc.,
as distinguished from the more fixed group of lands, buildings,
leaseholds, and the like. In the main, the point of differentiation
is the legal one of personalty and real property, although the
intricacies of the law on this vexed subject are never, so far as is
known, reflected in the books of account, nor is it the purpose here
to attempt to lay down any working rules or standards by which such
differentiation can be made. There seem to be none except certain broad
generalizations, each case resting on its own peculiar surroundings.
Circumstances, however, may arise under which a clear-cut distinction
is desirable. A bond issue supported by a mortgage on real property
or on personal property _may_ depend, although not usually, on such a
distinction for a large share of its security. The margin of safety may
hinge on this point. It may be desirable to be able to trace on the
face of a balance sheet the particular property covered by a mortgage.
And should foreclosure of the mortgage become necessary, it is, of
course, essential to know exactly the property subject to the lien.
These are not points under contemplation in a going concern, although
the possibility of their arising should not be lost to view. Here the
problem of valuation and accounting for such valuation is viewed from
the standpoint of a going concern and not one facing partial or total
liquidation. Furthermore, as stated above, the point is, in its final
analysis, one of law and not of accounting.
It is not intended by the foregoing statement to sanction any method
of keeping the records in non-accord with fundamental rulings of the
law, but only to state that, so long as substantial agreement is
secured, accounting has served its intended purpose. Wherever any
specific property is known to be subject to a lien, it is of value
to the management for the accounts to reflect the fact. There may,
however, be circumstances under which it is not desirable that the
_accounting_ records give this information. Conditions must govern each
particular case without prejudice, and the principle holds that so long
as substantial accuracy is reflected in the accounts as to this point
nothing more is necessary.
Machinery and Tools
Under this head will be included not only the assets carried under
that ledger caption, but also power machinery, power transmission,
shafting, connections, electric transmission cables, and the like. The
term is used in a very broad sense. While all these items are subject
to one general rule of valuation, usually each must be separately
considered to determine the practical application of the rule. The
valuation involves, of course, the factor of depreciation, and it is
readily apparent that not only do different pieces of machinery differ
in this respect, but the same machines in different factories will vary
as to this element and even in the same factory two similar machines
will not usually be affected in the same way. This may be caused by
defects or differences in quality, almost invariably latent, inhering
in the machine and also by the different conditions under which they
are operated. As pointed out in Chapter VI on depreciation, many of
these are engineering problems which the accountant alone cannot solve
but the existence of which he should know. Manifestly, all that can be
attempted here is to point out their existence.
Accounting Records
The valuation of machinery and tools as here contemplated is dependent
largely on the accounting records. Therefore, it is desirable to keep
separate records for each of the two classes. This is so because of
the greater degree of fixity of the one over the other. As to tools a
distinction is also made between machine tools and general shop or hand
tools. Machine tools are those with which the machine does its work.
Thus, cutting tools for use with any particular machine, auxiliary
equipment used for some operations, but not for others, and the like,
constitute a very essential and component part of the machine and
should be recorded and valued with the machine even though the tools
need to be replaced much more frequently than the machine. On the other
hand, shop tools comprise those of general utility which are largely
used by hand. Hammers, wrenches, hand shears, pliers, chisels, bits,
and the like, are examples of shop or hand tools.
Where the number of machines is large, proper accounting requires a
subsidiary record known as a machinery ledger or register controlled by
the machinery account on the general ledger. In this subsidiary record
accounts should be kept with each class of machines, and with each
machine separately if the record as to the performance of any specific
machine furnishes essential information.
Operation of Machine Accounts
Every machine should be charged with its full cost. Full cost is
understood to include invoice price, insurance during transit,
freight, duty, and drayage charges, and installation costs. The last
item usually includes the platform or stand on which the machine is
erected, with all costs in connection therewith, when special supports
or platforms in addition to the regular factory floor are needed. The
cost of attaching the machine to the power and meters for measuring its
power consumption are not usually included therein, these being classed
as costs of power equipment—although practice is not entirely uniform
in this regard. The machine record should also show the name of its
manufacturer and its order number and any other useful information such
as terms and period of guarantee, estimated life, rate of depreciation
to be applied, numbers and kinds of tool equipment, etc. All deductions
from the value of the machine must be on the same basis of full cost.
Such deductions might arise because of fire, sale, or replacement. The
proper handling of the account when deductions are necessary will be
explained at the close of the chapter, as the method is applicable to
all classes of asset equipment.
Valuations of Machinery and Tools
The statement of the principle of valuation for machinery is simple,
but the application of the rule is complex. The valuation formula for
machinery is cost less depreciation. As stated above, the condition of
the market has no influence on the going concern valuation of fixed
assets. If the market is now lower than at the date of purchase, this
simply means that more capital was then required to start operations
than is now required. If the forces of competition are free to act, the
margin of profit or the margin of return on the investment in machinery
will be somewhat less in the one case than in the other. If the market
is now higher, then the situation is in favor of the earlier investment
rather than the present one. In neither case should costs of production
be falsified by valuing the machinery and other equipment at any other
figure than cost.
Estimate of Depreciation
Estimating the depreciation on machines is the chief and vital problem
in their valuation, because depreciation is reflected in the cost of
the article manufactured, being a cost of production just as truly as
the raw material used. As brought out fully in Chapter V, page 93, the
so-called depreciating assets are really of the nature of deferred
charges to operation and a depreciation estimate is the amount of the
periodic charge against production. Because of the speculative nature
of an investment in machinery (neither the quality of the machine being
exactly determinable nor the conditions of its operation known), its
depreciation is always an estimate. For this reason it should be based
on the best possible knowledge available at the time of installation.
Any estimate so made must be the subject of periodic revision. How
frequently this revision should be made will depend both on the
length of estimated life and the way in which actual experience
compares with the expected or estimated conditions. The experience on
which the estimate is based should, of course, be with the same or
similar machines, gained, if possible, amid the same surroundings and
conditions under which the new machine will operate. In default of such
experience or as a valuable check thereon, the results of others in
the use of the machine and the expert advice of those who have studied
the problem of depreciation in its practical applications should all
contribute to the making of this estimate.
History of Machine
This need of experience data creates the necessity of a means for
gathering and preserving the data, and the machinery record above
referred to serves the purpose. Therein should be set forth the
complete life history of the machine—not only the original cost and
the additional data given above, but also the time and cost of all
replacements and all information relevant thereto and, as a memorandum,
the cost of maintenance, repairs, up-keep, etc. The record is not
complete without the data as to repairs. A periodic statement should
also be made as to any abnormal conditions under which the machine
has been operated, such as overtime, overload capacity, etc. Where
possible, the output of the machine in units of product should be
included in the record. Where a group or battery of similar machines is
operated, the average experience of all of them is the best possible
data on which to base future estimates of depreciation.
The more life histories available, the more reliable will be the
average obtained therefrom. After making due allowance for changed
conditions of operation, this average should prove a reliable forecast
of future experience. After all, an estimate of depreciation is in many
respects very like an insurance charge, and the time may come when the
life histories of a sufficiently large number of machines will provide
a very reliable basis for estimate at any given time of the expected
life of a machine when operating conditions are known.
Standards of Operation
One phase of the modern efficiency movement relates to the study of
machine operation. This has helped in the study of depreciation, in
that standardized methods of use have been established. These comprise
a standard speed of operation, proper periods of rest, correct methods
of throwing in the power, the proper adjustment of parts for each
machine; and for each kind of machine tool, the proper degree of
hardness to which the cutting edge must be tempered, the speed of
cutting, and the number of operations before resharpening—all these
standards have been established, resulting in an average performance of
maximum efficiency which may be called the normal operating conditions
of the machine. Where such studies have been made and where the set
standards are uniformly observed, a very reliable basis is furnished
for forecasting the future. To insure the observance of these standards
a permanent card should be attached to every machine, giving all
the information essential to standardized operation. A copy of this
standard should be made a part of the record in the machine ledger.
Abnormal Operation
To make the periodic revision of the estimate of depreciation accord
with the fact or rather with the best possible estimate of the fact,
any abnormal operation of the machine should be considered. Thus, if
the machine has been worked overtime, say on a three-shift day instead
of one-shift, or if it has been crowded beyond its capacity, if repairs
have not been made when they were needed, if the wage policy has been
changed from a per diem or per hour basis to a piece-work basis—all
these points must be considered.
Machines which are seldom used require careful consideration. It is
oftentimes necessary to include in the equipment special machines for
infrequent operations and processes. The normal operation of such must
be estimated for each particular factory and depreciation based on such
use.
All of the foregoing points must be taken into account in connection
with the operation of both machines and power equipment. In the case
of the power machinery, a consideration of kind and quantity of fuel,
manner of feeding and cleaning, quality of the boiler water, etc., with
the set standards, forms the basis for a revision of depreciation rates
and estimates.
Map of Machine Location
In connection with the machinery record, a complete map showing
location and number of every machine is especially desirable. In case
of fire it makes identification easy.
Methods of Application of Depreciation
In the application of depreciation, three methods are used more
generally than any others. The straight line method, as discussed in
Chapter IX, is the one most widely employed. It is to be preferred to
all others, giving satisfactory results and being easy of application.
The fixed rate of diminishing value method also has many adherents, and
depreciation based on the number of units of product turned out is a
third method often used where applicable—though applicable in a very
limited degree.
Under the straight line method, it may be ventured as an opinion that
10% is a fair average minimum rate and 15% to 20% an average maximum.
The knowledge as to what constitutes an average rate serves little
useful purpose, however, although it does give a rough estimate when
spread over a large variety of machines. It has been said that from
a mechanical point of view no machine can depreciate _actually_ more
than 30% and be operated efficiently. This does not, of course, mean
that the depreciation reserve should never show more than a 30% offset
to the value of the machine, as this would indicate too high a rate
were the machine still in operation. It does mean that, according to a
theoretical standard of operating efficiency, any machine which cannot
fulfill at least a 70% efficiency test should no longer be used. It
should be remembered that the depreciation reserve is a device for
financing depreciation and nothing else.
Basis of Valuation
The basis, therefore, for the valuation of machinery is its full cost
less estimated depreciation. Such an appraisal is subject to periodic
revision by comparing the estimated with actual depreciation as more
of the facts brought out by the period of life already expired become
available. Perhaps the method of inventory, as will be explained in
connection with hand tools, is best applicable to machine tools and
even to certain small bench machines on the boundary line between tools
and machines. However, special tools made for a particular purpose and
perhaps not adapted to any other use should be charged against the job
and not carried as an asset.
Scrap Material
A financial consideration in connection with machinery is the disposal
of scrap material. This should be disposed of as advantageously as
possible. It should be held until the market for old metals is high, if
at the time of its discard prices are abnormally low.
Accounting for Tools
With regard to the method of accounting for hand and shop tools and
the basis for valuing them, the additional factor of possibility of
loss claims consideration. Unlike machines, which are for the most part
securely attached to the premises, tools are loose, they may be carried
off or lost, and so not only loss in value due to depreciation but loss
from theft or carelessness must be taken account of. Unless an adequate
control is established over the physical handling of loose tools, a
very considerable _leak_ may result at this point.
In accounting for tools, different practices are encountered. Thus,
the Public Service Commission for the First District of the State of
New York, in its Uniform System of Accounts for Gas Corporations,
authorized that, “hand and other small portable tools liable to be lost
or stolen shall, when first acquired and before issued for use, be
carried in a suitable Materials and Supplies account; when issued, they
shall be charged to the appropriate expense account. Portable tools and
apparatus of special value may, however, be charged to the appropriate
tangible capital account, and remain therein so long as record is kept
of the persons to whom such tools and apparatus are issued and such
persons are made responsible therefor.”
Sometimes the practice is found of charging all purchases of tools to
an asset account for a short period of, say, two or three years, and
thereafter to a suitable expense account, with a periodic revision
based on an inventory about once in five or six years. Again, the Loose
Tools account may be handled just as any other asset account, i.e.,
charged with all purchases, credited with losses, and depreciation
provided for. The manner of handling the record is not vital, any
method sufficing that fits particular needs. All methods must, however,
take cognizance of the fundamental distinction between capital and
revenue charges and provide some means by which the Loose Tools
account, as an asset account, shall represent substantially correct
asset values. A successful method of securing control over the physical
handling of tools, where the plant is large enough to justify it, is to
place all tools when purchased in the care of a stores-keeper and issue
them only on authorized requisition, thus securing an accurate record
of them.
Depreciation on Hand Tools
As to the valuation of hand tools, depreciation is often left out of
account on the theory that, so long as a tool can be used to perform
the service expected of it, it is worth approximately what it cost.
Where as an adjunct to this method of valuation, a physical inventory
of tools is taken periodically and all losses so shown are charged to
expense, substantially correct asset values are secured. Of course,
_theoretically_, tools are as much subject to depreciation as other
similar assets, but the method of the inventory valued at cost, and
therefore disregarding depreciation, is perhaps the best practical
way of handling the valuation of tools, and it gives sufficiently
satisfactory results for most purposes.
Valuation of Home-Made Machinery and Tools
Machinery and tools made in own factory offer a problem in valuation.
It may be stated thus: Shall such be valued at the market price at
the time when made, or shall valuation be the cost to manufacture? It
is argued that had the machinery been purchased on the market, as is
usually the case, the cost would have been market price; the machinery
is worth that price and should be so valued. If the cost to make is
less than the market, to bring the machine on the books at market would
necessitate the taking of a profit of the difference between cost and
market. No profit has been made, only a saving in capital investment.
This confusion between profit and savings is referred to in Chapter
XIII.
In the long run, i.e., in the period covered by the life of the
machine, it makes no difference in profits for that period whether the
machine is carried at cost to make or at market, because its value is
written off to depreciation during its life and the higher value means
an increased depreciation charge. This will exactly offset during the
period of the life of the machine the profit taken by bringing it onto
the books in the beginning at market instead of cost. As a matter of
principle, however, the point involved is of sufficient importance
not to justify the practice. By cost to make is meant full cost,
which includes materials used, labor applied, and a fair share of the
overhead expenses. Whatever the cost to make, whether lower or higher
than the identical equipment could be purchased for on the market, that
represents the capital outlay and is the true basis for valuation,
taking cognizance of depreciation for the elapsed period.
Expenditure for Rearrangement of Machinery
In connection with expenditures made in the rearrangement of machinery
within the plant for various purposes, the question of the effect
of it on the value at which the machinery is being carried requires
some consideration. In Chapter V where an attempt was made to mark
out broad boundary lines for capital and revenue expenditures, it was
stated that any expenditure which produces greater earning capacity or
without which a lessened earning capacity would result (assuming that
all normal expenditures for maintenance and repairs are being made
concurrently), may be treated as a capital expenditure or at least as a
deferred charge to be spread over several periods.
In the case of depreciating assets, the practical identity of the
two methods is apparent. Thus, if the expenditures for rearrangement
of the machinery have either of the effects mentioned above, there
is no serious objection on theoretical grounds to capitalizing
them. Instead, however, of injecting such intangible values into the
machinery account, it is far better, because more exact and accurate,
to show them separately. Practical considerations demand that such
expenditures shall not usually influence the valuation of machinery and
a conservatism born of the fear of inflation requires that when treated
as deferred charges, they should be written off as quickly as may be
done without undue burden on the periods’ profits.
Definition of Furniture and Fixtures
Furniture and fixtures, as an asset title, is not clearly defined.
It may include the usual tables, desks, filing cabinets, bookcases,
typewriters and other mechanical equipment, safes, chairs, counters,
and in addition, light, heat, and plumbing fixtures, show windows,
partitioning, shelving, and the like. The account should be charged
originally with all such items at full cost. Great care must be
exercised in handling repairs and betterments to avoid an inflation
of values. The distinction between capital and revenue expenditures
as regards all such assets already acquired is usually so slight and
uncertain as to justify the establishment of a policy of charging all
these to expense. Otherwise, the ease of inflation is apparent. All new
purchases should be charged at full cost to the asset.
Valuation of Furniture and Fixtures
The basis for the valuation of furniture and fixtures is at cost less
depreciation. In applying depreciation, account should always be taken
of the usually very small residual values in this class of asset. Scrap
value in some cases is only as kindling wood and therefore almost or
entirely negligible. In some cases of easily movable equipment, the
method of the inventory as used for loose tools will give better
results in valuation than an appraisal method based on cost less
depreciation. One often finds the conservative practice of bringing
onto the books a rapid depreciation to scrap value during the first few
years, at which nominal value the asset is carried thereafter. This is
a common practice in financial institutions. While not theoretically
justifiable, in comparison with the opposite tendency based on too
great optimism as to the life of the asset, the practice is to be
commended.
The average range for depreciation of this class of asset is from 10%
to 20%, estimated by the straight line method. Where premises are
leased and any equipment of this kind is, according to the terms of the
lease, to remain with the building, it is necessary that a depreciation
rate be taken high enough to accomplish complete writing off by the
end of the lease. This rule also applies if the equipment may be
removed but would be in a badly damaged condition, resulting in little
remaining value.
Delivery Equipment—Definition and Valuation
Delivery equipment includes all property, direct or auxiliary, used in
connection with the delivery of goods both inward and outward. Horses,
wagons, and harnesses, motor trucks and cars, repair parts, and repair
equipment, containers, holders, and the like, are common examples of
this class of asset. In the main, these assets are handled very much
as all the others of the general equipment group. Valuation is on
the basis of cost less depreciation for the most part, but in many
instances the method of the inventory should be applied.
If horses comprise a part of the equipment, not only must depreciation
due to wear and tear be reckoned, but accidental causes such as death
and disablement must be given consideration. Experience in each
business based on the particular kind of work to be performed and
the conditions under which it is being performed furnishes the only
adequate basis for estimating the depreciation rate. Thus, heavy or
light draughting, speed to be maintained, kind of road on which the
haul is made—cobble stones, brick, asphalt, wood blocks, or dirt—and
the standard of appearance to be maintained—all these affect not only
the cost of up-keep but also the rate of deterioration. Sometimes it
may be safe, as with loose tools, to charge all purchases to capital
for the first few years until the equipment is complete, and thereafter
all renewals to revenue, depreciating the asset account, say, 20%,
and maintaining it at that figure. Any marked increase or decrease
in numbers would require respectively an added capital charge or a
reduction of the original charge. Whether this method or the method
of the inventory be used for valuation purposes, there should be a
periodic appraisal by an expert horse dealer and adjustment of values
based on this appraisal.
Wagons, trucks, and motor vehicles should be numbered and all accounted
for periodically by physical inventory. It may be desirable in some
cases to maintain a register for these, wherein the performance of each
can be recorded and so compared. This is particularly desirable when
a change of delivery policy is under contemplation and comparative
records are needed of the performance of various types of vehicles.
This class of delivery equipment is best valued on the basis of cost
less adequate depreciation, with the periodic inventory as a check on
numbers and condition.
Carriers and Containers—Valuation
The most difficult of all the items of delivery equipment to handle
and value is that class represented by carriers and containers. These
may be barrels, kegs, casks, bottles, baskets, and boxes, and are
met in the brewery, dairy, bakery, laundry, and oil businesses. In
some lines it is feasible and is the practice to charge the customer
with the fair cost of the carrier, giving a return privilege with
refund, dependent upon the condition of the returned carrier. This is
good where applicable, although it necessitates having an adequate
redemption fund which may be operated somewhat as a bank’s reserve
is, i.e., only large enough for normal needs but capable of ready
enlargement when the need arises. In other lines of business such
a method of handling the container cannot be used. Here, as in the
bottled milk trade, only experience will give a proper basis for
estimating the depreciation through loss, theft, and breakage. The rate
is almost invariably high, and liberal depreciation should be provided
for. Taken all in all, throughout the various kinds of delivery
equipment rates ranging from 16⅔% to 25% constitute fair average rates.
Patterns, Molds, etc.—Valuation
The last kind of equipment items requiring consideration is comprised
of such items as patterns, lasts, molds, dies, drawings, electrotypes,
wood cuts, forms, models, and the like. Wherever possible, these
should be charged to the particular job for which they were made and
not carried as assets. Unless there is a probability that the pattern,
mold, etc., will serve for other uses than those for which it was
made, the costs of making should be borne by the job on which it was
used. This is very often not the case, however, and these items can
be used for successive production. This is particularly true of a
standardized product which is not apt to be much affected by change
in style or the whims of a purchasing public. At the best, however,
they constitute a treacherous and highly speculative asset and require
careful handling to avoid inflation of value. Thus, it is easy in the
publishing business to allow electrotypes, wood cuts, etc., to assume
unwieldy proportions to the other assets. In manufactories of wearing
apparel, the fickleness of fashions requires that patterns, lasts, and
models be written down ruthlessly to the lowest possible figure. Here
obsolescence is a big factor.
Under the limitations set, valuation should be based on cost with a
very liberal periodic depreciation. The rate will _average_ anywhere
from 20% to 50%, though a lower rate may sometimes be proper.
Disposal of Assets
In connection with the handling of the asset and its valuation
account, the disposal of all or some portion of the asset requires
consideration. It is a fundamental principle that whatever is taken
out of the asset account must be taken at the same cost as it was
introduced into the record. Thus, an asset recorded at cost of $5,000
and sold for $4,500 would be shown as taken out of its account at
$5,000, the apparent loss of $500 being recorded in a suitable expense
account. If the asset has suffered depreciation between the date of
purchase and sale, and the depreciation reserve shows this, that must
be taken into account. Practically, it is best handled by transferring
to the asset account from the depreciation reserve the part of the
reserve applicable to the portion of the asset disposed of. Upon
disposal there is an additional credit to the asset account of the
difference between cost and the depreciation to date, i.e., the amount
of this credit is the present appraised value of the asset sold,
taking into account not only the recorded depreciation but the accrued
as well. This brings out the true as distinguished from the apparent
profit and leaves in the reserve only that portion which is applicable
to the asset remaining.
An illustration will show the process of handling. Assume that the
$5,000 asset is a portion of a $50,000 machinery account, for which
the recorded depreciation reserve is $10,000 and the depreciation on
the portion sold accrued to the date of sale is $200. The entries,
necessary to effect the sale, are:
(1) Depreciation $200.00
Depreciation Reserve Machinery $200.00
Accrued depreciation to date
on the asset sold.
(2) Depreciation Reserve Machinery 1,200.00
Machinery 1,200.00
To write down to appraised
value the asset sold.
(3) Cash 4,500.00
Machinery 3,800.00
Profit on Sale of Machinery 700.00
To record sale of machine
and the profit on it.
CHAPTER XVII
BUILDINGS, LAND, AND WASTING ASSETS
Definition of Real Property
The movable fixed assets—paradoxical as the limiting adjectives may
seem—having now been considered, the present chapter will treat of the
immovable tangible fixed assets. By immovable is meant real property
as distinguished from personalty, and by tangible the intention is
to exclude from the present consideration such intangible items as
good-will, patents, copyrights, trade-marks, franchises, and the like.
In accounting for this group of assets there is no place for the
caption “real estate.” In its stead the two titles, “land” and
“buildings,” are used. This is to avoid confusion and to afford a
better basis for calculating depreciation. The term real estate or real
property has a very definite legal connotation, but in the popular mind
is held to include land and buildings. From the accountant’s point of
view there is no objection to the use of the term in the balance sheet,
but in the accounts themselves the two assets should be carefully
separated. For the private commercial enterprise, land as a fixed
asset is subject neither to depreciation nor to appreciation; whereas
buildings are constantly depreciating in value. While depreciation can
be calculated with fair accuracy on the combined basis, the single
basis of building values is the only scientific basis. The separation
of the two values is also essential for insurance purposes and the
proper adjustment of fire losses. They will therefore be separately
treated in this discussion.
Cost of Buildings
Buildings as fixed assets should be valued by the formula for the
fixed asset group, viz., full cost less depreciation. Some points in
connection with proper methods of accounting and special cases of
valuation require comment.
First, as to making the proper record of cost of the buildings. Three
cases must here be considered:
1. If the building is purchased outright for cash, whatever costs
are incurred in securing full title and expert opinion as to the
sufficiency of the title are proper charges against the building. If
the building is erected on contract, the full cost of the contract and
any necessary supplementary charges comprise the carrying value of the
structure.
2. If the building is bought by the issue of stocks or bonds, the
present value of those securities and all costs in connection with
their issue should constitute the cost of the building. Determination
of the present value of the securities is oftentimes a difficult
matter. When sales on the market take place concurrently, that
determines the price. When, as is usually the case, several existing
companies are bought up or merged to form a larger company, the old
stockholders are given shares in the new company for their equities in
the old. The book value of their old holdings may be the basis for the
issue of the new stock or the issue may be on the basis of a larger or
smaller value than this. This whole question of the value of the assets
taken over is equally a question of the value of the securities issued
therefor. This is considered in full in Chapters XX and XXI and will be
given only brief treatment here.
Manifestly all considerations relating to buildings purchased by
stocks and bonds have equal application to all other fixed assets so
purchased, and the treatment in later chapters will therefore be more
inclusive than could be any statement of the case applicable only to
buildings. It suffices to say here that usually the par value of the
securities issued constitutes the value placed on the assets bought.
The valuation as a rule is made by an appraisal committee from the
board of directors which inspects the various properties taken over and
places a value on them. In the absence of fraudulent intent, the courts
will usually sanction and uphold these values as having been made by
interested parties competent to act. This is the method generally used
for injecting water into properties.
3. When buildings are put up by the concern itself, full cost may
include not only cost of material and labor and a fair proportion
of the overhead where supervision of construction is local, but all
other expenses directly incurred in connection with construction.
These will include architects’ fees for plans and supervision, cost
of permits and licenses, interest on borrowed moneys and insurance
during construction, accidents and injuries to workmen during the
construction period, easements, damages, strike costs, and the like.
If the structure is being erected on a site occupied by an old
building, the cost of wrecking less any salvage value is a proper
charge against the new structure. If bonuses have to be paid tenants
in the old building to secure release of their quarters, these, too,
are similar charges to the new structure. Charges such as interest and
insurance during construction are capital charges only up to the point
of fitting the building for occupancy and so making it an operating
and income-producing unit. Thereafter these must be treated as revenue
charges.
Some interesting and at times complicated situations arise when,
as in the case of an office building, the structure is occupied in
sections as completed. Theoretically, only the portions of the charges
of this kind applicable to the completed sections now become revenue
charges, the rest still being capitalized so long as sections remain
uncompleted. Practically all that is desired is substantial accuracy.
The items may be comparatively insignificant but when in doubt the bias
should always be on the side of conservatism.
Valuation of Buildings
In the valuation of buildings a much more difficult problem
is encountered after the structure is completed and repairs
and alterations are made. It is the old problem of the proper
differentiation between capital and revenue charges, and is
particularly difficult of solution in some instances. Nothing more
can be said here than was stated in Chapter V where the fundamental
rules to be observed in distinguishing between repairs, renewals,
and betterments were laid down. Changes in interior arrangement to
accommodate new fixtures and equipment, or a different distribution
and arrangement of existing equipment with a view to better operating
conditions require particularly careful handling. Such expenses were
mentioned in connection with the treatment of machinery on page 290,
and the reader is referred to it. Whatever decision is reached on any
doubtful item of this or a similar kind, the supporting vouchers,
bills, and papers constituting the full evidence should be carefully
preserved and made available for review in case of any future
questioning of the charges.
Betterments on Leased Buildings
In the case of betterments made on leased buildings, provision must
be made to write off their entire cost by the time of the expiration
of the lease, as they almost invariably revert with the building to
the owner. Sometimes the betterment, if material and so agreed as
between lessee and owner, may be taken over at a depreciated value upon
expiration of the lease. Here depreciation of the betterment must be
provided for. Whether all or only part of the cost of the betterment is
to be charged off periodically, record of this is best accomplished as
an addition to the periodic rent charge.
Application of Depreciation
As stated above, the basis for valuation of buildings is at full
cost less depreciation. It is the method of appraisal, although the
inventory may provide a good check in the case of concerns owning many
structures. A subsidiary record of buildings showing separate costs
and location, or at least a map showing location, may then prove very
essential, particularly in the case of fire losses. In the application
of depreciation to buildings many things must be carefully considered.
Not only must the depreciation of use, i.e., wear and tear and lapse of
time, be considered but also obsolescence and inadequacy as factors in
shortening the service life of the structure.
Buildings used for some purposes deteriorate more rapidly than when put
to other uses. Vibrations, whether caused by own use or due to exterior
causes, increase the rapidity of deterioration. Susceptibility to
fire, explosion, and the like, due to the nature of their use, should
be taken into account. It is stated that power plants operating under
normal conditions provide for an entire replacement of plant every
five years. Power houses depreciate more rapidly than store houses. A
building put to various uses will be subject in its different parts to
varying rates of depreciation. Although a composite rate applicable to
the whole structure will give a satisfactory valuation, if accurate
departmental costs are required it would be desirable to apply the
different rates to the building values distributed over the various
departments. In practice this is seldom done.
According to different authorities, rates of depreciation ranging
from 1% to 5% constitute a fair average. The nature of the structure,
whether occupied by owner or tenant, its location, kind of
composition, etc., are additional factors for consideration. While
some authoritative rates are available, no standard rates, unless
compulsory, should be used without a careful study of local conditions.
Structures which are temporary should, of course, be charged for their
net cost, i.e., full cost less salvage value, against the product or
the job which makes use of them. Other cheap structures such as mine
buildings, shaft houses, temporary housings for lumber mills, and
the like, should be written down very rapidly. Having practically no
realizable salvage value and their life being brief, they should be
charged off the books at least during the period of their use.
Buildings owned as a freehold for life, or, stated otherwise, a
life interest in buildings, are not subject to depreciation, the
remainderman taking the building in its condition as released by the
party owning the life interest.
Accounting for Land
In accounting for land as a fixed asset used in the conduct of a
business, one or more accounts may be carried as seems best. If the
land is in several different plots, perhaps widely separated and each
plot held with other groups of assets and under varying conditions as
to taxes and other obligations, some plots being subject to mortgages
and others not so subject, separate accounts with each plot would be
desirable. Otherwise, usually the one account will suffice.
The record should be as complete and full as possible. Notation after
the title or elsewhere, giving the description and location of the
holdings, is an advantage as a means of exact reference. The various
items in the account should be supported by full explanatory matter
together with documents available for the analysis of the various
items and proof as to their legitimacy. It should thus be possible, at
any time, to determine the items comprising full cost. The purchase
contract price, the attorney’s fees, and broker’s commissions or a
fair portion of the purchasing agent’s salary, the costs of search
and guarantee of title (if these are borne by the purchaser), notarial
and recording fees, the assumption of taxes owing at date of purchase,
local improvement taxes and assessments, such as sewer, water, curbing,
paving, and the like—all these should be indicated with clearness and
definiteness.
Where accounts with a “large number” of plots are kept, it may be
advantageous to carry these accounts on a subsidiary record specially
ruled to give the detailed information desired and control them all
by one general ledger account. Local conditions and the information
desired will determine the manner of keeping the records. In all cases,
the account should carry a notation as to where the supporting legal
papers and documents covering each parcel or plot may be found. This
prevents much needless loss of time and worry when quick reference to
those papers is desired.
Valuation of Land
The basis for valuing land with unclouded title, as a fixed asset
for business purposes has already been clearly indicated. Full cost,
usually with neither depreciation nor appreciation, constitutes the
valuation formula. By full cost is meant complete cost in condition
ready for use or, at least, up to full-title date. In addition to the
items enumerated in the preceding section, there may sometimes properly
be included such expenses as leveling, grading, filling, and draining.
Even the costs of dikes, dams, and embankments, and in the case of
railway construction the cost of the care and up-keep of _growing_
trees planted to prevent land or snowslides, tunneling, and the like,
may be carried as a part of land costs, although some of these may
more accurately be recorded as improvements. In the case of mining
land, the cost of stripping the surface to reach the ore body, and the
cost of shaft-sinking and of tunneling are proper capital charges and
may be recorded under the land account, although preferably under a
development account.
Whatever costs are necessarily incurred to make the land serve its
intended use are proper capital charges and should be recorded in
the land account unless better purposes are served by record in some
supplementary account.
Depreciation or Appreciation of Land
The relation of depreciation and appreciation to land valuation is
not difficult in theory but is often very perplexing and gives rise
to complicated situations in practice. In theory, so long as the land
is used for its intended purpose, fluctuations in the market either
up or down should not affect the valuation at which it is carried on
the books. Just as with the equipment group of assets discussed in
Chapter XVI, any increase or decrease in the value of the land cannot
be realized so long as the land is employed in operation. Its cost
represents the capital tied up in it and the amount on which profits
must be earned. This is therefore the value at which it should be
carried on the books. Sometimes other considerations than those of
accounting influence business policy in connection with the market
value of land; but so long as it is used for the business purposes for
which it was purchased, full cost price should be its valuation. This
may sometimes place a prospective borrower at a disadvantage when using
his balance sheet as the basis for credit. A footnote or other notation
giving market value will usually suffice, although such value is often
difficult of determination without a disinterested appraisal.
Appreciation of Land Values
When land is held over long periods in a growing community,
appreciation in value almost always results; occasionally depreciation
ensues. The amount of appreciation is oftentimes not as much as it
seems because land with buildings on it may not be convertible to some
other use at the market price of similarly located vacant land; the
cost of scrapping the buildings often being as much or more than the
appreciation in land value. Also, appreciation may sometimes be of a
temporary character, in the nature rather of a market fluctuation. If
so, the distinction must be carefully observed. Perhaps in the majority
of cases requiring consideration, appreciation not only is very real
but also very considerable.
It may sometimes be desired to base an issue of bonds on real
estate—land and buildings—which is being carried at an old cost figure
as of many years ago but which has a greatly appreciated and available
market value at the present time. Prudent financial considerations
would require an independent appraisal to determine the amount of the
bond issue. Upon the assumption that the issue is for a larger amount
than the original cost of the security, a peculiar situation arises. In
showing the transaction on the books and balance sheet, not only would
no margin of security appear, but even an insufficiency of security so
long as the original value of the security is carried. Here it would
undoubtedly be wise to bring the appraised value of the security on the
books, offsetting the appreciation in value by a suitably named surplus
or reserve account, such as “Reserve for Land Value Increment” or
“Appreciated Land Value Surplus.” Another method and perhaps a better
one where possible of application is to reorganize the concern by a
sale of the old to a new company and so capitalize the increment in
value of the old company’s assets.
Another financial consideration in connection with appreciated real
estate values concerns the advisability of the sale of the old and
the erection of a new plant on less valuable land. Usually, the
appreciation of land values is not reflected in increased profits; it
may even result in lessened profits due to higher rates of taxation
and other expenses. If there are equally favorable locations for the
particular kind of business, it may be the part of business sagacity
to use the old location for rental purposes so that the benefit of the
appreciation may be secured, or to sell and move to a less expensive
site. In the one case the status of the land has been changed from that
of an operating fixed asset to an investment, perhaps best considered
permanent. In the other case, the increased value is through sale
realized in a lump sum and, as a surplus item, is available for any
purpose to which surplus may legitimately be applied. Of course, the
amount of such surplus is the difference between the sum realized by
sale and the cost of an equally efficient plant on the new site. It
will usually happen that a better plant is erected, thus consuming some
of the surplus arising from the sale.
Depreciation in Land Values
In a great many instances land depreciates. Decrease in value due
to use will be considered under the discussion of wasting assets,
page 311. When land suffers depreciation it is usually because of
obsolescence or inadequacy. Due to certain natural facilities giving
out, or to the removal, dismantling, or decay of artificial facilities,
a site may depreciate so much as to become untenable. Business and
residence property in a mining town may be of mushroom growth and have
practically no value when the market, which is dependent on mining
operations, declines. Ventures of this sort are recognized as highly
speculative from the beginning and should be handled as such in the
accounts. Wherever depreciation due to these causes can be foreseen,
suitable provision should be made; otherwise the burden will fall
entirely on the period when the plant has to be abandoned and this
stage is usually preceded by periods of lessened profits. Depreciation
of land is therefore always a local question.
Valuation of Land Investments
Business considerations oftentimes make advisable the purchase of
adjoining or otherwise located tracts of land, with an eye to the
future when enlarged facilities will be required. These should be
carefully differentiated and segregated in the accounts from the land
in use for business purposes. Some points in their valuation, in
addition to those treated under the discussion of investments in land
on page 278, need to be considered. Such tracts of land may usually
without prejudice be valued at cost.
If later developments should turn out as originally expected, there can
be no objection to loading the carrying costs of these lands, including
taxes and interest on any borrowed purchase money, on their value year
by year. The only reason for their purchase at the present time is
because it is expected that the transaction can be more advantageously
made now than later. If such should not be the case, the cost of the
land proves to be higher than if purchased later. Only by loading
these carrying charges can this information be developed. If the land
is finally put to its intended use, no serious objection is seen in
carrying it at the figure of full cost to the date of use. Because of
the speculative nature of the transaction, it is usually advisable
to set up a reserve of the same amount as the accumulating carrying
charges. This reserve becomes free when the land is put to its intended
use.
Because of the ease of inflation of values in transactions of this
kind, due largely to an overoptimism as to the future and even
sometimes to fraud, all such transactions must be scrutinized very
carefully and ample provision against an unfavorable outcome should be
insisted upon. It is interesting to note in this connection that in the
case of valuations for rate-making purposes, as a usual thing carrying
costs on land of this kind are not allowed as expenses to be covered
by the rate of the service rendered. But when these lands come into
use such expenses become a part of the cost of the service.
Mortgages on Land
Mortgages on land require consideration as affecting the manner
of showing the land value. Freehold land, i.e., land held in fee
simple, if afterwards mortgaged should be shown on the balance sheet
at full face value with the mortgage listed among the liabilities.
The liability is usually a note or other bond which in case of the
deficiency of the security would be a general claim against the free
assets of the concern. It is therefore best, theoretically, not to
show such a mortgage as an offset to its security. In the case of the
purchase of land subject to mortgage without the assumption of the
mortgage as a direct liability, theoretically the mortgage may be shown
as a deduction from the full land value and only the equity value of
land be extended as a significant asset. This differentiation is almost
entirely an academic one and is seldom seen in practice. The land is
usually listed among the assets and the mortgage as a liability.
Donated Land
The valuation of donated lands presents some interesting points. A
town may offer a free site to secure the erection of a plant within
its midst rather than allow it to go elsewhere. Sometimes the donation
may be outright and absolute; at other times it may be conditional,
depending upon the doing of certain things by the donee, such as the
employment of a minimum force of men for a certain number of years, or
the circulation of a certain amount of advertising, or the purchase
of given amounts of raw material supplied locally. In the case of an
outright gift, the cost to the company is usually nil, but for the
proper statement of the concern’s financial condition the land must
be shown as an asset. If the acceptance of the gift necessitates the
scrapping of the old plant and removal expense to the new site, such
costs would provide a minimum carrying value for the land. Where this
is not the case, the land might be given a nominal value, with suitable
explanation.
Usually, however, neither of these methods is so satisfactory as that
of bringing the land onto the books at a fair appraised value and
showing the contra side of the transaction as surplus, or donated
surplus, or donated land surplus. Any gift received increases the
proprietorship of a concern and should be so shown, and there
need be no suspicion of inflated value in such a surplus item, if
conservatively set up, and with the supporting records available. Any
expense in connection with the acceptance of the gift is a proper
charge against the donated surplus. Aside from this, it is free surplus
available for customary uses so far as this transaction is concerned.
In the case of a conditional gift subject to reversion until the
satisfactory fulfillment of the condition, no title nor asset value,
other than a contingent one, inheres in the land. It is not therefore
proper to show any. If a condition, extending over a period of, say,
five years must be met, at the end of the first year one-fifth of
the time has elapsed and the condition is nearer to fulfillment—the
contingency has become more nearly a fact. But until its full
satisfaction and the danger of a lapse has passed, there is no value in
the gift. To show the progress and status of condition, the pro rata
portion of the gift may be shown periodically by a charge to Donated
Land or Equity in Land, offset by an equal credit to some suitable
reserve such as Donated Land Reserve or Unrealized Profit on Land. On
the balance sheet the reserve would be treated as a valuation item, no
value being extended among the assets. This would seem to satisfy all
demands for information and show the exact status of the transaction.
Land as Stock-in-Trade
A final consideration, not logically belonging here but treated as a
matter of convenience, is that of land as stock-in-trade. In the case
of a land company developing a tract of land for certain purposes, the
individual plots, or the whole piece if division is not contemplated,
constitute its stock-in-trade and it should be valued as such, i.e.,
as a current asset and not a fixed. All costs necessary to put it
in condition ready for the market are capital charges and should be
loaded onto the cost of the lands. These include all of the usual costs
mentioned in connection with land as a fixed asset, and in addition all
improvement costs such as parking, the laying out of streets, roading,
etc. The loss in the use of land for these purposes should be prorated
over the plots, or otherwise equitably distributed. Plots of land so
developed are not usually sold all at one time. Any unsold plots should
be inventoried at cost. Sometimes the first plots may be sold at a
loss to make the rest of the proposition move. The practice is met of
loading the loss in the early sales onto the unsold plots, and it is
quite common to add any carrying charges to the cost of the unsold
plots.
Both of these practices are to be deprecated and opposed. They are not
right in theory and serve no necessary purpose. All costs after the
stage of sale is reached are operating costs—charges against revenue
which should not be capitalized. It may be desirable to know at what
price the unsold plots must be disposed of to cover all expenses and
losses and to make a profit, but that does not justify an inflation of
the carrying values of the asset. If it is desired that the books shall
show this, an amount equal to these costs and losses may be added to
the carrying values if offset by a valuation reserve of equal amount,
the costs and losses themselves being handled as operating expenses of
the current period—or spread over several periods if applicable.
Wasting Assets—Definition and Characteristics
Wasting assets, as they are usually called, are better described as
assets subject to depletion. They differ from depreciating assets
in that, whereas the latter wear out through use or the effect of
age, wasting assets simply “give out.” They are subject to depletion
because they comprise stores of raw materials and natural resources the
supply of which, through being mined and disposed of, is definitely
and finally diminished. The stores will in every case finally come to
an end through yielding up their product. Examples of enterprises of
this kind are minerals and deposits of all sorts, such as coal, gold,
silver, lead, clays, slate, gravel, stone quarries, oil, asphalt,
nitrate, timber, and “all growing plants yielding recurring crops, such
as tea and rubber.”
Dividends May Include Return of Capital
The law recognizes the distinction by requiring in the case of
depreciating assets that the decrease in value must be made good
before the payment of dividends—i.e., dividends cannot be paid out
of capital—while in the case of assets subject to depletion it is
recognized that some portion of the dividends paid may represent a
return of the capital originally invested in the undertaking.
If the latter is the policy pursued, there will be no liquidating
dividends at the time of the break-up of the undertaking, inasmuch as
the regular dividends have already included a return of all or some
portion of the capital. If, however, it is a matter of business policy
to continue the enterprise elsewhere when the present natural stores
are exhausted, then the dividends should represent only profits. During
the process of operation, assets in other forms which represent the
capital investment of the undertaking are retained in the business.
This is accomplished on the books by a charge to each period’s
operations of such an amount as represents the depletion of the stores
of product prepared for the market during that period and by a credit
to a depletion reserve account or direct to the property or stores
account.
Basis of Depletion Charge
The amount of the period’s depletion charge is reckoned by comparing
the amount of product worked during the period with the total estimated
amount owned. Whatever value was taken for the original purchase, that
value becomes the basis for the annual or periodic depletion charge.
There is, of course, a large element of speculation in some estimates
of this kind. In the case of timber, the original amount purchased is
easily determinable with fair accuracy by _cruising_; the amount cut
each period is a matter of record. The ratio of the amount cut to the
original amount is the portion of the original value or cost of the
timber tract to be written off periodically. In the case of a mine or
pit, the estimate cannot be made with an equal degree of accuracy.
Competent engineers do make calculations of the amounts of available
ores with sufficient certainty to warrant the expenditures of vast
sums in the purchase of properties. If their estimate avails for this
purpose, it can with equal certainty be made the basis for the periodic
depletion charge. Nice questions arise in this connection when the
property is being operated under a lease or on a royalty basis.
Application of Income Tax to Wasting Assets
Under the 1916 income tax law specific provision was made for allowing
depletion and the manner of handling it is prescribed. First, for such
a charge to be allowed as a deduction, it must be recorded on the
books. Secondly, as soon as the depletion reserve equals the capital
investment no further deduction can be made—all else is pure income.
If, however, it is desirable to carry on the books as an asset the
estimated amount of product still remaining in addition to that written
off, it may be done, the offsetting credit being to income, which must
be shown as income on the tax return for the year in which it was
brought onto the books. This new value may be depleted until wiped off
the books.
The law as now operated bases value of the asset subject to depletion
on the value existing as on March 1, 1913, or at cost or purchase price
if acquired subsequent to that date. Because the book values on March
1, 1913 seldom agreed with the estimated values, it was necessary to
adjust these by charging the asset, plant, or mining property and
crediting an account called “Property Surplus” with the amount of the
adjustment where the estimate showed more than the book value. When
dividends are paid, if it is the policy to return capital as well as
profits, the charge should be made partly against operating surplus for
the profits share, and partly against property surplus for the capital
share.
Depreciation on Buildings and Machinery of a Wasting Asset
In addition to the depletion charge, proper allowance should be
made for depreciation of the other fixed assets, such as buildings,
machinery, and the like. The limit of their service life is evidently
the working life of the venture, which must be estimated. If there
is still operating value in the equipment at that date, this is
covered by the higher salvage value taken into account when fixing the
depreciation charge.
Unusual Risks
In connection with both the estimate for depreciation and for
depletion, the elements of unusual risks, due to fires, floods, and the
like, should be taken into account. Their effect might be to cut down
the supply of available product and so increase the periodic depletion
charge. Another factor, of great importance at times, is the available
supply of any auxiliary product needed for the treatment of the main
product. Thus, large ore bodies may remain unmined and unprofitable
because of the failure of a ready supply of auxiliary material needed
in the reduction, smelting, or refining of the ore. This applies
particularly to iron ores.
Water Rights
Sometimes valuable water rights are acquired along with mining
property, and it may be profitable to utilize them for the manufacture
and sale of power long after the depletion of the mine. In that case
their capital value should be separated from that of the mining
venture, and retained as an investment; or a new company may be formed
to carry on the power project after ceasing mining operations.
Leaseholds
On the boundary line between a depreciating asset and one subject to
depletion stands a leasehold, i.e., the right of occupancy of premises
for a stated term. Thus, a building may be rented for a term of years;
or a piece of land may be leased for a long enough period to justify
the erection of a building thereon, the building going to the owner of
the land as a gift or at an appraised value, or the land may revert in
its original condition to the owner upon expiration of the period of
the lease, according to the contract. The payment for the lease may be
an annual sum similar to a rental charge, or a bonus and an annual sum.
In the latter case, the bonus should be treated as a deferred charge
and spread as additional rent over the period of the lease.
Leases may run for any period up to 99 years, 63 and 84 years being
favorite terms in New York. An original lessee may sell his lease
outright for a set sum sufficient to cover the remaining period of the
lease, or on an annual rental basis. The set sum is calculated as the
present worth of an annuity of the amount of a fair annual rental.
Where property values have greatly appreciated, a leasehold on
favorable terms may have a high market value which may not appear on
the books or balance sheet. If the terms of the lease call only for a
_periodic_ payment like rent, the value of the lease will not usually
appear on the books. If the lease is purchased outright for a lump sum
or a bonus is paid, some value for it will appear on the books. Where
the balance sheet is to be used as the basis for credit, the present
appraised value of the leasehold should appear, either in a footnote
or preferably incorporated into the balance sheet with an offsetting
reserve.
If the leasehold is carried at any value on the books, this must, of
course, be depreciated or amortized by the end of the leased period. As
stated above, the periodic charge for this is to the rent account and
the credit to the leasehold account, writing it down directly instead
of by means of a reserve. The straight line method of amortization
is the easiest of application, but authorities seem to favor, on
theoretical grounds, the annuity method which brings in the element of
interest. If the agreement provides for the reversion of the building
to the owner of the leased land, then also the full cost of the
building must be depreciated over the life of the lease. Any excess of
this depreciation over normal depreciation is in the nature of a rental
charge but not usually of sufficient importance to require segregation.
If the premises must be returned in original condition to the owner,
the net costs of demolishing any structures erected thereon must be
treated as expenses of the lease and provided for accordingly.
CHAPTER XVIII
INTANGIBLE ASSETS—PATENTS, FRANCHISES, GOOD-WILL
General Considerations
The final place among the assets of the balance sheet is given to the
intangible items. Because this class of assets has so frequently been
used for doubtful or illegitimate purposes, whatever the value given
to them they should be shown boldly in a group by themselves and not
merged with the values of tangible assets. Their real value, if any,
should be open to verification. To list them with tangible items on the
balance sheet is apt to raise a suspicion as to their validity much
more than if they are shown in a group by themselves.
Because the assets of this group are intangible is no reason in
itself for the hasty judgment frequently made that therefore they are
worthless. It is true, as above stated, that the doubtful uses to which
they may be put have caused them to be viewed with suspicion. Yet they
have an entirely legitimate use and oftentimes constitute the most
valuable portion of the assets. Therefore, the values at which these
intangible assets are carried on the books should always be open to
investigation and capable of verification.
It is purposed here to lay down the principles of the legitimate use
of intangible assets, and to point out some of the wrong uses to which
they easily lend themselves. The group comprises patents, copyrights,
trade-marks, formulas, receipts, franchises, organization expense,
going concern value, and good-will.
Patents a Monopoly Grant
A patent is “a grant made by the government to an inventor conveying
and securing to him the exclusive right to make and sell his invention
for a term of years.” The purpose of the government in making such
grants is to encourage and stimulate individual ingenuity along lines
that will ultimately redound to public welfare. Letters of patent
are in the nature of a monopoly grant but, although extreme care is
taken in their issuance to see that they cover really new devices, no
governmental guarantee implies that the patentee shall have free and
uncontested use of his invention. If encroachment is made upon his
rights under the patent, the courts are open to him for protection
and similar privileges are extended to all alike. Oftentimes, until
infringement proceedings have established a clear and uncontested right
and property in an invention, little commercial value attaches to it.
Patents therefore tend to create a monopoly in the marketable product
protected by them and accordingly have value so long as the right to
monopoly continues.
Purchase of Patents
The valuation of patents owned and made use of by a business should
always be on the basis of cost. If owned by purchase from the inventor,
the consideration paid for the patent constitutes cost. When the
consideration is cash, there is no question as to the valuation at
cost. When payment is made in the capital stock of the purchasing
concern the problem is the same here as in the proper valuation of
other fixed assets purchased in the same way, referred to in Chapter
XVII. The federal income tax law takes cognizance of this different
basis for valuation and attempts to establish a true cash basis by
allowing depreciation on patents, when purchased by means of stock,
only on the basis of the cash value of the stock. Prevailing practice
sponsors the bringing of patents onto the books at cost, as shown
either by the cash paid for them or by the _par_ value of the stock
issued for them. Except where deceit and fraud are the points at
issue, no serious objection can be raised to the practice, for any
overvaluation thus occasioned is absorbed in the product by means
of the depreciation charge spread over the life of the patent. Any
additional costs necessary to secure the full enjoyment of the rights
granted under the patent are considered proper charges against the
patent, as giving it additional value.
Patents Developed within the Plant
When the patent is not purchased from outside but is developed within
the plant itself, only the costs of development and of securing the
patent are proper charges to the asset as constituting its value.
In some concerns an experimental laboratory is maintained for the
purpose of working out improved methods and devices. Much of the work
of such a laboratory is often fruitless so far as patentable devices
are concerned, but if the entire effort is directed towards the
development of patents, then the entire cost becomes a proper charge
to whatever patents result from the effort. More often some portion of
the laboratory organization is also used for other purposes. However
developed, whether in the formal laboratory or in any other way, the
full cost of development and of securing letters patent is the figure
for the original valuation of the patent. This cost includes the labor
and material used in the process, drawings, models—including discarded
models—attorney’s fees, government fees, etc.
As in the case of purchase, all the costs, whenever incurred, of
defending the right to the patent or of prosecuting for infringements
constitute additional elements of value, as only by such means can the
real holder be made secure in the exclusive enjoyment of his right.
It is hardly necessary to point out that if such proceedings and
prosecution establish the right of the other party to a device which
practically destroys or greatly diminishes the worth of the contested
patents, not only must such costs usually be charged against revenue
but also the whole or major portion of the value at which the patent
is being carried. However, where the development of patents is one
branch of a concern’s organization, costs of this nature may usually be
absorbed by those patents which are successful. Because inflation of
values is easy at this point, a careful investigation to establish the
legitimacy of all such charges is always desirable. Each case must be
judged on its merits.
Patents Purchased and not Used
Patented devices are sometimes purchased with no intent to use them.
This may be for the purpose of eliminating competition, of forestalling
obsolescence or supersession, and so of postponing the necessity of
making expensive alterations that would be required to meet threatened
competition, even to the point of scrapping a valuable organization.
The ethics of such practice is not under review here. Correct
accounting practice justifies the addition of the purchase price of
such devices to the value of the asset, patents, and its periodic
depreciation in regular course.
Elements of Depreciation on Patents
Patents are subject to depreciation. At the time of their purchase or
acquisition, they should be valued at full cost, as stated above. At
any subsequent time, value should be calculated on the basis of full
cost less depreciation. The elements of depreciation as applied to
patents are (1) time lapse, (2) supersession, and (3) obsolescence.
1. _Time Lapse._ There is no such thing as wear and tear on a patent
itself, but since the grant by the government is for a definitely
prescribed term of years, as each of those years goes by there passes
with it some portion of the value attaching to the exclusive enjoyment
of the right for the prescribed period. In this country a mechanical
patent is granted for a term of seventeen years, after which the
patented device or process becomes common or public property. The
period allowed for patents covering designs is three and one-half,
seven, or fourteen years, depending on the application. Thus, simply
through the lapse of time the value of the right diminishes.
2. _Supersession._ If no other causes than time lapse were operative,
the problem of depreciation would be a simple one, consisting of
spreading the value of the patent over its life. In addition to lapse
of time and operating simultaneously with it is the possibility of
supersession. Supersession as an element of depreciation is the attempt
to measure the probability of the patent’s being superseded before
the expiration of its term by a better machine, device, or method.
The measure of this element of depreciation is always speculative but
should be attempted with the best judgment possible.
3. _Obsolescence._ Akin to the element of supersession is that of
obsolescence. Obsolescence is particularly operative in cases where
the patent covers a product the life of which depends on the whims of
fashion. Obviously, when the market for the product ceases, the value
of the patent is gone.
From the above it is seen that the three elements of depreciation are
usually operative concurrently and the rate of depreciation must take
cognizance of them all.
Service Life of Patents
While the vast majority of patents become valueless before their
expiration, some few may have a value beyond their protected term. It
may happen that the concern using the patent has built up such an
organization that competitors cannot with profit enter the field after
the patent has expired; or it may have acquired the good-will of the
purchasing public to such a degree that buyers come to it rather than
to a competitor. In these and other ways the value of the patent may
extend beyond its life. This is exceptional, however, and cannot with
conservatism form the basis for estimating the service life of the
average patent.
The prevailing practice authorizes writing off the value of a patent
quite rapidly during the early years of its life when its earning
capacity should be at a maximum, leaving only a small part of the
value to be spread over its later years. This policy applies to the
possession of single or separate patents. An effective method used for
extending the life of a patent is the securing of auxiliary patents
every few years. Thus an improvement of some part may be patented,
without which the use of the original or basic patent would not be
worth while. The basic patent may thus have its effective life—though
not its legal life—extended almost indefinitely.
Where an additional cost, such as infringement costs, is incurred
some time after the grant is made, strict accuracy would demand that
these costs be spread over the remaining life of the patent. Where,
however, the above policy of securing periodic improvements is in
force, sufficiently accurate results are secured by wanting off at the
end of each year—in the case of mechanical patents—one-seventeenth
of the total values to date. In this way, by the end of the original
17-year term, there will be values left in the account which may be
looked upon as applicable to the patented improvements. There is in
these cases a constant overlapping of the grant periods and no serious
inequity results as between fiscal periods by writing off each year
one-seventeenth of the total value in the Patents account. In the case
of the one original patent or an _occasional_ improvement, the more
accurate method is desirable because here the life of the patent is
rather definitely limited.
If the estimated life on which the depreciation estimate is based,
should prove longer than the real life, the value remaining in the
asset at the end of its real life must be absorbed by the profits;
i.e., charged against surplus. The Federal Income Tax Law allows this
remaining value to be charged against the profits of the period in
which it is written off.
Booking Depreciation on Patents
In booking the depreciation of patents, the periodic charge is to the
expense account, Depreciation—or Depletion—and the credit is made
either direct to the asset account or to the corresponding Depreciation
Reserve account. It is sometimes argued that since the life of the
patent is for a definite term, its depreciation is equally definite and
the value of the asset should be written down rather than carry the
estimated amount of the periodic depreciation in a reserve account.
Because of the elements of supersession and obsolescence on which in
the majority of cases the service life of the patent depends more than
on its time grant, it is evident that determination of the amount of
periodic depreciation is just as much a speculative estimate as is
the case with any other asset. Either method of showing the periodic
value of the patent may be used with equal propriety. If an easy
determination of “total value to date” is sought, as under the policy
referred to above, the information is better secured by carrying the
offsetting estimate of depreciation in a reserve account. When no such
purpose is to be served, it is a needless multiplication of accounts to
use the reserve account.
Accounting Classification of Depreciation on Patents
A problem closely related to the valuation of patents has to do with
the classification or incidence of the periodic depreciation of the
patent. According to some theorists it is stated that if the patent
applies to the _process of manufacture_—i.e., to any part of the
manufacturing equipment used—the periodic depreciation is a cost of
manufacturing and should be allocated to the product at that point. But
if the patent covers the _article itself_, its periodic depreciation
expense should be treated as a selling expense. Perhaps the point is
well taken but the distinction is rather finely drawn. Another view
requires the showing of depreciation on patents among the general
administrative items, on the several grounds that there is no logical
basis or method for distributing it directly to the product; that
there is no direct connection between the product and this expense;
and that it is a general overhead item which must be cared for out of
gross earnings but cannot be applied definitely to manufacturing or
selling. Failure to establish a suitable basis on which to apply the
cost in practice cannot, of course, be allowed to militate against the
determination of its theoretical incidence.
Royalties
An analogous problem arises in the treatment of royalties where such
cover the cost of renting the patented devices of others for the
purpose of manufacture. Although the general practice is to treat
this expense as a cost of manufacture, it is sometimes handled as a
general management expense on the ground that it represents a policy
of management which has adopted the royalty method of production in
preference to the outright purchase or development of the patents.
The point seems not well taken, however. The value of a patent may
be looked upon as a prepaid expense item which is the equivalent
of royalties expense and should therefore usually be treated as a
manufacturing cost. There may be instances, however, where such
treatment would not be advisable on practical and perhaps theoretical
grounds.
Relation of Depreciation Rate to Cost of Manufacture
Related to this problem of patent costs is the effect on manufacturing
costs of the rate of depreciation of the patent. It is evident that
a too rapid depreciation will result in an inequitable loading of
the product made during the early years of the life of the patent as
compared with that of its later life. A product made under a patent
still valuable after all value has been written off the books, bears
none of the burden though enjoying the benefit accruing from its being
a patented article. On the other hand, if the rate of depreciation
is not rapid enough, the product is then underburdened. It should
constantly be borne in mind that depreciation is always an estimate. It
should be the best estimate possible and subject to periodic revision
where accurate results are desired. Slight inaccuracies and inequities
are bound to occur and must be absorbed by the future product; the
record of the past is a closed book and cannot usually be reopened.
Sale Price of Patents
The sale price of a patent, as distinguished from the value at which
the owner may carry it in his accounts, frequently is based on the
estimated savings in royalties which could be made by a purchaser.
When a new concern is organized and patents are owned by some of the
incorporators, and purchased from them, the value at which they are
carried is almost always speculative and arbitrary. A valuation based
on the saving in royalties has no place on the books of a concern
unless that price were paid in purchase. Similarly, licenses to use
patents should not be carried as an asset unless purchased by a lump
sum payment even though they grant a virtual monopoly in the product.
Copyrights
Copyrights are similar to patents in that they secure to the author
or publisher the exclusive right for a term of years to make and sell
copies of literary or artistic productions. They are thus in nature a
monopoly grant. The term for a copyright is 28 years, with a renewal
privilege of 28 years if application is made within one year prior to
expiration of original copyright.
A more rigid application of the principles of valuation enunciated
for patents must be made for copyrights. On the books of the original
grantee they should be carried at full cost which may be only the
fees required in securing the copyright. For a subsequent purchaser
they should be set up at full cost to him. A much smaller proportion
of copyrights than of patents continue valuable for their granted
term. Periodic valuations, then, require a very liberal and rapid
depreciation from original value. In the accounts of publishers who
make outright purchases of copyrights, extreme care is needed in
keeping track of and valuing this asset, else a too optimistic outlook
will result in carrying false and misleading values. Oftentimes the
only satisfactory and reliable method of valuation will require an
examination of each copyright owned and an independent appraisal of its
worth.
Trade Secrets
Akin to copyrights are formulas for manufacture, receipts, and other
trade secrets. These may constitute very valuable holdings, perhaps the
most valuable of all the assets, but they are not usually carried on
the books as assets under this title. A baker with a secret economical
process of making yeast may have a marked advantage over competitors.
An oil refiner with a process which secures a larger return of
gasoline has a similar advantage over competitors without such means
of refining. If costs are incurred in developing or acquiring these
formulas or processes, the same reason exists for treating them as
assets as in the case of patents or copyrights. If not protected in
any way by the government, greater need of rapid depreciation is
apparent as the discovery of the secret by others might greatly reduce
its value.
Trade-Marks
A trade-mark is an earmark of ownership for advertising and selling
purposes. Thus a firm may adopt a label for their products or a manner
of marking or displaying them which wherever used is evidence of the
make, brand, and quality of the goods. A concern enjoying a trade built
up by educating the public to recognize its trade-marks and what they
represent may possess therein a very valuable property. The courts of
the country guarantee the rightful owner in the exclusive enjoyment
of any benefits arising from the use of his trade-mark. Priority of
continuous use is the factor determining rightful ownership. Such
priority is most easily established through registration of the
trade-mark with the government. Registration is not necessary but
is offered by the government as a convenient and certain means of
establishing rightful ownership. Continuous use is necessary to retain
unquestioned ownership of the right.
Trade-marks must be valued at cost. Cost to develop, cost of purchase,
cost to defend—all are legitimate charges to the asset. At times even
some portion of the advertising expense may be capitalized under the
caption “Trade-Marks.” This question and that of periodic revaluation
follow so closely the principles of revaluation of good-will and the
treatment of depreciation in relation thereto, that its consideration
is deferred for combined treatment in later pages of this chapter.
Franchises—Definition and Kinds
A franchise is an intangible asset of considerable value in most
cases. Its appearance on a balance sheet is usually limited to those
of public, or quasi-public, utility companies. There it is included
as an asset of value from the standpoint of rate-making rather than
for ordinary commercial purposes. Such companies are usually under the
close supervision and regulation of public service commissions. The
latter prescribe the manner of showing the utility company’s accounts
and the basis for the valuation of its assets, chiefly from the point
of view of an adequate protection of the interests of the public. It is
neither the purpose nor within the scope of the present volume to raise
the question of the valuation of public utility companies, part of
which problem would be concerned with the valuation of franchises. An
attempt will be made, however, to lay down some principles of valuation
from the commercial standpoint as distinguished from the rate-making
standpoint, applicable to a very limited number of concerns which are
not subject to state regulation, and to indicate briefly the tendency
of the rulings of the best public service commissions with regard to
franchises.
A franchise is defined by H. A. Foster[45] as “a privilege given by
the community to a private person—or corporation—for use of the public
property for the benefit of the public, and only incidentally is it
the intention of the community in granting such a right, to allow the
person accepting the same enough profit to insure his willingness to
take advantage of it by investing in plant to make use of the grant.”
To the same effect is the statement of the Federal Court in the case
of the Consolidated Gas Co. of New York, 157 Fed. 373: “The franchise
is but a part of the power or privilege of sovereignty allotted to a
private person for the benefit of all, and only incidentally given for
private emoluments.”
[45] In “Engineering Valuation of Public Utilities and Factories.”
Franchises may be perpetual, where the grant is without time limit;
limited, where the term is definitely stated; and indeterminate
where the privilege granted is good “during good behavior and may be
terminated by the authorities at any time by paying the fair value
of the property exclusive of the franchise.” It may be noted that in
Massachusetts no provision is made for buying the property of the
utility company in case of revocation of the franchise. Manifestly the
contract entered into with the state will influence very largely the
manner of handling and the valuation of all the assets. Without regard
to such contract and on the general principles of valuation as laid
down for fixed assets, a franchise should be taken onto the books at
full cost to acquire. Proper charges to the account would cover:
1. Lump sum payments to the state or some division
thereof, applicable to the life of the franchise
as distinguished from regular annual payments
which are in the nature of a license or rental
charge and are therefore an operating expense.
2. The full purchase price paid another company for
the assignment of its rights and privileges under
a franchise owned by it.
3. Legal and other fees in connection with securing
the grant.
4. Any other legitimate expenses, such as the cost of
securing the consent of affected property owners
or of the whole community where such cost is to
be borne by the petitioning company.
All of these are costs which from the standpoint of good business
practice may be capitalized under the caption “Franchises.”
Depreciation on Franchises
For periodic revaluations, depreciation should be in accordance with
the terms of the grant. If the grant is perpetual, no depreciation
need be taken account of; if it is for a limited term, the cost of
the franchise should be prorated over that term; if the grant is
indeterminate, as defined above, not only should a very liberal
depreciation policy be pursued with regard to the franchise but, in
the case of the type of franchise granted by Massachusetts, a liberal
provision for writing off all the assets should be made, unless in the
execution of the law a policy of non-revocability of franchises has
become fairly well fixed.
In contrast with the above, note the ruling of the Public Service
Commission for the First District of the State of New York. “To this
account—Franchises (Gas)—shall be charged ‘the amount (exclusive of
any tax or annual charge) actually paid to the state or to a political
subdivision thereof as the consideration for the grant of such
franchise or right’ (Section 69 of the Public Service Commissions Law)
as is necessary to the conduct of the corporation’s gas operations. If
any such franchise is acquired by means of assignment, the charge to
this account in respect thereof must not exceed the amount actually
paid therefor by the corporation to its assignor, nor shall it exceed
the amount specified in the statute above quoted. Any excess of the
amount actually paid by the corporation over the amount specified in
the statute shall be charged to the account ‘Other Intangible Gas
Capital.’ If any such franchise has a life of _not more than one
year after the date when it is placed in service_, it shall not be
charged to this account but to the appropriate accounts in ‘Operating
Expenses,’ and in ‘Prepayments’ if extending beyond the fiscal year.”
To a depreciation account called “General Amortization” is to be
charged, besides depreciation of tangible fixed capital, “such portion
of the life of intangible fixed capital as has expired or been consumed
during the month.”
Such careful regulations as to the content of intangible asset
accounts are not always nor everywhere imposed at the present time.
It is not putting the case too strongly to say that the reader of a
balance sheet containing items about which practice is not standardized
should always be on his guard to assure himself as to the content of
such items in order to establish the legitimacy of their use and value.
Organization Expenses
Organization expenses are those costs necessarily incurred for the
purpose of getting an enterprise under way, i.e., of putting it in
readiness to do business and produce income. These expenses usually
comprise such costs as state incorporation fees, attorney’s fees for
drawing up the application and other papers, the cost of prospectuses,
soliciting costs for stock subscriptions, fees paid promoters and
organizers, cost of printing and issuing certificates of stock, cost
of capital stock records, and similar items. These are necessary and
unavoidable expenses without which the company cannot come into being.
A company organized and ready to commence business is in a better
position than one whose elements have not been brought into harmonious
working. In the same way that the costs of installing machinery in
position and ready for use are capitalized by being added to the value
of the equipment, so may the organization expenses of a corporation
be legitimately capitalized as being the measure of the amount of the
greater value which these organized business elements have over the
same elements unorganized. Capital has been brought together and set to
work, management and plan of operation have been secured, and business
is ready to begin.
Organization expenses are therefore, from the standpoint of
classification, best treated as an intangible asset rather than as
a deferred or prepaid expense. In strict theory the value of these
costs will last as long as the corporate existence. In Italy where
corporate life is limited to fifty years, it is prescribed that
organization costs be prorated over the full life of the corporation.
The best practice in this country requires a much more rapid writing
off of these items; R. H. Montgomery[46] advocating writing them off
as they occur or at most over the first two years’ operation. To one
not cognizant of the many abuses which have crept in—and even frauds
perpetrated—through this channel, the treatment advocated may seem
harsh and severe. Perhaps no harm is done in pursuing a more liberal
policy, if such expenses are carried under a proper title, if they
are not used to inflate the value of the tangible assets, and if the
caution stated above is observed as to the need for investigating the
values of all intangible asset items. Certainly organization expense
should never be used as a cloak for discount on stocks or other
securities marketed.
Good-Will—Definition and Nature
The last of the intangible assets to be treated is good-will. Lord
Justice Lindley, in an English case, says: “Good-will regarded as
property has no meaning except in connection with some trade, business,
or calling. In that connection I understand the word to include
whatever adds value to a business by reason of situation, name and
reputation, connection, introduction to old customers, and agreed
absence from competition, or any of these things, and there may be
others which do not occur to me.” The definition by George Lisle[47]
is to the same general effect: “Good-will is the monetary value placed
upon the connection and reputation of a mercantile or manufacturing
concern, and discounts the value of the turnover of a business in
consequence of the probabilities of the old customers continuing.”
Good-will therefore includes every advantage connected with location,
premises, reputation, personality, name, etc. That all these are
elements of good-will cannot be gainsaid, but unless an earning power
larger than that of a newly established competing concern goes along
with these elements, no one would be willing to pay anything for the
good-will of the old concern.
[46] In “Auditing, Theory and Practice.”
[47] In “Accounting in Theory and Practice.”
It sometimes happens in the case of a merger, that because of the
dormant or latent good-will of the various units—or some of them—to be
merged, a promoter may be willing to pay something more than the value
of the tangible assets in order to acquire the various properties.
Dormant or latent good-will signifies the excess earning power that
would exist if it were not for poor management, an inharmonious working
together of the various parts of the organization, and other similar
handicaps which the new management will remove. It may be objected that
until such handicaps have been removed there is no good-will; that any
good-will brought into evidence through the removal of these handicaps
is the good-will built up by the new concern and not the old. It cannot
be denied, however, that all the other elements of good-will may have
been acquired and built up by the old company and that without them the
new concern would be unable to bring good-will into evidence simply
by a change of management. It is true that the merger may be able to
build up quickly a good-will of its own through the elimination of
competition, and through the full utilization of all the advantages
of the different units—such as access to supplies of raw material,
favorable trade agreements of various sorts, and the like.
While there is a sense in which expected future performance as
indicated above, may be an element in the determination of good-will
and may be legitimately paid for as such, as a usual thing the
essence of good-will lies in the ability to make a profit in excess
of the normal. Past performance must be reviewed by which to judge
the normality of the present profits and the probability of their
continuance in the future.
Local and Personal Character of Good-Will
It should be pointed out, as a corollary to the above statement that
only those elements which are transferable and are transferred can be
disposed of for a price. Thus, when a business goes to the new owner,
if there is apt to be a very appreciable shrinking in profits—as is
the case in the transfer of some professional businesses—or if the
favorable location on which in some cases depends the ability to earn
excess profits cannot be turned over to the purchaser because of the
expiration of the lease or other reason, good-will may not be worth
much to a prospective purchaser. There is thus a local and personal
character to good-will which cannot be ignored.
Difficulty of Valuing Good-Will
The valuation of good-will presents at times many complexities. The
general principle of valuation at cost—and not market—may be said
to apply here, too. What constitutes cost is sometimes difficult to
determine. A corporation which buys out an existing business, paying
an agreed sum for the good-will, should set up on the books that sum
as the value of good-will. The vendor concern during the years of the
establishment of its good-will, unless specific expenditures were made
for that purpose, should not show any value for it on its books. In
an English case, Stewart v. Gladstone, 1879, the court said: “Is it
reasonable ... that a changing thing like good-will, the value of which
would vary year by year according to the state of the trade ... and to
the reputation which the house had acquired or had lost for integrity,
punctuality, solvency, and mercantile prudence, was to be valued from
year to year,” and the increase or decrease was to be treated as profit
or loss for the year and distributed?
The impropriety of bringing good-will on the books unless paid for by
purchase or otherwise, is established and rests on principles of sound
business.
Creation of Good-Will by Advertising
There is perhaps only one case in which a concern which has not
acquired good-will by purchase but has built it up for itself may
with propriety set up its value on the books. Creating a demand for
a product by means of extensive advertising is one of the quickest
ways of building up good-will. The difference between the cost of the
advertising necessary to retain a given volume of trade—which we may
call the normal advertising expenditure—and the cost of the publicity
required to secure that trade may be treated, in theory at least, as
an expenditure on account of good-will and be so shown on the books.
This is usually a difficult matter to determine at the close of the
publicity campaign and before the cost of normal advertising is known,
and the valuation at best is somewhat speculative. But where handled
carefully and with conservatism there seems no serious objection to
bringing good-will on the books at a value calculated in this way.
Unless it is possible to treat some expenditures of this sort as the
direct cause of good-will, the evidence of the possession of good-will
must be sought in the profit and loss record rather than in the balance
sheet, as its existence would be indicated only by above-normal profits.
Valuation of Good-Will Based on Normal Profits
Valuing good-will for a purchaser is not so difficult. Two standard
methods are in use, the one based on profits, the other on excess
profits. According to the first, the value of the good-will is
estimated as so many years’ purchase price of the net profits of the
last year; or, better, the average of the last three or five years.
This simply means multiplying the profits by the number of years’
purchase. The number of years to be used as a multiplier varies from
one to fifteen, or twenty in some instances. Thus, if the agreement is
to pay three years’ purchase of the average profit for the past five
years and this average is $50,000, the price paid will be $150,000 and
at that value good-will should be shown on the purchaser’s books.
Valuation of Good-Will Based on Excess Profits
The other method determines first the excess profits, i.e., the amount
by which the profits of a particular business exceed the normal or
average figures for that line of business. Thus, if the profits are
$75,000 and normal profits are $50,000, the excess earning capacity per
period is $25,000. This amount is then capitalized on some arbitrary
basis, ranging in practice from the prevailing interest rate, say 5%,
to 20% or even 50%. The effect of such capitalization is to apply a
multiplier, as in the first method, ranging from 20 to 5 or less. Thus,
if 20% is the agreed rate, the excess, $25,000 multiplied by 5 gives
$125,000 as the value.
It is, of course, apparent that the valuation of good-will for
prospective purchase is largely dependent upon the individual judgment
of the buyer and that seldom will any two men arrive at the same
valuation. As a matter of prudence, under either method the average
profits for the past few years should be used rather than those of
the last year. The latter may be sporadic and under conditions such
as not to warrant their continuance. An average figure gives a better
indication of what the business may be expected to do under normal
conditions. Inasmuch as the value of good-will depends on excess
earning capacity, the second method of valuation rests on better
theoretical grounds than the first. Practically there is no preference,
since valuation is largely a matter of personal judgment under either
method.
Valuation of Good-Will Based on Capitalization of Profits
A slight variation of the second method is sometimes used. Under it
the average net profits are capitalized at some agreed rate, giving the
amount of money on which the average profits could be earned at the
rate used. The difference between this amount and the amount of capital
actually invested gives the value of the good-will. Thus, if on an
investment of $250,000 net average profits are $60,000 and the normal
rate for this business is 15%, $60,000 would represent a 15% income on
$400,000. Good-will must therefore represent the difference between
$400,000 and $250,000, or $150,000. This must evidently work out in
exactly the same way as the second method if the rate used is the same.
Therefore it constitutes not a distinct method, but only a variation.
In the one case the difference between the average and normal profits
is capitalized; in the other both are capitalized and the difference of
their capitalizations is taken.
False Good-Will to Cover Capital Deficiency
A method of valuing good-will which makes it represent the difference
between the value of tangible assets contributed or purchased and the
par value of the stock issued cannot be countenanced at all. This use
of good-will to cover up a capital deficiency is not only improper and
misleading but often fraudulent. It is the favorite means by which
“water” is injected into corporations. Thus, a concern desiring to
capitalize at $500,000 and unable to sell its stock for more than
$300,000, might carry an asset, good-will, to take care of the $200,000
discount on stock. A partnership desiring to incorporate might issue
for the partnership assets stock with a par value much more than the
assets taken over, and either inflate the asset values or set up a
good-will account to care for the difference. This practice cannot be
too severely criticized. In connection with this it should always be
kept in mind that a newly organized company can never include good-will
among its assets except by purchase.
Somewhat analogous to the above practice is that of increasing the
capitalization of a company and issuing new shares in exchange for
the old. Thus a company capitalized at $1,000,000 might increase its
capital to $2,000,000, issuing two shares of the new for each share of
the old. This will necessitate bringing onto the books an intangible
asset, usually good-will, to cover the additional $1,000,000 of stock
issued. Sometimes a real good-will may be existent as shown by the
abnormal profits. In such cases, the effect of an increase of capital
stock will be to keep down the _rate_ of profit on the capital stock
and so decrease the market value of each share, but not the real value
of the total shares nor the _amount_ of profit distributable to each
of the holders of shares of the original issue. The purpose in such
an increase of capital stock is usually an ulterior one, such as the
desire to cover up real earnings in order to prevent a reduction of
rates, as in the case of a public utility company. The purpose may
sometimes seemingly justify the practice. The problem is mainly an
ethical one and it is not proposed to discuss it here further than to
say that the practice is usually to be condemned.
Periodic Revaluation of Good-Will
Periodic revaluation of good-will must next be considered. This
involves a determination as to whether it is subject to depreciation.
From what has been established as the essence of good-will, viz.,
the ability to earn excess profits, it is apparent, as stated in the
case Stewart v. Gladstone on page 333, that its value must fluctuate
from time to time with the earnings of the business. Because of this
changing and at times doubtful value, some authorities advocate its
being written off the books periodically, and a good many concerns
do so write it off. The effect of this, so long as there is any
value remaining in good-will, is to create a secret reserve and this
is justified on the ground of conservatism. The practice is not
reprehensible, though usually to be discouraged.
The weight of authority is to the effect that all purposes are best
served by allowing it to remain always on the books at cost. There is
no logical reason for writing it off. When profits are large, good-will
is a very real asset. To write it off then is not logically consistent.
When profits are small and good-will is accordingly of less value
than before, it would hardly be logical to write off any amount less
than its decreased value, yet the profits at such a time are rarely
sufficient to stand so heroic a treatment.
As was stated above on page 330, all intangible assets should be
examined carefully by a prospective purchaser as to the values at which
they are being carried.
Good-will, because of the improper and misleading uses to which it has
so often been put, is never above suspicion and its value should not be
taken without close investigation. If it _really_ exists, the profit
and loss record will show it. That should guide as to its valuation
and not the value carried on the balance sheet. Accordingly, since the
asset does not depreciate but only fluctuates in value, and since it is
neither prudent nor consistently possible to take these changing values
onto the books, the best course for all purposes seems to be to retain
good-will in the accounts always at its cost figure.
The above considerations as to the depreciation of good-will apply with
almost equal weight to the depreciation of trade-marks.
In closing this chapter attention should be called to the fact that the
term “going value” is used in the case of public utility companies in
much the same way as good-will.
CHAPTER XIX
LIABILITIES ON THE BALANCE SHEET; CURRENT AND CONTINGENT LIABILITIES
Form and Valuation
The problem of handling liabilities on the balance sheet is usually not
so complicated as that of assets. The questions of arrangement, form,
groups, and suitable nomenclature have in the case of liabilities an
equal or even greater importance than that of the assets, the governing
principle being clearness and fullness in the information given, with
due regard to the purpose and intended use of the balance sheet.
The problem of valuation, which assumes great importance in the
treatment of the assets, has normally little or no significance in
the consideration of liabilities. This is due to several causes. In
the first place, human nature being what it is, there is normally
little danger of an overstatement of liabilities; they are usually
sufficiently large, and no desire exists to make them appear more than
they really are. Secondly, and likewise based on human frailty, while
a concern may desire to undervalue its liabilities, the other party to
the liability, the person holding the claim, can usually be depended
upon to press his claim with sufficient insistence as to make the
concern aware at all times of the amount of its liabilities.
From the viewpoint of a going concern, while all business experience
points to a decrease and a necessary diminution in the values at which
certain assets may appear on the books, no such diminution in the
value of liabilities can be looked for; as legitimate claims must be
met if a business is to exist as a _going_ concern. Similarly, there
is normally no tendency to inflate the liabilities by the inclusion
of items which do not rank fully in this class—intangible liabilities
seldom find place in any balance sheet.
On the other hand, there is frequently a very real hesitancy about the
inclusion of some liability items until their claim becomes urgent
or their full liability status becomes determined. Occasionally, and
usually with ulterior intent, the liabilities may be inflated in value
and items included therein which are fictitious; but our present
concern is not with such conditions.
The one principle underlying the showing of both assets and liabilities
is that their _true_ status should be indicated. As applied to
liabilities this means that they should be shown not only in correct
amount but also in their true light, viz.: that all facts bearing
on their relation to the business which ought to be known properly
to judge conditions must be stated. The chief problem in handling
liabilities is, therefore, how to show and list them so as to
accomplish this purpose of truth and usually the further purpose of
full truth. In a consideration of this problem, the auxiliary one of
the inclusion of doubtful items among the liabilities will also receive
consideration.
Arrangement on Balance Sheet
As to the classification and arrangement of liabilities on the balance
sheet, it may be stated in a general way that whatever classification
and arrangement are adopted for the assets, the liabilities should
be shown similarly. For most purposes a standard grouping under the
captions, Current, Deferred Income, Fixed or Funded, will suffice.
The order of the groups as given here follows the order given for the
assets. This is desirable for purposes of easy comparison, because in
this way current liabilities are brought into juxtaposition with the
group of assets to which current creditors must look for payment of
their claims; and fixed liabilities and capital are opposed to the
assets in which for the most part they have been invested.
Items within Groups
Arrangement within the group may be attempted on the basis of relative
degree of liquidity of the items. This, however, is not always
determinable nor is it an end to be sought; the chief desideratum is to
show items in the main group to which they properly belong.
The manner of listing the items within the group is not a question
of relative order so much as it is of nomenclature and clearness of
expression. Thus, desirable and valuable information would be given by
a separation of the items to show (1) those past due; (2) those due but
not payable because of their credit term; (3) those neither due nor
payable, such as accruing items; and (4) contingent liabilities.[48] It
may be remarked that such an analysis is seldom seen on the ordinary
balance sheet. Corporations which have to report to a regulating body
may be required to give more information concerning their business than
those not so regulated. For internal use the suggested analysis has
undoubted merit. For public use, it is neither necessary nor usually
desirable that the information be given in that form; a showing of the
items under the usual titles within the group to which they properly
belong being here deemed sufficient.
[48] P. J. Esquerré, in “Applied Theory of Accounts.”
Cancellation of Liabilities against Assets
Occasionally the practice is met of cancelling the liabilities, or
some group of them, against corresponding assets, showing only the net
assets remaining. Thus, Current Assets less Current Claims might appear
as an item among the assets. Even for publication purposes this would
not be deemed sufficient; for the outsider as a prospective creditor or
investor has a right to judge for himself the relative sufficiency of
the assets to meet the claims of creditors. No basis for such judgment
is offered by a cancellation of the one against the other with a
showing of the net amount only. A somewhat analogous situation arises
in the double-account form of statement used by some English companies.
Here, the capital assets are canceled against the capital and fixed
liabilities and only the net surplus—usually of capital—appears in
the balance sheet proper. The criticism is not so pertinent here,
however, because almost invariably the balance sheet is accompanied
by the so-called capital account which shows the full detail of the
net item in the balance sheet. So also, the practice is often condoned
wherever an accompanying schedule shows the full facts as to assets and
liabilities. As a matter of principle, it should be condemned because
accompanying schedules do not always “accompany.”
Inventory of Liabilities
The principle of showing the full truth as to the liabilities raises
the problem of the complete inclusion or inventory of the liabilities.
Under this will be considered any adjustments that must be made in the
book record in order to show the true state of the liabilities, and
also the proper treatment of contingent liabilities so as to show their
relation to the state of the business.
The adjustment of the book record is not usually complicated. The
necessary data are for the most part available. All that is required
is an analysis of each item to determine what, if any, adjustment is
needed to bring the books to a true statement of conditions as on the
date of the balance sheet. These adjustments fall into six main groups,
only two of which appear among the liabilities, while one of the others
is often based on information obtainable only from an analysis of the
liabilities. These groups are:
1. Accrued Expenses
2. Deferred Income
3. Deferred Expenses
4. Accrued Income
5. Valuation Reserves
6. Merchandise Inventory
The first three groups are discussed below, as well as another
analogous group.
_Accrued Expenses._ These expenses comprise the liability existing
at the close of a fiscal period because of expenses incurred but not
settled for and oftentimes not yet due. Information as to these may be
gathered—not in completeness however—from an examination of the various
expense accounts and a somewhat intimate knowledge of the operations of
the business. Unless a record is kept of all services being rendered to
the business, it is very easy to omit some items of this kind. These
will be discussed in detail under “Current Liabilities,” page 350.
_Deferred Income._ This income comprises the items of income received
in advance of the full performance of the service required to earn
it. In cases of this kind there are in the possession of the business
certain assets which must be used to perform the service not yet
completed in order to entitle the business to the full enjoyment of the
income. That is, the property of the owners is liable for the service
not yet rendered. Also, in order to make a correct showing of results
as between the current fiscal period and the next, this unearned income
must be carried forward for credit in the period in which the service
is performed.
_Premium on Bonds._ Somewhat analogous to deferred income is the item
of premium on bonds. As indicated in Chapter XV this is preferably
treated as a direct deduction from the periodic interest payments on
the bonds, because the bonds were marketed at a rate higher than the
interest rate prevailing at the time of their flotation. Inasmuch as
the premium must be spread over the life of the bonds, its unexpired
portion will appear as of the nature of deferred income at all
intermediate stages. A more detailed showing of this is given in
Chapter XX, in the discussion of the liability, bonds.
_Deferred Expenses._ These expenses have been explained in detail
in Chapter XIV. Here it is to be noted that, while this group of
adjustment items is always an asset, for the proper determination of
deferred interest an examination of the liability, notes payable, is
often necessary. Notes payable given for a loan at the bank, or given
to a creditor, with prepaid interest added to the principal of the
debt as a part of the face amount of the note, will give the data for
calculation of the amount of interest or discount to be deferred to
later periods.
Contingent Liabilities
As stated above, the second group of items under the head of inventory
of the liabilities is that of contingent liabilities. It is taken for
granted that all items which on the date of the balance sheet have
assumed a status of full and direct liability will, of course, appear
as such on the books. Here, all that can be said without trespassing on
the distinctive field of auditing, is that all such items must appear.
For the method of detecting their omission, whether omitted with
fraudulent intent or through carelessness and inaccuracy, the student
is referred to a standard work on auditing.
We have here to consider, however, a group of items the status of
which is one of suspended or indeterminate liability. Expressed
otherwise, they are items concerning which it is hoped—it may be even
expected—that the business will never incur liability but for which in
the event of certain happenings liability must be assumed. There are,
of course, degrees of contingency, ranging from almost certainty to
negligible remoteness. It would seem that no business man would omit
the almost certain type from his books, and in case of doubt prudence
demands that decision be rendered in favor of at least the greater
probability.
Yet there is often seen a failure to book even the liability on account
of goods purchased and shipped, but not received. If it is argued that
the liability is not fully established until receipt and acceptance of
the goods, every manager knows that non-acceptance of purchases is the
exception, not the rule. On the other hand, upon receipt of consigned
goods to be sold on account of a principal, no liability except to
exercise ordinary care usually attaches to a broker until some part
of the goods has been sold by him. Between these two extremes are
many shades and degrees of probability, all of which in some cases
are recorded as liabilities; in others none are so recorded. The
importance of the information as to contingent liability on account of
notes receivable discounted and discounted acceptances is now accorded
general recognition. As to liability under court judgments awaiting
appeal, guarantees of work and product, deposits made on contracts or
bids—these and other similar matters will be treated fully in following
pages.
These, then, constitute the main problems in connection with
liabilities on the balance sheet. The group of current liabilities will
now be considered, followed by a discussion of the nature of contingent
liabilities.
CURRENT LIABILITIES
Notes and accounts payable, using the terms broadly, constitute
practically all of the current liabilities. Not all notes nor all
accounts payable are, however, current items. The term “current” cannot
be standardized; it varies and will perhaps always vary according to
customs and practices in any particular trade. In the main, the 90-day
period may be taken as the average. That is, on the given date of the
balance sheet a knowledge of the debts that must be met within the
next 90 days is a minimum of necessary information for the purpose of
judging business condition, particularly so far as concerns the credit
extended to it. When a balance sheet is submitted to the bank as the
basis for credit, other data concerning notes payable are usually
called for—such as notes given for merchandise, notes negotiated to own
banks, notes otherwise disposed of. The Federal Reserve Bulletin for
April, 1917, under the title “Uniform Accounting a Tentative Proposal”
suggests for balance sheet presentation a list of notes analyzed as to
acceptances made for merchandise or raw material purchased; notes given
for merchandise or raw material purchased; notes given to banks for
money borrowed; notes sold through brokers; notes given for machinery,
additions to plant, etc.; notes due to stockholders, officers, or
employees. R. H. Montgomery[49] suggests a division of notes into the
groups: notes issued for merchandise; notes discounted by own banks;
notes sold through brokers; and demand loans. He suggests further that
an additional separation into notes accompanied by collateral and notes
with which no collateral is given would be desirable.
[49] In “Auditing—Theory and Practice.”
From the above it is seen that the present tendency of bankers is
to insist on a full statement of essential facts needed to pass
intelligent judgment as to the exact status of affairs. Even in the
case of balance sheets, the accuracy of which has been certified by
someone, some bankers require a certificate as to the character of the
certifier unless he is well known. More and more is the fact being
recognized that legitimate business has nothing to fear and much to
gain by making a full and free statement of exact condition, and that
the sooner business supported by fraudulent statement is eliminated,
the better will it be for legitimate enterprises. In certain cases,
however, the interests or purpose of a business would not be well
served by the detailed information demanded by the banker and, here
as elsewhere, no specific rule can be laid down other than that the
purpose should in all cases govern the form and particularly the amount
of detail.
Loans from Bank
In connection with advances from the bank it should be noted that
the banker does not expect to become a permanent partner in the
business, but that one of his legitimate functions is to furnish funds
for seasonal fluctuations. Oftentimes a concern does not start with
enough capital to carry its load of maximum trade, from the fear that
advantageous investment of surplus funds during the dull season will
not be possible. It may rightly expect its bank to furnish funds for
this purpose when expenses are heaviest, and to await repayment of the
loan out of the income, as accounts are collected after the peak of
the seasonal trade is passed. This is one of the fields of legitimate
banking and the banker has a right to whatever information is necessary
to assure himself that his aid is being put to proper use.
General Classification of Notes
For general purposes, a separation of notes into notes for trade
purposes and notes for other purposes is desirable. Trade purposes
would be limited to merchandise purchases and loans for working
capital. Other purposes would be long-time loans, purchase money notes
often secured by mortgage on equipment, and notes of officers and
employees. These last would best be classified by their showing as
fixed rather than current liabilities.
Accounts Payable
The use of the term, accounts payable, to cover only creditors
for stock-in-trade and other trade purposes is too indefinite and
inaccurate, the term being too comprehensive and inclusive. The
considerations applying to trade debtors have equal weight in requiring
the use of the term trade creditors for the purposes mentioned above.
Accounts payable to trade creditors are usually the current items,
whereas those payable to stockholders, officers, etc., and those due to
a parent or holding company are more or less fixed, as there is usually
no particular urgency as to the time of their payment. An analysis
of trade creditors into “not due” and “past due” will at least bring
out the information as to neglected discounts and some idea as to the
amount of cash needed to pay off debts and to secure their discount.
There is no necessary relationship between accounts and notes payable,
nor any significance in their relative amounts. In some trades notes
are given in order to obtain the discounts; in others notes are given
at the date of purchase of the commodities.
_Deposits._ Another group of accounts payable of a more or less current
type consists of deposits of various sorts. The business may accept
deposits from customers or employees for various purposes. Consumers’
deposits with gas and electric light companies as guarantee to cover
payment of bills and possible damage to meters or other company
property; deposits covering locker privileges, breakage of materials,
keys issued, and the like, are examples of this kind. These deposits
are seldom all claimed at any one time; experience only can indicate
the necessary financial provisions to be made currently for them. In
some instances there is an accruing liability on account of interest on
these deposits which must also be cared for.
_Guarantees._ Sometimes goods are purchased and only partly paid for, a
portion of the purchase price being retained as a guarantee of quality
until opportunity is given for adequate examination and acceptance
or rejection. Similarly, in the case of construction work done by
contract or subcontract, the owner—or, if a subcontract, the general
contractor—retains a certain percentage of the contract price as a
guarantee of performance of the whole according to contract agreement.
This liability for the portion retained is a current liability, as a
usual thing, and is to be listed under accounts payable with suitable
subtitle.
_Long-Term Notes._ Long-term notes and accounts, bonds, and other fixed
liabilities become current as their maturity closely approaches and
provision for payment must be made.
_Future Deliveries._ On the border lines between contingent and full
liabilities may be classed the liability because of goods purchased
with long future dating. This is sometimes allowed by a seller to
secure warehouse room for new product. It is undoubtedly best to set
up both the asset and the liability, even where the goods have not yet
been received.
_Consigned Goods Sold._ The factor’s real liability on account
of consigned goods sold should, of course, be shown as a current
liability, offset by any claims for expenses incurred on account of the
consignor and any accrued commissions earned on sales to date.
_Dividends Not Yet Paid._ Another item belonging to accounts payable
is dividends declared but not yet paid. Though it may be the custom of
a company always to declare a dividend on a given date, no liability
is incurred on account of dividends until they are actually declared.
Upon declaration of a dividend the company makes itself liable to
stockholders for the amount of the dividend. This liability ranks
as an unsecured debt on the same footing as unsecured liabilities
to other creditors. The dividend liability in large part is usually
soon liquidated. Any unclaimed dividends constitute a liability until
claimed or authority is given for other disposition. The item is
usually small and is best shown as a current liability even though the
chance of its being claimed may be remote. The method of handling and
safeguarding the dividend transaction is treated in Chapter XXIV.
Accrued Expenses
The final item to be considered among the current liabilities is the
group of accrued expenses. These constitute such items as wages,
salaries, rents, royalties, expense supplies purchased but unpaid for,
interest, advertising, sales commissions, traveling expenses, freights,
water and other taxes, etc.—in fact, all services which have been
rendered the business previous to the date of the balance sheet but
which on that date are unpaid. These usually comprise the most urgent
of the liability items and so are properly classed as current. There
is seldom any business in which items of this kind are not encountered
and, as stated on page 343, a careful examination of the records and
familiarity with the business is needed to secure a full statement of
them.
With regard to some of these items, difference of opinion exists.
It is argued that until the amount of the liability is known, no
real liability can be said to exist. Thus, taxes for the current
year may not be known until the following year. Proverbially taxes
are as certain as death, and there would seem to be no unreality or
contingency about their incidence. As the current year passes by, the
accounts should include a charge for taxes. Since the real amount is
not known, it must be carefully estimated; for any difference must be
taken up when the real amount becomes known, and so may disturb and
somewhat invalidate the results for comparative purposes. Because of
the fact that the current amount is an estimate, the title given the
liability thereunder is sometimes called “Reserve for Taxes” rather
than “Accrued Taxes.” No matter what the caption may be, it should
usually be listed as a current liability.
Booking of Accrued Expenses
As in the case of deferred expenses, so in the booking of accrued
expenses, in some quarters it is thought highly unscientific to record
both the expense and liability elements in the same account at the time
of adjusting the books. Use is made of a separate liability account
entitled “Interest Accrued,” for example. When so used immediately at
the opening of the new period, this account is either transferred to
the expense account where it will act as an offsetting credit to the
expense when paid, so automatically reducing the amount to the part
properly applicable to the new period; or the account may be allowed to
stand untouched (and therefore having no real significance) till the
end of the next period when only the difference between it and the new
amount accrued is made the basis of the new adjusting entry. Both these
methods, while securing a more evident separation of the expense and
liability elements, do so only at the cost of a needless multiplication
of accounts and work. To one acquainted with the significance of
bookkeeping methods, the old way of treating the liability element as
an inventory in the expense account makes a definite allocation of the
two elements, and does so with less burden on the bookkeeper and is to
be preferred in most cases.
Deferred Credits
Deferred credits, as already explained, are analogous to current
liabilities in that they represent unearned income. The enjoyment or
earning of this income requires the rendering of certain services which
are a claim on the current assets. In this sense, then, they belong
to the current liability group, for the payment of which the current
assets must be available.
NATURE OF CONTINGENT LIABILITIES
Statement of Contingent Liabilities
As stated on page 345, contingent liabilities range from those almost
certain to materialize to those extremely remote. For some purposes a
full statement of all such liabilities is needed to give an adequate
view of conditions within the business. For other purposes, so detailed
a statement may not be necessary although usually desirable. The
Federal Reserve Board requires on a balance sheet submitted as the
basis for credit a full statement of contingent liability as follows:
Kind of Contingent Liability Amount
Upon customers’ notes discounted, sold,
or otherwise transferred $......
Upon drafts negotiated ......
For accommodation indorsements ......
For guarantees ......
Upon leases ......
Upon bonds or other obligations of ......
subsidiary companies ......
Under contracts or purchase arrangements ......
Under agreements ......
Under pending lawsuits ......
This company is not a guarantor or indorser
of any liabilities or obligations of any
individual, firm, or corporation, and it is
not liable under any contracts, bonds, or
profit-sharing arrangements, or any other
agreements, and there are no lawsuits pending
except as set forth above.
Sign Company’s name here ..........................
By ..........................
N. B. It is most essential that each question be fully answered.
Full answers to the above inquisition would often prove embarrassing
but very enlightening. Two additional kinds of contingent liability not
listed above sometimes exist, viz.: that arising out of a call for the
unpaid portion of stocks owned but not fully paid for; and in the case
of a corporation, unpaid accumulated dividends on preferred stocks.
Some of these contingent liabilities require detailed consideration.
Notes and Drafts Transferred
The proper method of handling notes discounted, sold, or otherwise
transferred, and negotiated drafts is given in Volume I and will not
be repeated here. The showing of these items on the balance sheet is
by inclusion among both the assets and liabilities, or preferably by
inclusion among the assets with the liability element shown deducted.
When a person or firm lends its credit by means of an accommodation
indorsement, the transaction should be recorded as a charge to the
accommodated party and a credit to Notes Payable if the liability
is primary; or to Indorser’s Liability, if secondary. In case of
primary liability, liability is full and must be listed on the balance
sheet as a note payable. In case of secondary liability, liability
is contingent, as in the case of discounted notes, and should be so
shown on the balance sheet. In either of these cases, the practice of
cancelling the liability against the corresponding asset and by a feat
of mental dexterity persuading oneself that there is therefore no need
to show the item on the balance sheet, is a practice to be universally
condemned.
Guarantees as a Contingent Liability
Guarantees are of many sorts—guarantees of product sold or work
performed, guarantees of the good faith of others in meeting their
obligations, etc. The transferred note is one kind of guarantee.
Oftentimes, a parent company may guarantee the principal and interest
or the interest only of the bond or note obligations of a subsidiary.
While the expectation is usually that the contingent liability will
not become real, yet experience shows the need of making adequate
provision against it. The recent example of the Denver & Rio Grande as
guarantor of the bond interest of Western Pacific bonds drives home
that necessity. In a case of this sort provision is best made in the
creation of a contingency reserve, for there is no experience on which
to base a better estimate. In the case of a policy of guaranteeing the
quality of a product or its workmanship, after a few years’ experience
very accurate estimates can be made of the loss to be expected
therefrom, and at the end of a fiscal period the books can be adjusted
on that basis just as they are for taxes. A charge to a suitable
expense account and a credit to a reserve or accrued account comprises
the book entry, with a listing of the reserve as a real liability.
Long-Term Leases
Contingent liability brought about by a lease covering a long period
may be disregarded if the lease has a marketable value sufficient to
cover the liability. Otherwise a contingent reserve should be set up.
Liability under the subletting of a lease is best handled by means of a
reserve.
Purchases for Future Delivery
Purchase contracts for future delivery, if made at a fixed price, may
be disregarded unless at the date of the balance sheet market value is
lower than cost, when a reserve should be set up. A fuller statement of
the facts shows the transaction among both assets and liabilities. If
the contract, being speculative, is not at a named price, the showing
of the reserve is prudent and conservative.
Pending Lawsuits
In the case of pending lawsuits, the contingent reserve is usually all
that is necessary. If the case is on appeal, it might in addition be
wise to create a fund which would provide funds for settlement if the
decision is unfavorable. Here the item of costs, fees, and accruing
interest is usually large and liberal provision must be made.
Stock not fully Paid
Where shares of stock are held which are not fully paid, a liability
attaches for the unpaid portion contingent upon call being made for it.
Showing the stocks at subscribed price with the offsetting liability
for the unpaid amount as a deduction, is perhaps the best method,
though there is no serious objection to omit mention of it if the stock
has increased in value, or of using the method of a reserve. Where a
double liability attaches to stock ownership in case of bankruptcy,
no notice need be taken of the contingent liability so long as the
business whose stock is held shows an entirely solvent condition. When
such is not the case, whatever provision seems necessary should be
made, even to the extent of liability to the full value of the stock
held.
Accumulated Dividends on Preferred Stock
There is no liability on account of accumulated dividends on preferred
stock until profits have been made out of which they may be paid.
If the policy of management does not allow their declaration at
the present time, although sufficient profits have been made, the
accumulation of dividends should be shown as a liability. Where the
company is unable to declare dividends because of insufficient profits,
mention of the accumulating dividends should be made in a footnote as a
possible future liability.
Signature to Surety Bond
The liability arising through signature to a surety bond is a
contingent liability resting upon the good faith and honor of the
bonded party. The practice of personal bondsmen is not so prevalent
as formerly. Experience shows that the liability of the bondsmen may
become very real, and not only should suitable provision be made for it
but its existence should be shown on the balance sheet.
CHAPTER XX
FIXED LIABILITIES—BONDS AND MORTGAGES
Nature of Fixed Liabilities
Fixed liabilities, called also capital, bonded, long-term, and
funded liabilities or debts, comprise all debts of which the date of
maturity is some distance ahead and considerably longer than that
of current liabilities. Government regulating boards, for purposes
of standardization, may set a minimum life-period for this group of
liabilities and any kind of debt falling within the period is so
classified. Thus, the Public Service Commission for the First District
of the State of New York says: “Funded debt comprises all debt which
by the terms of its creation does not mature until more than one year
after date of creation.” Private undertakings do not need such exact
uniformity. Any debt the maturity of which extends beyond the period
adopted within that business for current liabilities will usually be
grouped with the fixed liabilities, there seldom being an intermediate
group.
Purpose of Fixed Liabilities
Fixed liabilities, as distinguished from current, are those issued
distinctively for the purpose of raising capital. Due to insufficient
original capitalization, funds may be needed for one or more of many
purposes. Working capital may be required; extensions of plant and
market may be desirable; additional equipment and improvement within
the plant itself may be advisable; the control of the plant of a
competitor may prove advantageous; it may be deemed wise to fund
floating liabilities; the refunding of liabilities soon to mature may
become necessary; the financial policy may dictate the unification of
several diverse forms of debt—these and other purposes may be served by
the assumption of long-term debts.
Corporation Bonds
The most common type of fixed liability is the bond. As an instrument
of credit the bond is limited almost exclusively to corporations. The
purchasing public, interested in securities of this kind, looks with
suspicion on a long-term promise to pay issued by either a single
proprietor or by a partnership. Such businesses are almost wholly
dependent on the health and ability of individual owners. During a
long period of years so many contingencies may arise and seriously
cripple the business that the long-term debts of a partnership or sole
ownership have no market, although isolated instances of such issues
exist. The corporation, however, has continuity of life, is not so
dependent on individuals, and therefore has avenues for the raising of
funds open to it which are closed to other types of organization.
Nature of Bonds
A bond may be defined as an instrument under seal promising to pay
a certain amount of money at a definite or determinable future time.
From a legal standpoint, a bond is a contract setting forth the terms
and conditions under which the obligation is assumed. Furthermore, it
is a negotiable contract transferable from hand to hand, though in
some cases registration is necessary to prove ownership in the eyes
of the issuing corporation. From a financial standpoint, a bond is
essentially a long-term promissory note. Bonds, as here used, are to
be distinguished from the old real estate bond and mortgage. Bonds are
usually secured by a lien on some definite property or prospect of
property, just as the real estate bond and mortgage. The corporation
bond, however, is a separate instrument, divisible into small parts,
whereas the bond and mortgage is not usually an instrument of that type.
Corporation bonds are also to be distinguished from the surety bonds
mentioned in the preceding chapter. These latter, as already noted, are
instruments whereby individuals, firms, or corporations bind themselves
as guarantors for the conduct of others or for the payment of sums of
money for which the guarantor is not directly liable.
Difference between Bond and Real Estate Mortgages
With regard to the mortgage covering the bond issue, points of
difference from the ordinary real estate mortgage are to be noted.
To the ordinary mortgage there are two parties, viz., the party
obligated and the party accommodated, the obligor and obligee. To the
bond mortgage, the obligee is a trustee standing in the stead of the
numerous bondholders who could not conveniently act individually.
In this trustee the title to the property liened is vested for the
benefit of the bondholders. The mortgage instrument itself is often
a model of completeness and comprehensiveness, defining with minute
care the relations, duties, rights, interests, and status of the
issuing corporation, the bondholders, and the trustee under present
circumstances and all possible future contingencies.
Kinds of Corporation Bonds
Since bonds were first issued, perhaps one hundred different kinds
have been placed on the market. They all have the same fundamental
characteristics but differ in minor particulars. No universally
recognized basis exists for their classification, nor is such a basis
possible, the use which they are to serve determining always the
basis of analysis into classes. Thus, in the opinion of a leading
authority[50] on the subject bonds may be classified under the
following heads, according to:
1. The character of the issuing corporation under
which are treated:
(a) Civil Loans
(b) Corporation loans
2. The security of the bonds under which come:
(a) First mortgage (second, third, etc.)
(b) General mortgage
(c) Divisional
(d) Guaranteed
(e) Collateral trust
(f) Debenture
(g) Income
(h) Land grant
(i) Real estate
(j) Prior lien
(k) Consolidated (consols)
Etc., etc., there seemingly being no limit to
the descriptive titles that may be used in
order to indicate some feature of the security.
3. The purpose of the issue, as:
(a) Improvement
(b) Construction
(c) Refunding
(d) Purchase money
(e) Unified
(f) Subsidy
Etc.
4. The conditions incident upon payment of principal
and interest, as:
For the payment of interest—
(a) Income
(b) Participating
(c) Unconditional
(d) Registered
(e) Registered coupon
(f) Coupon
(g) Interchangeable
Etc.
For the payment of the principal—
(a) Premium
(b) Gold
(c) Silver
(d) Straight
(e) Serial
(f) Extended
(g) Callable
(h) Optional
(i) Convertible
Etc.
[50] “The Principles of Bond Investment,” by Lawrence Chamberlain.
The issuing corporation often distinguishes its bonds by means of
some descriptive adjectives purporting to classify them or indicate
their nature. Thus, consolidated first and improvement, general and
refunding mortgage, first mortgage extension, general lien railway and
land grant, are titles sometimes met, though a simpler title carrying
also the interest rate is more common, as general mortgage 4’s of 1965,
C. & A. 5’s, Toledo Light & Power 4’s, etc. As listed on the exchange
the title usually gives the name of the issuing corporation (i.e., the
obligor), the distinctive name of the bond, and its interest rate.
Bonds rank very much as mortgages do in the priority of their liens.
A first mortgage bond has a first lien on the property securing it;
a second mortgage bond has a second lien and its claim is said to be
junior to that of the first. No attempt can here be made to explain the
distinguishing features of the above-named issues. Attention is called
to them only because the reader of a balance sheet—an investor or
prospective creditor—often must have a knowledge of the various classes
of bonds and a detailed knowledge of the conditions of particular
issues. It is obvious that the accountant should have a knowledge of
the particular issues of a business in order intelligently to draw up a
balance sheet and make a report thereon.
Authority for the Issue of Bonds
A corporation has generally a charter right to issue bonds for the
purpose of securing money, acquiring property, or in payment for
labor or financial services rendered. The exercise of this right may
be curtailed by, or be dependent upon, authority from a regulating
body. Within the corporation itself, the right to issue vests in the
stockholders. In some cases a majority vote suffices; in others as
many as three-quarters of the votes may be required to authorize the
issue. The directors themselves may, upon proper authorization from the
stockholders, make the actual issue, and usually the initiative for a
bond issue comes from them because they have intimate knowledge of the
business and its needs.
Financial Considerations Involved in Issue
Financial considerations involved in the determination to issue bonds
may be reviewed briefly. It is interesting to note that the bond has
been used very extensively as a means of securing capital. There is,
however, no necessary relationship between the amount of capital
raised by stock issues and that raised by bond issues. The sale of
additional stock or of bonds or other similar securities is the main
source of corporation funds for capital purposes. Some concerns have
obtained approximately one-half of their capital through the issue of
bonds. Percentages of capital so raised ranging from 15% to 40% are not
uncommon.
The manner of raising capital is largely a matter of credit,
expediency, and the question of fixed operating expenses. It rarely
happens that bonds carry with them the privilege of voice in the
management of the corporation’s affairs; that is usually limited
strictly to the shareholders. Accordingly, the issue of bonds instead
of additional stock does not interfere with the management or control
of the concern—so long as the contract requirements of the bond issue
are adhered to.
Because of the definiteness of the income on bonds and usually the
greater security of the principal, bonds may often find a market where
stocks would not. On the other hand, if the stock can be marketed as
advantageously as the bonds, no definite dividend rate is necessarily
attached to them. The price at which stocks may be marketed, aside from
the features of extra inducement which might influence the market,
depends largely upon the prospective income rate judged mostly by
what the company has been able to do in the past and any features of
present condition or expected future condition which might influence
the earning capacity of the corporation. Therefore, unless a dividend
rate a little higher than the current interest rate is in prospect, the
company usually finds it difficult to market its stock advantageously.
Bonds versus Stock Issues
The bond market furnishes opportunity for investment to quite a
different class of people from those interested in stocks. Security,
conservatism, and a definite income are the main elements desired.
Thus conditions may oftentimes be such that one market or another may
be more favorable for absorbing an issue of securities, dependent on
conditions in that market as much as on the credit and standing of the
issuing corporation.
Aside from these points which are usually given consideration, is the
question of how heavy are the fixed charges the corporation can carry.
While from the investor’s viewpoint an income at a fixed rate is highly
desirable, from the corporation’s point of view it may impose so great
a burden as to eat up all the profits. The bond interest constitutes a
fixed charge deductible before the determination of profits. In case of
failure to meet the bond interest, the mortgage covering the bonds is
subject to foreclosure. Upon foreclosure at forced sale values always
shrink greatly, oftentimes the shareholders lose their entire interest
in the company, and all the net assets may be taken to satisfy the
claims of the bondholders. As compared with an additional issue of
stock—common or preference shares, as may best meet the situation—a
bond issue may thus be of doubtful value. One of the knotty problems
upon a reorganization following insolvency is that of lowering the
fixed charges by converting some of the bond issues into preferred
stocks in order to prevent the recurrence of operation at a loss and so
of inability to meet bond interest.
Accounting for Bond Issue
Accounting for the bond issue presents much the same problems as
those connected with an issue of stock. Inasmuch as most corporation
issues are sold in block to a banker who in turn markets them to the
investing public, often through a syndicate (or the process may be one
of under-writing), there is usually no need for detailed subscription
records and accounts. In the case of coupon bonds no record of
individual ownership is required because the bonds pass by delivery,
possession evidencing ownership and the interest coupon being payable
to bearer. In the case of registered bonds, a record of individual
holdings must be kept similar to the record of stockholders. The party
in whose name the bond is registered on the company’s records is the
prima facie owner to whom the periodic interest check is also sent.
If the bond is registered as to principal but bears coupons for the
interest, records of individual ownership are also required here.
Entry of Issue on Books
Placing the bond issue on the books is accomplished by either of two
methods. Assuming an issue of $500,000 of first mortgage 5% bonds of
which $350,000 are sold at par for cash, the balance remaining unissued
for the present, the entries would be:
_First Method_
(1) Unissued First Mortgage Bonds $500,000.00
First Mortgage Bonds Payable $500,000.00
(2) Cash 350,000.00
Unissued First Mortgage Bonds 350,000.00
Entry (1) is used to make a memorandum entry of the authorized issue.
Entry (2) shows the amount sold for cash. The balance in the Unissued
Bond account is treated as an offset to the Bonds Payable account.
Sometimes the title “Treasury Bonds” is used instead of “Unissued,”
but the term is apt to be misleading because of the restricted meaning
given the word in connection with treasury stock.
_Second Method_
(3) Cash $350,000.00
First Mortgage Bonds Payable $350,000.00
Under the second method, the desired information as to authorized
issue would be carried parenthetically in the account title. At the
present time the tendency is to deprecate an unnecessary multiplication
of accounts as is brought about through the use of memorandum
accounts. The second method is therefore the preferred method and in
its operation brings onto the books the same information as the first
method.
Entry of Premium or Discount on Books
Bringing the bond premium or discount onto the books is accomplished in
the same manner as for stock. Thus, using the above data and assuming
$100,000 of the bonds sold at 101 and the remaining $50,000 at 99¾, the
entries would be, illustrating only the second method:
(4) Cash $101,000.00
First Mortgage Bonds Payable $100,000.00
Premium on First Mortgage Bonds Payable 1,000.00
(5) Cash 99,750.00
Discount on First Mortgage Bonds Payable 250.00
First Mortgage Bonds Payable 100,000.00
Subsequent handling of the premium and discount accounts will be shown
on page 368.
Bonds may be issued for cash or property, as in the case of stock.
Unless there is evidence to the contrary, when bonds are issued for
property they are brought onto the books at par value, the courts
holding here as with stock that the parties to the transaction (usually
the corporation’s directors) are in a better position to judge the
value of the property taken over than anyone else. This oftentimes
results in an inflation of property values—an injection of water—and
should not be countenanced where a true basis for determining the
value of the bond is offered. Thus, if almost simultaneously with the
issue of the bonds for property, some are sold for cash, the cash
price received would usually be a fair basis for booking the premium
or discount on those issued for property. The sale for cash must be a
bona fide sale in the open market if it is to represent the market’s
judgment of the offering. Sometimes an objection is raised to a Bond
Discount account appearing on the books; hence the practice, wherever
possible, of charging the discount against some asset account as a part
of the cost of that asset. When the true nature of bond discount or
premium in its relation to the periodic interest charge is appreciated,
the objection has no weight.
Entry of Interest Payments on Books
Booking the payment of the periodic interest is accomplished by a
charge to Bond Interest and a credit to Cash. This interest should
never be entered in the regular Interest and Discount account. If the
bonds are coupon bonds with the coupons redeemable through a designated
trust company, a check for the full amount of the interest on the
outstanding bonds should be issued and booked as above. If the coupons
are redeemable at the company’s office, an entry debiting Bond Interest
and crediting Coupons Payable should be made, to record the interest
charge and the liability therefor. As the coupons are redeemed, Coupons
Payable is charged and Cash credited, any balance remaining in Coupons
Payable account representing the liability existing because of coupons
not yet presented for redemption. In the case of bonds registered both
as to principal and interest, the interest checks made payable to the
registered parties constitute a charge to Bond Interest and a credit to
Cash. It is sometimes advisable to transfer by one check the total bond
interest payable to a special bank account and issue the individual
interest checks against this fund. Whenever the books are closed it is
always necessary, unless the end of the fiscal period coincides with
the bond interest date, to take account of the accrued bond interest
as on that date. The adjusting entry here is similar to that for any
accrued expense.
Relation of Bond Interest to Premium or Discount
The main problem in connection with accounting for bond interest is
that of the relation between bond premium or discount and the periodic
bond interest. At practically any time in the market there is a rate
at which the bonds could be sold at par. This rate is known as the
effective rate. If a company puts an issue of bonds on the market at a
higher rate than this, the market will offer a premium for them. The
amount of the premium will be, theoretically, the present value of the
periodic sum represented by the difference between the stated bond
interest and the effective interest, these periodic payments extending
over the life of the bond. In other words, the premium represents
the price paid to buy the additional interest, dollar for dollar, on
a compound interest basis. The premium is therefore not an earning,
an item of income, but is an offset to the excess bond interest. The
portion of it applicable to each period represents the excess interest
which deducted from the bond interest shows the real or effective cost
of the money borrowed and to be paid back. Thus, the bond interest
rate based on the money actually received, i.e., par plus premium,
is exactly the same as the market or effective rate on par. In other
words, the corporation is paying for its actual borrowings simply the
current market rate of interest.
It is therefore incorrect to show on the books the cost of the loan
at any other figure than the effective interest. The actual periodic
payment of interest is, however, at the bond interest rate. This must
be brought down to the effective rate by application to it of a portion
of the premium which represents the sum paid for the privilege of
receiving the higher rate of interest. Similarly, bonds are marketed
at a discount when the bond interest rate is lower than the market
rate prevailing on similar security at the time the bonds are floated.
This may be looked upon as a payment by the company in lump sum to
compensate a purchaser for the difference in the income on the bond
and what he might obtain on the open market. The discount should be
applied, therefore, periodically to bring the cost of the loan up to
its true figure, viz., the market or effective rate. An illustration
will clarify the points of the above discussion.
Example of True Interest Cost
Assume a 7% bond, interest every six months, payable in 25 years (50
periods), par $1,000, sold in a market whose prevailing interest rate
is 6%. By the method developed on page 273, the value of such a bond is
found to be $1,128.6488, the premium being $128.6488. At the effective
rate the real cost to the issuing company is 3% on $1,128.6488, or
$33.8595. The actual sum paid as interest is $35, i.e., 3½% on $1,000.
The difference between the effective and actual bond interest, or
$1.1405, is the portion of the premium to be used that period in order
to reduce the amount of actual interest paid to the real or effective
cost of the loan. The bookkeeping entries are:
(6) Bond Interest $35.00
Cash $35.00
(7) Premium on Bonds 1.14
Bond Interest 1.14
Similar calculations and entries for each of the succeeding 49 periods
would be made, the application of the effective rate always being,
of course, to the amortized value of the bond as on that date. This
process is called scientific amortization of the premium (or discount)
of the bond. Its effect is readily seen to be to spread over the life
of the bond the premium (or discount) and so not to take credit for it
in a lump sum during the period in which the bond is matured. There are
four cases to which this principle of showing the true interest cost is
applicable, as follows:
1. A bond sold at a premium to be redeemed at par on maturity.
2. A bond sold at a discount to be redeemed at par on maturity.
3. A bond sold at a discount to be redeemed at a premium on maturity.
4. A bond sold at par to be redeemed at a premium on maturity.
At the close of a fiscal period which does not coincide with the bond
interest period, not only must the bond interest accrued to date be
shown as an accrued expense, but also there must be so shown the
portion of the premium (or discount) accrued to that date required to
bring the bond interest cost down to the effective basis.
Presentation on Balance Sheet
The final problem in connection with bonds concerns the manner of
their showing on the balance sheet. That has perhaps been sufficiently
indicated. The amount of the authorized issue should be short-extended,
and the amount unissued subtracted therefrom with the net amount
outstanding full-extended as the significant figure in the balance
sheet.
Other Fixed Liabilities
_Real Estate Mortgages._ Another item among the fixed liabilities is
the simple real estate mortgage. This is usually called a bond and
mortgage, the bond being simply the promise to pay and the mortgage
being the security for the amount of money borrowed. In some states the
more formal document called the bond is used as a contract according
to which a named sum is to be paid in case the amount borrowed on the
mortgage is not paid. This named sum is usually the amount borrowed,
although in some states it is twice this amount. In booking a note
or bond supported by a mortgage, the customary title is “Mortgage
Payable” rather than “Notes Payable” which is generally understood to
be applicable in the main to current liabilities. In case the double
amount is named in the bond, it is not customary to take cognizance of
the contingent liability thereunder.
_Loans on Collateral._ Short-time loans are frequently made on
collateral security. Stocks and bonds, particularly of the borrowing
company or its subsidiaries, may also be made the basis of a long-time
loan. This may take the form of a bond issue, promissory notes, or
other similar obligations. Accounting for the loan and its showing on
the balance sheet follow the principles already laid down. The title of
the loan account should carry the word “Collateral” or other similar
term to show its nature. Accounting for the collateral is usually
accomplished by a memorandum in the stocks, bonds, or investments
account to show exactly what securities have been withdrawn for deposit
as collateral. No further record is needed other than a complete list
of such securities; the securities are still owned by the company,
though deposited under a conditional contract with someone else. If
the loan is dishonored at maturity and the securities are sold in
satisfaction thereof, the necessary entries must be made to show the
sale of the securities, the profit or loss attendant thereupon, and the
repayment of the loan. In showing the pledged securities on the balance
sheet, it is well to present the securities in two groups or classes,
viz., those pledged as collateral for the loan shown contra and those
not so pledged.
_Short-Term Securities._ When the market is not favorable to the
issue of long-term securities, because of the high rate of return
demanded by investors, corporations often have recourse in their
borrowings to short-term securities—usually note issues with maturities
ranging from one to five years, two- and three-year terms being the
commonest. The financial consideration in their issue is merely a
speculation that by the time of their maturity the market will be more
favorable for the flotation of long-term securities. Thus the company
hopes at the maturity of the notes to free itself from the need of
paying so high an interest rate as it is required to pay now for the
short-term securities. These notes may be in different denominations
and are accounted for just as other notes. On the balance sheet they
are grouped with the fixed liabilities until within a short time of
maturity, when they must be shown with the other current items.
CHAPTER XXI
CAPITAL STOCK AND ITS VALUATION
Problems in Valuation
The problems in connection with the valuation of the assets and the
liabilities and the manner of showing them on the balance sheet—and
in some cases the manner of booking them—have been treated in some
detail in the preceding chapters. It might seem that, inasmuch as
proprietorship or net worth is determined always by the excess of
assets over liabilities, no question would arise concerning the
valuation of net worth, its value being automatically determined by
whatever values are placed on assets and liabilities. That its value
is so determined, that every change in net worth must be reflected in
the assets and liabilities, does not admit of argument. There are,
however, certain phases of the question of valuation and certain
problems connected with it, that, because of their close connection
with net worth or their direct effect upon it, are best treated under
this head rather than under the head of each particular asset that
may be affected. Thus, if treated among the assets, the valuation
of properties purchased with stock would require, under the head of
each asset which might be so acquired, an almost identical statement
of principle. For this reason, some problems in valuation have been
reserved for treatment here in connection with capital stock.
In addition, there are related problems which concern the surplus
and reserves. It is true, these all have their origin in the general
considerations of valuation as given for the assets and liabilities.
But questions as to what constitutes a profit, whether all profits
are applicable to dividends, the proper treatment of capital profits,
the relation of capital losses to profits and dividends, the
differentiation of the classes of reserves, and finally the manner of
showing and explaining the periodic changes in net worth by means of
the supplementary statement of profit and loss—all these and other
similar questions are closely related to the problem of valuation and,
as indicative of the financial policy of a business, may directly
affect all going concern values. On this account they require separate
treatment from that of any individual assets and liabilities or group
of assets and liabilities. Accordingly, the next few chapters will be
concerned with these problems and any others which are relevant thereto.
Kinds of Stock
Capital stock is of various kinds—that with a stated par value and that
without, common stock, various kinds of preference shares, debenture
stock, guaranteed stock, founders’ stock, convertible stock, and
redeemable stock. The student is referred to Chapter I where these
various kinds of stock are discussed.
Par, Real, and Market Values
Capital stock may have several kinds of value, as the term value is
used. All stock is expressed as so much per share. The value mentioned
as the stated value of a share of stock in the contract of issue is
known as the par, face, or nominal value.
The book value of stock is the value of the stock, as shown by the
books—not the amount carried in the stock accounts, but the entire net
worth of the corporation divided by the number of shares outstanding.
Thus, if the assets minus the liabilities—the net assets—of a
corporation amount to $1,500,000, of which $1,000,000 represents
10,000 shares of stock of par value $100, and the $500,000 is surplus,
the book value of the stock is said to be $150 per share. From the
standpoint of a going concern, this value is also spoken of as the
real value in the sense that it is represented, dollar for dollar,
by actual assets held by the corporation. Real value is also used to
mean liquidation value, the value which the net assets upon forced or
voluntary sale would realize for distribution to each shareholder.
Finally, there is the market value of stock by which is meant the value
placed on it in the stock market or wherever stocks are dealt in. This
value depends primarily upon the dividend-earning capacity of the
stock, although many side issues of fact and opinion affect it. Thus,
not only present, but past as well as prospective future dividends
influence the market. At times, particularly in a declining market, the
financial needs of the holders of the stock may affect prices more than
the dividend rate of the stock.
The problem of stock valuation as related to the commercial balance
sheet takes cognizance of only one of these values, viz., par value,
though each of the others is related to and measured by the showing
of values on the balance sheet. That par value is not always the
true value cannot be controverted. As already shown, the inclusion
on the balance sheet of assets of doubtful value is allowed when the
doubtfulness of their value is generally recognized and no one is
thereby misled. Some problems in connection with stock values and their
inflation on the books will now be discussed.
Value Dependent upon Earning Capacity
Upon the inception of an enterprise the problem of stock valuation
is always bound up with the question of valuation of the assets and
liabilities, as pointed out above. When the asset to be valued is only
cash, the problem is not usually difficult, as where the capital stock
is sold for cash. Where, however, the sale is for a property taken
over, the valuation of the stock is related to the larger problems of
capitalization, with which in turn the valuation of the assets is bound
up. It seems best, therefore, for an intelligent understanding of the
question to review briefly some of the bases of capitalization.
As indicated above, the market value of any stock is dependent in the
long run more on the factor of its earning capacity than anything else.
If investment in a stock nets the prevailing income rate on money,
that stock will approximate its par value. So when determining the
capitalization of a company which expects to be taken over as a going
concern, the main consideration is not so much its true valuation as
it is its earning capacity and its ability to pay dividends. Thus, if
on a cost basis the net values taken over amount to $250,000, but past
performance and future expectation reasonably indicate a capacity to
earn a normal dividend on $1,000,000, it is very probable that the new
company will capitalize at $1,000,000. If this sum is actually and
in good faith paid, little or no exception can be taken to recording
the value of the plant taken over at $1,000,000. The transaction is
the result of a bargain. The additional value over cost may, in the
estimate of the purchaser, represent the true value of the good-will
or other intangible assets acquired but not included in the $250,000
referred to above. In a bargain transaction such as the foregoing,
judgment of value is sometimes wrong; but the buyer can only show the
property bought at what it cost him at the date of the purchase—whether
the payment is in cash, stock of a stated par value, or other assets.
Increase of Book Capitalization
If, however, the transaction is merely a reorganization of the old
company by its owners solely for the purpose of increasing its book
capitalization by bringing onto the books an existent good-will or
by other means of inflation of assets, the result is a so-called
watering of the stock. The propriety or impropriety of this is chiefly
a question of business ethics, and its discussion is beyond the limits
and the purpose of this volume. It may be said here, in passing, that
under certain conditions the practice may be entirely proper and
no inequities may result. On the other hand, the purpose of such a
reorganization may be fraudulent, in which case it frequently works
hardship and injustice. The main accounting problem involved when
the book capitalization of a concern is increased is the method of
recording the transaction, so that the true status of affairs will
appear unmistakably and any attempted fraud will be shown.
Capitalization on Cost
Opposed to the basis of capitalization on earning power is that
of capitalization on cost. In a case of capitalization it is very
difficult to know exactly what is meant by cost, as there are so many
kinds of cost. There is original cost; original cost less depreciation;
present cost new of an identical property, i.e., reproduction new cost;
reproduction cost less depreciation, etc. In this discussion original
cost is taken as the basis, less depreciation, or such cost plus a
bona fide payment for good-will or for the privilege of securing an
established business. All these other factors may and frequently do
enter into the determination of a bargain and sale price and therefore
affect capitalization.
The regulation of the Public Service Commission of the First District,
State of New York, concerning the manner of keeping the capital stock
accounts of public service corporations, is as follows: “To the account
for any class of stocks shall be credited when issued the par value
of the amount of stock of that class issued. If such issue is for
money, that fact shall be stated; and if for any other consideration
than money, the person to whom issued shall be designated and the
consideration for which issued shall be described with sufficient
particularity to identify it; if such issue is to the treasurer, or
other agent of the corporation, to be by him disposed of for the
benefit of the corporation, that fact and the name of such agent shall
be shown; and such agent shall in his account of the disposition
thereof show the like details concerning the consideration realized
thereon, which account when accepted by the corporation shall be
preserved as a corporate record. If the fair cash value of the
consideration realized upon the issue of any amount of stock is greater
than the par value of such stock, the excess shall be credited to the
account ‘Premiums on Stocks’ and the corresponding reference thereto
shall be contained in the entry relating to such stock in the stock
account.”
The Law and Stock Issues
Thus, it is seen that the state takes cognizance of financial
arrangements and methods of accounting in some of those particulars
wherein the state is vitally interested. These regulatory provisions
are usually found in the corporation laws of the state or amendments
thereto. At the present time there are at least three types of such
laws:
Under one type it is provided that, when property is taken by the
corporation in payment of its shares, the incorporators alone are the
judges of the values of such property and that the state’s only duty is
to prevent fraud. Fraud must be shown by the injured party and usually
the facts by which this might be established are hidden in records to
which a stockholder has no access. The remedy is against the directors
personally. This type of corporation law is found in most of the states.
Under the second type active control of the issue of stock is
undertaken by the state. This requires an independent appraisal and
valuation by the state’s experts. This type of law is found frequently
governing the incorporation of public utility companies. It is based
on a paternalistic theory of state functions not yet recognized as
applicable to private undertakings.
Under the third type, we find the law authorizing the capitalization
of any and all kinds of property—in the absence of fraud, of
course—provided that a full statement is put on record showing the
amount of stock and the exact manner in which it is paid for. The
amount of cash received must be shown; the property acquired so labeled
as to render identification possible; and any payments for services or
other expenses must be shown. The attitude taken is that a prospective
investor, provided with these facts about the company, can make his own
judgment as to stock values.
Thus, we find that practice is not uniform in these regards. From the
viewpoint of theory, any accounting treatment of the issue of stock
which shows the full facts with regard thereto may be considered as
meeting all reasonable requirements.
Treatment of Discount or Premium
Valuing capital stock when issued for cash presents no problem in
itself, but the treatment of the discount or premium incident thereto
requires consideration. In most of the states and in Great Britain
stock cannot be issued below par. The manner of nullifying this
provision has already been referred to in Chapter I. There it was shown
how the issue of fully paid stock is made for property and how treasury
stock is created by donation, which may then be disposed of for any
price obtainable, without any additional liability attaching to it. In
most of the states and in Great Britain, however, a sales commission is
allowed which has, in some instances, been used as a cloak for sales
at a discount. The booking of the discount or premium presents no
difficulties, but the manner of handling it on the balance sheet is not
uniform. Premium or discount on stock should be recorded as such on the
books, under titles of definite meaning.
One occasionally hears the argument that the discount on stock is
a necessary expense incident to financing the company, a sort of
“cost of getting started,” an expense without which the enterprise
could not be launched; accordingly the discount should be properly
capitalized as a part of the property costs. The argument is plausible
but not convincing. The information as to the discount on stock is
very necessary to the prospective creditor or investor and should
always appear as a separate item on the books. To the same effect is
the ruling of the Interstate Commerce Commission that premiums on
capital stock must be carried on the book permanently unless offset by
discounts later allowed. Discounts may be extinguished by premiums,
assessments, surplus, or by the retirement of an equivalent amount of
stock.
A premium on stock may be looked upon as similar to a capital surplus.
It represents a fund of capital originating upon the inception of
an enterprise, and is in no sense an increase of capital, i.e., of
net worth, due to operation. So far as the law is concerned, there
is nothing to prevent the return of this surplus to the shareholders
in the form of a dividend. To treat it as available for ordinary
dividends, however, would seem not to be in keeping with the manner
of its origin. Rather should it be set aside as a permanent surplus.
One requirement in the case of national banks is the creation of a
permanent surplus equal to 20% of the capital, and so, frequently the
original subscribers agree to take their stock at a 20% premium, this
premium providing the legal surplus required. In the case of discounts
no accounting principles are violated if they are allowed to remain on
the books. If there is a surplus from premiums, that should be used
to wipe off any discounts. In the absence of premium or other capital
surplus, conservatism usually sanctions the use of operating surplus
for this purpose, thus bringing the value of the net properties owned
at least into equivalence with the par value of the stock.
Valuation of Stock Issued for Property
The difficulty of valuing stock when issued for property has already
been stated and the attitude of the laws towards any valuation placed
on the properties taken over has been shown. Nothing further here need
be said except to state that where also a bona fide sale of a portion
of the stock takes place for cash at the same time, a fairly reliable
basis for valuing the stock given for the property is offered. It is
not the usual practice to show the probable discount on the stock,
although such treatment would be logical and consistent with the facts.
A similar valuation of the stock might be secured by an independent
appraisal of the properties taken over, but this, if done, is not
often made the basis for entry on the books. If all the facts are
fully recorded, that probably is as much as can be hoped for under
the conditions now prevailing. Undoubtedly the use of no par value
stock for incorporations of this kind offers the best solution of the
problem. With regard to booking the properties acquired by a stock
issue, attention is here called to the method of valuation of the
individual units by an appraisal committee usually appointed from among
the directors and the use of their findings as the basis for the book
entries of the transaction.
Valuation of Treasury Stock
In connection with the purchase of properties by stock, there often
arises the need of working capital. This is frequently furnished by the
pro rata donation or return of some of the stock to the corporation,
the sale of which furnishes the necessary working funds. As illustrated
in an earlier chapter this donation is booked at the par value of the
stock, the charge being to Treasury Stock and the credit to Donated
Surplus, Donated Working Capital, or other similar account. Being
true treasury stock, it can be sold at any price without liability.
It is usually disposed of at a discount which must be recorded on the
books either as a charge to Discount on Treasury Stock account which
will later be closed against Donated Surplus or as a charge direct
to Donated Surplus. Thus when the treasury stock is all disposed of,
the net credit balance in Donated Surplus shows the real amount of
working capital obtained through the donation. If not entirely sold,
the portion sold gives a fair basis for the valuation of the unsold
portion, although this value is seldom brought onto the books, it being
used as a guide to financing rather than as an item to be regarded in
accounting valuation.
Redemption and Reduction of Capital Stock
The redemption and reduction of capital stock presents a problem of
surplus adjustment requiring careful treatment. If a corporation has
accumulated no surplus of any sort and redemption of the stock is at
par, no difficulty is met in making the entry. If, however, a surplus
has been accumulated and redemption is either above or below par, care
must be exercised to record the transaction properly. Redemption at
a stated price is sometimes one feature of a preferred stock issue.
Again the stock may be bought in the open market for the purpose of
cancellation. Reduction of capital, except when made a condition of
the original issue, cannot usually be accomplished without the consent
of at least a majority of the shareholders and authorization from the
state. For the sake of simplicity, assume just one class of stock and
a surplus in which each share has an equal interest. If redemption is
at par, the surplus is evidently not affected but each share of stock
remaining outstanding has a larger share in the surplus and so acquires
a higher book value.
Redemption of a stock at its _book_ value is accomplished by charging
capital stock for its par value and surplus for its pro rata share
in the surplus, the offsetting credit to both these being to cash.
The value of the remaining shares of stock has not been affected in
the least. If redemption is at any other figure than book value, not
only is surplus affected, being increased if the redemption price
is below par and decreased if above par, but also the value of the
remaining shares. In the case of different classes of stocks, a careful
determination of their respectively equitable shares in surplus would
have to be made before the effect on the remaining shares could be
calculated.
In passing from the question of stock values, it should be pointed
out that an undervaluation of stock when issued for property, though
seldom seen in practice, has the refreshing effect of creating a secret
reserve. That is, property values are carried on the books below their
actual values and a secret reserve is thereby created. A further
discussion of secret reserves will follow in a later chapter.
Dividend Stock
Stock is sometimes issued for dividend purposes. In such cases, it is
always issued as of par value. If profits have been earned or a surplus
accumulated out of which a dividend may be declared, that dividend
may be paid in any way the corporation sees fit. Payment may be made
in cash, scrip, or in the shares of the company. If the corporation
has neither unissued stock nor stock in the treasury, permission to
increase its capitalization must be secured before a stock dividend can
be paid. Some corporations, notably financial institutions, often make
it a matter of policy to accumulate a large surplus and then distribute
it by means of a stock dividend. Declaration of the dividend is made
and recorded as usual. Record of the payment in stock is made as a
debit to Dividends account and a credit to Capital Stock.
The effect of a stock dividend is twofold. From the point of view
of the management of the surplus it has the effect of a permanent
investment of the surplus in the business. Thus it places the
accumulated profits beyond the control of any future board of
directors. If left in surplus, a cash dividend might have been declared
and the asset dissipated to that extent. The stock dividend, however,
keeps the profits invested in the business in such a way as not
hereafter to be available for dividends. From the point of view of the
stockholder, upon the declaration of a stock dividend his equity, his
proprietorship in the business, is not in the least affected excepting
that it is divided into more parts; he has more shares to represent
it than he had before. Before he possessed as a community right a pro
rata share in the surplus. Now the ownership of that share has become
personal, individual. Each share of ownership thus has a smaller book
value but each stockholder’s equity is the same as before.
Stock Issued as a Bonus
The manner of recording stock issued as a bonus with bonds or for
any other purpose has been illustrated in an earlier chapter. Here,
attention is called to the effect of such an issue in states where
stock cannot be sold below par. There is no legal bar to the sale of
bonds below par. If, then, the price received for the bond carrying a
bonus of stock is at least equal to the par value of the bonus stock,
there is nothing extra legal in the transaction. However, record must
be made of the issue of the stock at par, the discount or bonus being
carried as applying to the bond.
The valuation of stock issued in effecting combinations or for labor or
services follows along the same general principles as of that issued
for property, and the same general considerations are pertinent.
Unissued and Treasury Stock on the Balance Sheet
When showing capital stock on the balance sheet, it is best to
treat unissued and treasury stock as valuation items. The reason for
this was stated and discussed in Chapter XIV. Here the relevancy of
showing the unissued stock will be considered, as a statement of the
outstanding stock is thought by some to be all that is required. It has
been argued that the unissued stock does not in any sense represent
an asset nor does it show proprietorship. Why not, therefore, leave
it off the balance sheet statement entirely? It is true that an
investor, a creditor, or a stockholder is interested in the main only
in the condition of the business as shown by its present assets and
liabilities. Unissued stock has no value till placed on the market;
all that it shows is that certain legal requirements have been met
authorizing its issue and to that extent it has a contingent value
which may become a real source of capital to the corporation if
additional funds become necessary. While, therefore, the omission
of the item entirely from the balance sheet does not affect present
conditions, it is considered best, in the interest of full information
as to the exact status of the company, to show the amount of the
authorized capital with the amount unissued extended short on the
balance sheet, the difference being the amount outstanding—which is
full-extended as the significant item, thus:
Capital Stock Authorized $1,000,000.00
Less Amount Unissued 250,000.00
-------------
Amount Outstanding $750,000.00
A similar showing of the treasury stock is also considered best,
although good authority can be found for its inclusion among the assets.
Preferred Stock Covered by Redemption Contract
On the border line between liabilities and proprietorship is preferred
stock covered by an unfulfilled redemption contract. Such stock
is issued with a definite redemption contract to become effective
at stated dates, and is manifestly different from preferred stock
redeemable upon call at any time _after_ a named date. In the latter
case the option of redemption is with the company, whereas in the
former case the company binds itself to a contract enforceable at a
definitely stated time. From the financial standpoint the wisdom of
a company binding itself to a contract enforceable some time in the
future may be open to question because of the inability at the time of
issue to foretell the company’s condition at the time of redemption;
although in this respect the condition is practically the same as that
confronting a company at the time of a bond issue. There is this marked
difference, however: A bond issue is always a liability and continues
as such after maturity; but in the case of a stock redeemable at a
given date, the point at issue is whether the failure of the company to
redeem automatically changes the status of the owner of the stock from
that of a proprietor to that of an outside creditor.
“For instance, a corporation sold $750,000 of first preferred stock,
with a provision for the retirement of $150,000 annually after a
certain period had elapsed. When the first instalment became due the
corporation was unable to meet its obligation. There was no provision
in the certificate bearing on the treatment of the overdue payment in
the accounts or the balance sheets. The auditors declined to certify
the balance sheet until a decision was reached as to whether or not
the amount represented a liability to be liquidated as soon as funds
were available. So long as this possibility existed the position of
the general creditors was subject to change. Finally it was decided
to secure an extension from all stockholders and upon satisfactory
evidences thereof the auditors passed the balance sheet.
“No general rule can be laid down for the auditor’s guidance in
such cases as this, as each case must be decided on its merits. The
most important facts for the auditor to ascertain are the rights of
stockholders to insist upon payment, and the aggregates and due dates
of all probable obligations. Their disposition in the accounts is then
a matter of disclosing full information to creditors, prospective
creditors, and to other stockholders.”[51]
[51] Montgomery’s “Auditing, Theory and Practice.”
CHAPTER XXII
PROFITS
Difficulty of Determining Profits
What constitutes a profit is oftentimes a perplexing question and at
all times its determination is more an estimate than an absolute fact.
This arises from the nature of accounting itself in that so many items
of expense are known to exist and must accordingly be provided for but
the amount of such expenses cannot be exactly determined. This is seen
to be true in the case of the provision which must be made for bad
and doubtful accounts and for depreciation of fixed assets and is, of
course, inherent in all problems of valuation. As is proverbially true
of the prescriptions of different physicians for the same malady, so no
two accountants would arrive at the same figure of profit for any given
concern.
Economic Definition
It may be of some advantage at this point to attempt a definition of
profits although to compress the meaning of the word within defined
limits is hardly possible and for this reason the formulation of a
working definition is very difficult. Etymologically, “profit” comes
from the Latin word _proficere_, meaning to make progress, and a better
definition than this would be difficult to find. At the best the term
is an elusive one, being used with slightly different connotations in
different schools of thought. Thus, we find the word used and defined
in economics, law, and accountancy, and some of the definitions are
twisted almost to the point of absurdity. Alfred Marshall,[52] the
English economist, says: “If a person is engaged in business, he is
sure to have to incur certain outgoings for raw material, the hire
of labour, etc. And, in that case, his true or net income is found
by deducting from his gross income ‘the outgoings that belong to its
production.’” Charles S. Devas[53] says: “The income from production
combining both labor and capital is profits.” He defines gross income
as “the total wealth added to the property of a given person in a given
time from _whatever_ source ... and net income as gross income minus
the following items: (a) Destruction, damage, or loss by fire or other
accident, by violence, by thieves, by bad debtors. (b) Using up of
materials in production, and wear and tear of machinery and industrial
buildings such as factories or shops. (c) All sums spent on purchases
of goods that are to serve the purchaser not as subjects of enjoyment,
but as means of getting an income. (d) All sums spent on hire of goods
that in like manner are to serve as means of getting an income. (e) All
payments for labor that in like manner are to serve as means of getting
an income.” One wonders if Marshall’s idea of incomings and outgoings
is limited to a cash basis or if he recognizes accruals. On the other
hand, from the point of view of accounting, Devas includes too much, as
will be pointed out later. E. R. A. Seligman[54] says: “Profits are the
income from business enterprise.... Profits are always a surplus. They
are the difference between the cost of production or acquisition and
the selling price.” He summarizes expenses of production as including
cost of raw materials, wages, rent, interest on capital borrowed
or _invested_, taxes, and miscellaneous outlays such as insurance,
advertisements, and transportation expense. Again, he says:[55] “Income
is that which comes in to an individual above all necessary expenses
of acquisition and which is available for his own consumption.” He
recognizes depreciation as a necessary expense.
[52] In “Principles of Economics.”
[53] In “Political Economy.”
[54] In “Principles of Economics.”
[55] In “Income Tax.”
All of this attests the statement made above that the formulation of a
satisfactory working rule for the determination of net profits, from
the business standpoint, is extremely difficult. It should be said,
of course, that in some respects the idea of net profit as used in
economics differs from that used in business; the chief difference
being that interest on invested capital is in economics looked upon as
an expense deduction before the determination of profits.
Legal Definition
The efforts of the law, as evidenced by court decisions, to mark out
definitely the meaning of net profits have resulted in many odd twists
of terms and meaning. In an English case[56] decided as recently as
1902, this language is used: “If it is a mere question what were the
profits made in a particular year, it seems to me that the duty is to
ascertain what cash has been received and what cash has been expended,
and, if that is fairly done, you know the profits of the year. If
there is a large outstanding liability which cannot be settled, the
partners will estimate that, and it will not be considered as part of
the profits. If there is a large outstanding possible loss, and there
is a large sum due to a client, then you would provide for that. But
in ascertaining what is really actually divisible for the year fairly,
you would take the cash account as it stands.” In the light of such
mental obtuseness and obliquity, one cannot wonder at the occasional
reluctance of business to entrust the determination of important
matters to the courts.
In cheering contrast is a legal opinion quoted by R. H.
Montgomery,[57] in the following: “I should think that no commercial
man would doubt that this is the right course—that he must not
calculate _net profits_ until he has provided for all the ordinary
repairs and wear and tear occasioned by his business. That being so,
it appears to me you can have no net profits unless this sum has been
set aside.... If you had done what you ought to have done, that is, set
aside every year the sum necessary to make good the wear and tear in
that year, then in the following years you would have a sum sufficient
to meet the extra cost.” Even here confusion is apparent between a
valuation reserve and a reserve which has been funded and the emphasis
is rather on the point of providing funds necessary for the purpose—a
financial problem as distinguished from an effort to define net profits.
[56] Badham v. Williams.
[57] In “Auditing, Theory and Practice.”
Between these extremes of legal opinion and phraseology one finds all
shades and degrees of understanding and misunderstanding. In recent
years there is evident in the decisions of our higher courts and of our
many excellent governmental commissions and bureaus a real appreciation
of some of the technical points involved in profits determination.
It is believed that a body of authoritative decisions will in time
and perhaps soon reflect the best opinion of the business men of the
country.
Accounting Definition
The purpose of this chapter is to discuss some of the points at issue
in this vexed problem, but before entering upon this discussion it will
be of advantage to quote from leading authorities on the attitude of
accountants towards the determination of profits.
A. Lowes Dickinson[58] says: “In the widest possible view, profits
may be stated as the realized increment in value of the whole amount
invested in an undertaking; and, conversely, loss is the realized
decrement. Inasmuch, however, as the ultimate realization of the
original investment is from the nature of things deferred for a long
period of years, during which partial realizations are continually
taking place, it becomes necessary to fall back on estimates of value
at certain definite periods, and to consider as profit and loss the
estimated increase or decrease between any two such periods.” It is
in the making of these estimates that the most difficult problems of
profits determination are met.
[58] In “Accounting Practice and Procedure.”
Mr. Montgomery in his dictum, “The net profit of a business is the
surplus remaining from the earnings after providing for all costs,
expenses, and reserves for accrued or probable losses,” offers the best
available working definition, although a caution is needed against the
danger of relying exclusively upon any one definition.
Methods of Determining Profits
Systems of bookkeeping, in the main, provide two distinct methods for
the determination of profits, namely, by means of single entry and
double entry. The student is referred to the author’s first volume
for the detailed working out of profits by single entry. Here it is
sufficient to say that the determination of profits rests upon a
comparison of assets and liabilities as at the beginning of a fiscal
period, with those as at the end of the period. Then the increase or
decrease in net worth as so determined, after making due allowances
for any withdrawals or investments of capital during the period,
constitutes the figure of net profit or loss for the period. The
disadvantages and inaccuracies inherent in this method have already
been pointed out.
The method of determining profits by means of double entry provides an
entirely distinct set of accounts known as temporary proprietorship or
profit and loss accounts. These record the daily changes in net worth
and must be summarized through the Profit and Loss account at the close
of the fiscal period, at which time they must prove against the profits
as determined by the balance sheet, the method of which is essentially
the single-entry method. In addition to this control secured by
checking the results obtained by one group of accounts against those
of another group, is the important advantage of presenting in the
record a mass of statistical information for guidance in the conduct
of a business, without which the present-day enterprise with its many
complexities of organization and working could not hope for any certain
measure of success.
The Problem a Question of Valuation
Inasmuch as every profit made must be reflected in a corresponding
increase of some asset or the decrease of a liability, and, conversely,
every expense incurred is reflected as a decrease of assets or increase
of liabilities, it is apparent that profits determination is largely a
question of the valuation of assets and liabilities and therefore rests
upon the principles already established. Thus the amount of _gross_
profit is not determinable until the value of the stock of merchandise
on hand is known. Gross profit rests on inventory valuation, whether
that be accomplished by the perpetual inventory method or that of
periodic stock-taking. While under the double-entry system the charges
for expense are more or less fixed and certain and not so dependent
on inventory, it has been seen in Chapters XIV and XIX that before
accuracy can be secured, here too there must be an inventory or
appraisal to determine the prepaid and accrued expense items. The
basis for valuing these was indicated in the chapters referred to.
Estimates of depreciation, bad debts, and other similar items must
also be made to secure a proper appraisal of the corresponding asset
items. Similarly, in the determination of other income, accruals and
prepayments must be taken into account. In the making of the record
of temporary proprietorship data, the fundamental distinction between
capital and revenue charges is vital and must be kept constantly in
view.
Thus the problem of profits is seen to be in its broader aspects the
same problem of valuation to which attention has already been directed.
It is purposed here to point out the application of the valuation
problem to the periodic determination of profits and to re-examine some
phases of the problem from the standpoint of profits as distinguished
from that of assets.
Effect of Asset Losses on Future Profits
The first question for discussion may be stated as follows: In the
determination of _periodic_ profits must all the data which have
affected proprietorship during that period be summarized in order to
make a proper showing of profits for the period? An illustration will
better present the issue. A manufacturing concern with plants in many
places suffers a heavy loss from fire. Must this loss be considered (1)
as an expense applicable to the current period and to be taken account
of before the determination of profits for the period; or (2) may it
be treated as a deferred expense to be shared by several succeeding
periods; or (3) may it be charged directly against capital?
Three somewhat different solutions are thus presented. The first treats
the loss as a _temporary_ proprietorship charge; the second as a
deferred charge to operation and so includes the portion deferred among
the assets and to this extent does not reflect the loss as a diminution
of net worth; and the third treats the loss as a charge against
_vested_ proprietorship.
Any adequate treatment of the question requires a consideration of
(1) the type of business organization, i.e., single proprietorship,
partnership, or corporation; (2) the appropriation of profits, whether
they are to be withdrawn or reinvested in the business; and (3)
the nature of the loss, as to whether fixed or current assets were
affected. The practical aspect of the problem is the adoption of a
policy not in contravention with the law, and in the determination of
this phase of the subject there are some court decisions none of which,
however, seem entirely trustworthy.
It must be borne in mind that in the types of organization known
as single proprietorship and partnership, there is little legal
restriction in their formation and operation. The law presumes
that the full liability of the owner or owners offers sufficient
protection to creditors. Hence the withdrawal of profits or capital
is not safeguarded in any way in the interest of creditors. With the
corporation, however, provision is specific that nothing shall be
returned to the stockholder except profits so long as the business
continues in operation. Exception here is usually made for those
concerns operating assets which are subject to depletion, in which case
it has been held that dividends may include a return of the depleted
portion. The theory of the law is that, except as just indicated,
the capital of a corporation is an _indication_ to creditors of the
amount by which the assets may suffer shrinkage and their claims still
be protected in full. Hence, the return of capital in the form of
dividends is not allowed, as that would impair the margin of safety for
creditors.
From the practical standpoint, therefore, the problem concerns only
the corporate form of organization and that only in its relation
to dividend payments. So long as the profits are reinvested in the
business, neither creditors nor owners have any cause for action,
except in case of fraud.
Legal Decisions as to Asset Losses
In decisions relating to this question of asset losses, the courts
have seen fit to make a distinction between what they term fixed and
circulating capital, corresponding in the main to the fixed and current
classification of assets for the balance sheet. In the leading English
case,[59] it was held that a trust company holding stock, which during
the last business year paid 50 per cent dividend but which before the
end of the year became utterly worthless, may include the 50 per cent
in its yearly profit, without deducting a penny for the depreciation
of the property from which this profit was derived. In the language of
the court Lord Justice Lindley said: “Fixed capital may be sunk and
lost and yet the excess of current receipts over current payments may
be divided. But floating or circulating capital must be kept up, as
otherwise it will enter into and form part of such excess (seeing that
circulating capital, with the particulars of its purchase and sale,
must appear in revenue account), in which case to divide such excess
without deducting the capital which forms part of it will be contrary
to law.”
[59] Verner v. General and Commercial Investment Trust, Limited, 2 Ch.
239 (1894).
The stock held by the trust company was for permanent investment and
therefore in the nature of a fixed asset. The language of the court is
quite specific and there would seem to be no _need_ for including all
or any portion of the loss in the current statement of profit and loss.
Other later decisions have somewhat extended the doctrine so that it
has been held that the current profits may be determined without making
any provision for a loss, even of circulating capital, occurring in a
_previous_ year. Thus it would seem that so far as the _legality_ of
profits determination is concerned, each fiscal period may be counted
as entirely free from liability for the happenings in other periods—a
unit of business history distinct from all other units. These decisions
are English cases and have not always been followed in this country.
For a statement of the prevailing opinion in this country, see page 443
of Chapter XXIV, “Dividends.” The danger of the position is apparent.
In the hands of unscrupulous managers the profit and loss might be so
manipulated that alternate years would always show profits in spite of
the fact that the company’s capital was constantly being depleted.
Loss Charged against Current Profits
In stating the question on page 393, three alternatives were presented
by way of solution. The first of these suggested that the entire loss
be treated as a charge against the profits of the current period.
It has been seen that there is no support in law for this method of
handling the loss, nor is there any need or justification for it from
the standpoint of correct accounting theory. Only such losses as
occur more or less regularly and which within the experience of the
business can be fairly accurately estimated, are proper charges to the
current period. It is not the function of the periodic profit and loss
statement to reflect charges covering contingencies which with almost
equal certainty may or may not materialize.
Loss Treated as Deferred Expense Charge
The second solution suggested, viz., that the loss be treated as
a deferred expense to be shared by several succeeding periods, has
much to commend it and little to condemn it, except a possible lack
of business foresight as will be evident when the third solution is
examined. It may be argued, and with a good show of reason, that such
losses are so infrequent, occurring perhaps only once or twice in the
life of any business, as to make it unfair as between periods to burden
some with a charge of this sort and not all. For comparative purposes,
the spreading of the loss over several periods will tend to obscure the
true state of operations for those periods, although that is largely
a matter of the way in which results are presented. The situation is
relentless, however. If it is desired to recoup the loss in order not
to show an impairment of capital, the loss must be charged in its
entirety or piecemeal against profits. If there are no accumulated
profits against which it can be charged in its entirety, it must be
charged piecemeal against current profits.
Loss Charged to Capital
The third solution suggested that the charge be made directly against
capital. Without the limitation as to the policy of recouping the
loss mentioned above, this solution may take two somewhat different
directions. If a surplus has been accumulated out of previous profits,
such surplus constitutes a part of the capital and provides the logical
place for setting up the charge. If no surplus is available, the
loss must be charged against the capital stock, thus constituting an
impairment of it. In either case, the results of the current period’s
operation are not affected, except in so far as a diminution of the
assets may have made necessary a curtailment of operation. Of course,
the charge against the capital stock, whether made direct to the
account or carried in a separate account, does not automatically bring
about a reduction of the capital stock; that can be accomplished only
by legal process and is often shunned because of the difficulties
incident thereto and also because of a possible reflection on the
concern’s credit occasioned thereby. The charge does indicate a
reduction in the value of the shares outstanding. Since there is no
compulsion in law and there may be no need from a business standpoint
that the loss be recouped, undoubtedly this third method offers the
best solution both practically and theoretically.
That this is so is brought out clearly by H. R. Hatfield’s almost
classic illustration:[60] “An individual’s entire income is derived
from ten houses each worth $10,000 and each yielding 10 per cent
net income. If two of these houses burn down, uninsured, the common
sense view is that the proprietor’s income is thereby cut down from
$10,000 to $8,000 per annum, and that coincidentally, there is a loss
of capital of $20,000. It never occurs to him that he must consider
his income as entirely cut off for two years until the principal can
be restored. Similarly it might be an act of cruelty to dependent
stockholders to stop dividends entirely until an exceptional loss
is reimbursed. The main difficulty is that in a corporation such an
occurrence really calls for a reduction of the nominal capital, a
cancellation of part of the capital stock.... The criticism properly
to be made is not so much that dividends are paid before restoring the
capital ... but rather that the capital stock has not been reduced to
correspond with the amount of remaining assets, before the dividend is
paid.”
[60] In “Modern Accounting.”
It should be stated that this criticism is of little real weight if
the balance sheet shows the true condition of the business. Carrying
the loss as a part of the assets, particularly if clothed with a title
the meaning of which even a code expert could but lamely guess at, is
to be condemned. If, however, the title clearly indicates the nature
of the item, the situation is not so bad, although it does reflect
the slavery to form which compels some very well-meaning individuals
to show impairment of capital on the asset side of the balance sheet
for the sake of making it _balance_. The best practice compels the
showing of impairment items as direct deductions from capital. The
carrying value of the asset destroyed must, of course, be reduced to
accord with the facts of present value, and, if there is no surplus
available, the amount of the loss should be shown as a deduction from
the capital stock outstanding, short-extended, with the present capital
full-extended, somewhat as follows:
Capital Stock Outstanding $1,000,000.00
Fire and Earthquake Loss resulting
in impairment $250,000.00
-------------
Net Capital available for the business $750,000.00
Profit on Work in Progress
A second problem to be solved in the determination of profits is
concerned with the allowance or non-allowance of profit on work in
progress but not completed. Most manufacturing and contracting concerns
have at all times a more or less constant volume of work in various
stages of completion. At the close of the fiscal period when results
are summarized, the proper treatment of this uncompleted work is an
important matter. The general principles governing the valuation of
this work were discussed in Chapter XIII where it was pointed out that
in the main conservative business policy demands that work in progress
be included in the inventory at full cost, which is to include both
prime cost and an equitable share of burden accrued to date. Manifestly
this principle precludes the taking of any profit, the theory being
that there is no profit until goods are sold. A full discussion of the
subject requires separate consideration of work which is being done on
order or contract and work for the concern’s own stock-in-trade, due
weight being given always as to whether the unit of work is large or
small.
Goods Made for Stock but not Sold
The general principle mentioned above must usually be applied to
the valuation of the concern’s own stock-in-trade in process of
manufacture. Here sales are being made constantly from finished stock
and manufacture replenishes the stock. But the essential step before
profits can be claimed, viz., making the sale, usually comes after the
process of manufacture and not before. It may sometimes happen that
stock is sold out ahead of its manufacture, because the factory is not
able to keep up with sales. It is not intended here to include the case
in which it is the custom of the trade to sell goods in advance of
their manufacture and regulate the operation of the factory to turning
out the advance orders booked. This will be considered later. The
discussion here concerns those firms which usually keep their finished
stock well ahead of sales but because of the exigencies of the market
find themselves behind their sales. Such a situation is sometimes
called a sellers’ market. If purchasers contract for goods with full
knowledge of factory conditions, such sales are in the nature of work
on contract and might in unusual instances be so treated. Usually,
however, conservative management requires that no profits be taken
under such circumstances.
Goods Made to Order
Where the factory works only on order, conditions as to profit-taking
are somewhat changed. Here, the sale has already been made for
delivery of the product at some future time, named or left indefinite.
While, of course, cancellation of the order is always possible before
date of delivery and acceptance, inasmuch as here we have under
consideration a special product made to individual specifications and
not a stock or standardized article, cancellation of the contract
is not probable without incurrence of damages or even being held to
specific performance. Under these circumstances it is apparent that,
within reasonable limits, a portion of the profit may be taken up in
the current period, which has, of course, done a portion of the work
and therefore earned a portion of the profit, if there is one. This
last contingency is, of course, the crux of the whole problem. If a
portion of the profit is taken, this necessitates a predetermination
of profit on the whole contract, an estimate of the portion of the
contract completed, and adequate provision for unforeseen difficulties
in completing the work. Where conditions are such that these things can
be done with any degree of certainty, there is not only no objection
to taking up a portion of the profit for the current period, but it is
the only way in which profits may be allocated to the period earning
them and so stabilized somewhat as between periods. As has been said
already a number of times, the summary of results at the close of
regular periods is in many cases based on _estimate_, which in the
final analysis is merely the expression of an opinion. If the estimates
are made with due care, in the light of all available information and
probable contingencies, and without intent to deceive or defraud, more
than that cannot be asked of any concern.
The practical application of this principle requires consideration.
In some few cases the volume of product passing through the factory
will be fairly constant as between periods. Where this is so—and
frequent tests should be made to establish it—it would be a useless
expenditure of effort to make the estimates necessary for determining
profits on uncompleted work. The same situation is met with also in
concerns where the unit of work is small. Here the effort, entailed
in making the estimate is more than offset by any advantage gained
thereby. If the product is somewhat standardized, it may be possible as
a result of past experience to make a rough estimate on the basis of
the _volume_ of work in progress instead of by means of an examination
of the conditions of each contract. Such a policy is fraught with many
pitfalls and, as a usual thing, does not commend itself to conservative
management; speculative conditions are too many.
Profits on Long-Term Contracts
Where the unit of work is large, conditions are somewhat different,
however. The necessary estimates are not based on so many
uncertainties, and, oftentimes, financial considerations and an
equitable treatment of stockholders demand the determination of profits
on work in progress. Thus, one contract extending over a number of
years may occupy the entire attention and facilities of a concern. To
withhold profits if earned, until the completion of the contract might
work a real injustice. Such contracts are usually financed by means
of periodic payments on account, based on a careful estimate by the
supervising engineer or architect of the portion completed on such
dates. As these estimates are sufficiently accurate on which to base
payment of contract price, they can be allowed to serve as the basis
for a determination of profits after liberal reserves for contingencies
are made.
The nature and terms of the contract itself will usually indicate the
method of estimating the profit. If the price agreed upon is for the
contract as a whole, then extraordinary care must be exercised in
estimating the portion completed and almost a seer’s prevision of the
requirements to complete is needed. If, on the other hand, the contract
is broken into smaller units on which price is based and there is no
guarantee as to the number of units in the contract, profit may be
taken on the number of units completed. Thus, a contract calling for
excavation of earth or other material may be taken at a named price
per cubic yard. The building of a canal, the driving of a tunnel, the
construction of a dam and reservoir, are frequently handled on this
or a similar basis. So, also, the use of a concern’s equipment and
organization on a per diem basis. Under these conditions each fiscal
period can safely take its profits or losses with little regard for the
uncompleted portion of the work. Contracts taken on a so-called “cost
plus” basis, i.e., at cost plus a definitely agreed upon per cent of
profit, may have their profits determined without consideration of the
uncompleted portion.
Profit on Goods Awaiting Delivery
Similar to the problem of profits on work in progress is that of
profits on goods awaiting delivery. The goods have been sold, are
completed, and may even be prepared for shipment. All that remains is
delivery and that cannot be effected until the date agreed upon. In
some lines of trade this method of sale is a time-honored and even
necessary custom. The practice is found in some kinds of clothing
industries, woolen manufactures, farm implements, etc. Here because
the product is a standard product, cancellations take place and are
usually allowed right up to, and in some instances beyond, the date of
shipment. Because of this trade practice, profits should never be taken
until delivery has been effected. To a similar or even greater extent
than with work in progress, costs and expenses are under this principle
incurred and charged in one period and the profit is taken in another
period which is not thus charged with the cost of getting the income.
Two methods of handling the difficulty are met. The one operates on
the expectation that the volume of such orders awaiting delivery is
fairly constant as between periods; hence, the income from goods of
this sort delivered during the current period is charged with the costs
and expenses of goods to be delivered in future periods. This is the
rule-of-thumb method to be used where accurate allocation of costs is
neither necessary nor justified by results.
The other and more accurate method consists of deferring the costs and
expenses properly applicable to the deferred income. But the difficulty
of determining just what expenses are so applicable often causes this
method to break down, giving less accurate and dependable results than
the first. The roseate optimism of the average proprietor or manager as
to his own business almost always results in a too liberal estimate of
the portion of expense to be applied against the deferred income. In
treating this problem of profits in connection with contracts and the
length of the cost period (Chapter XIII), the principle was stated that
such goods should be included in the inventory at cost. This results
in deferring the main item of cost, but omitting the further costs
of selling and administration which belong to all sales effort made
and to the progress of the order up to the point of delivery. While
theoretically these should be deferred, practically the estimate of
the amount to be deferred should lean on the side of too little rather
than too much. Where, as stated above, the volume of this kind of trade
is fairly constant, the rule-of-thumb method first stated gives more
satisfactory and safer results.
Interdepartment Profits
The problem of interdepartment profits was stated and discussed briefly
in Chapter XIII, page 233, and will later be treated in another
connection (see page 607 following). Here, it may be repeated that
while such profits are not to be allowed because they are not yet
realized, they may, under exceptional circumstances, be estimated and
shown if offset by reserves of an exactly equal amount.
Profits Due to Appreciation of Assets
The problem of profits due to appreciation of assets, both fixed
and current, has also been handled in the chapters on valuing the
various assets. All that need be said here is that such profits are
not realized until the asset is sold. While for purposes of credit it
may be wise and proper to show the true valuation of the assets, for
the purpose of profits, particularly profits available for dividends,
such appreciation in values must not be taken into account. It should
be remembered that appreciating the value of fixed assets frequently
results in the necessity of meeting higher depreciation charges and
is thus not an unalloyed gain. The payment of dividends based on
such profits would, without taking profits from other sources into
consideration, always result in the diminution of the fund of working
capital.
Capital Profits
There remains a final problem, viz., that of capital profits, which
is more a question of their disposition than determination. When any
of the fixed assets are sold, the profits, if any, are classed as
capital profits. These are as legitimate as those arising from sale of
stock-in-trade or other source, and belong to the owners. The question
of their disposition hinges mostly on practical considerations. If
the sale is for cash, funds are available for distribution without
encroaching upon the working capital. If not for cash, payment of
dividends based on such profits might seriously diminish working
capital. The question as to whether capital profits should ever be
distributed is, of course, a mooted one. Many well-known cases of such
distribution—the so-called cutting of juicy melons—are on record.
Conditions seem to justify their payment at times, and under other
equally impelling conditions distribution of them should not be made.
As a general policy it is always safe to set aside such profits in a
special reserve to be used to care for capital losses. If the company
is well provided with such reserves beyond any reasonable doubt, it
is oftentimes unwise and unjust to withhold their distribution. Of a
similar nature and to be handled under like considerations are the
profits arising from sale of capital stock at a premium, the reissue of
forfeited stock, etc.
In concluding this subject no better summarization of the accounting
principles and practical considerations to govern in the determination
of profits can be given than the following from A. Lowes Dickinson:[61]
[61] In “Accounting Practice and Procedure.”
“1. All waste, both of fixed and circulating assets, incident to the
process of earning profits by the conversion of circulating assets must
be made good out of the profits earned.
2. Profits realized on sales of fixed assets should be first applied
to make good estimated depreciation (if any) in other fixed assets not
resulting from the ordinary conduct of the business. If there is no
such depreciation, such profits may be distributed as dividends, but
should be distinguished from the operating profits.
3. A sufficient surplus should be accumulated (in addition to the
provisions required to maintain wasting capital assets) for the purpose
of making good losses due to shrinkage in values of fixed assets
arising from causes other than the ordinary operations of the company.
This provision must, however, be considered more a question of policy
than a requirement of sound accounting.”
CHAPTER XXIII
SURPLUS AND RESERVES
Definition
Under the corporate form of organization, “surplus” in its broadest
sense represents the difference between the net worth of the business
and the capital stock issued and outstanding. Because of the legal
requirement that the value of the capital stock be shown always at
the original amount—which is usually par—any increments or decrements
in value because of profits or losses made and reinvested in the
enterprise must be shown under separate heads. Thus surplus—or
deficit—is the general term to indicate this increase in value. In
England the term “rest” is used in almost this same sense. “Margin” is
also a title occasionally seen.
Because of a much narrower technical meaning given to surplus, the
general adoption of another term with the broader connotation above
given would serve a really useful purpose. Of the titles in use, margin
seems best to express the exact shade of meaning. In the interest of a
standard terminology, the highest accounting authorities are coming to
restrict surplus to that portion of the margin available for dividends
and in that sense the word will be used in this chapter. Contrary uses
of the word are frequently met. In banking institutions the surplus is
almost as inviolable as the capital stock itself and is never used for
dividend purposes. In government-controlled or supervised institutions,
these special uses of the term have become too well established by
law and custom ever to hope for a change in the interest of general
uniformity.
Creation of Margin
The sources of the margin have for the most part been already
indicated. The chief source is the net profit for the period as
determined by the Profit and Loss account balance. What enters into
that balance has been discussed in Chapter XXII, where it was also
pointed out that under some circumstances it may be entirely legitimate
to carry some temporary proprietorship items directly to a vested
proprietorship account instead of by way of the summary account. Thus
there may be other sources of margin than the current balance of Profit
and Loss—extraordinary items whose inclusion with current summaries of
operation would render those summaries useless as a guide for judging
comparative results of various periods.
_Capital Stock Premiums._ Sometimes, for the purpose of creating a
margin at the inception of an enterprise a fund is contributed beyond
the par value of the capital stock issued. This is accomplished by
purchase of the stock at a premium, and is frequently seen in banking
institutions, where it serves as an easy and speedy way to satisfy the
law’s requirements for the accumulation of a “surplus.” The effect
of this is to give the institution a better standing than it would
otherwise have. The reduction of the capital stock outstanding without
full recompense to the stockholder also results in the creation of
margin. This is often done in reorganizations when fewer shares of the
new stock are given than were held of the old. The effect, then, is to
set up a book profit against which may be charged the existing deficit,
and so secure a balance between the real net worth and the par of the
new stock issue.
_Stock Donation._ Another source of margin is a stock donation. This
may result in only a book profit. It is exceedingly difficult and
generally impossible to determine the true value of many speculative
ventures, such as mining enterprises. As a general rule, capitalization
based on opinion is usually overcapitalization. While a stock donation
may have no relation to real values and is merely a method of securing
working capital, its effect when the stock is sold is to increase the
cash asset and show a profit of an equal amount. Some authorities hold
that instead of retaining the profit on the books, the logical thing
is to reduce the carrying values of the speculative assets by the
amount of the realized profit on stock donation. There would be more
reason for this treatment were there any real relationship between the
amount of the stock donation and the overvaluation of the assets. Since
usually there is none and the whole undertaking is speculative, there
is no valid objection to showing the realized profit, as the public is
sufficiently warned by the nature of the enterprise. All stock donation
is not of this sort, however. Occasionally a very real profit results
which should be treated as a margin item.
_Stock Assessments, etc._ Similar to a stock donation is a stock
assessment. In cases of reorganization or of impending bankruptcy,
a pro rata assessment is levied on the outstanding shares. Being a
donation, it constitutes a proprietorship increase item and becomes
a part of the margin. This method is frequently used for the purpose
of wiping out a deficit, an impairment of capital, and is, of course,
a _real_ profit as distinguished from a _book_ profit. Similarly,
additional payments made by common shareholders to convert their
holdings into preferred shares are a realized profit and should be
recorded as part of the margin.
_Capital Profits and Bonuses._ Capital profits, as discussed in
Chapter XXII, have their proper place of record direct into some margin
account rather than by way of the current Profit and Loss. Donations
from the outside, such as factory sites and other bonuses, sometimes
given to induce enterprises to locate in certain places, must also be
treated as entries direct to a margin account. These and other like
items constitute the chief sources of the margin.
Disposition of Profits
The statement of profit and loss carries the summary of operations to
the point of showing a net profit or a loss for the period. The next
step for consideration is the disposition made of these profits. This
is sometimes spoken of as the appropriation of profits. Two practices
are met at this point. Under the one, appropriation is made directly
from Profit and Loss for all desired purposes. Any unappropriated
balance goes into Surplus account, which will represent the balance
of profits available for dividends but not used. Under the other, the
Profit and Loss balance is transferred to Surplus out of which all
appropriations are made, the residue remaining therein showing the
same condition as under the first method. Where this second method is
followed—and it is more prevalent than the first—a statement of surplus
is needed for full information of the period’s transactions, thus
providing a connecting link between the statement of profit and loss
and the balance sheet. The form of this statement is given on page 426.
Reserves
From the point of view of the stockholder’s immediate interest,
the appropriation of profits for dividends is his chief concern.
Other and equally vital and urgent uses are found for profits in any
well-managed concern with an expanding outlook towards the future. The
appropriations of these profits to definite uses are very generally
carried under the title of reserves with suitable descriptive phrases.
Thus we may have a Sinking Fund Reserve, an Insurance Reserve, a
Building Fund Reserve. Sometimes these are called “reserve funds” but
the demands of an accurate nomenclature limit the use of “fund” to
an asset account. The title “undivided profits” is also met. Where
careful differentiation is made, “surplus” should be used to denote
profits available for dividends; “reserve,” for profits set aside for
a specific purpose; and “undivided profits,” for those on which no
definite action has been taken.
Different Meanings of Reserve
Because of the loose way in which the term reserve is used by the
layman and its different uses by the professional accountant, an
examination of these uses will be made at this point. As a distinctive
banking term, “reserve” is used to indicate the amount of cash and cash
items on hand and on deposit which under the law may be counted as a
cash reserve fund held against deposits and note issues. This use of
“reserve” is limited strictly to financial institutions.
We find also various so-called reserves shown on the commercial balance
sheet, both among the liabilities and the assets. As deductions
from the assets are the various depreciation reserves and reserves
for bad and doubtful accounts and notes receivable. These items are
“offsets” to the carrying values of the assets in order to effect a
true valuation of them. For reasons previously set forth, these offsets
are carried in accounts separate from their corresponding assets.
Thus they are in the nature of suspended credits to asset accounts
and, if properly estimated, are in no sense related to profits; nor
have they any of the elements of profits or proprietorship in them.
It is unfortunate that there is lacking an adequate title, other than
reserve, for this group of items. The terms “allowance” and “estimate”
have been suggested, but so far have not found general favor. This
group of reserves are called valuation reserves.
Reserve for Bad Debts
A fine distinction is sometimes drawn between the reserve for
depreciation and the reserve for doubtful accounts, on the ground
that at the time of the creation of the reserve in the one case, the
depreciation is an accomplished fact, all that is then required being
a fair estimate of it; whereas in the other case no _particular_
account is known to be uncollectible, business experience teaching,
however, that in the aggregate there will be some loss from this
source. The purpose of this reserve is to bring about as on a given
date an appraisal of the claims against customers in the light of past
experience, and so apply the expense due to this cause to the period
in which the sale transaction took place. This purpose is not always
accurately accomplished but the estimate at the close of each period
does effect an equalizing of the bad debts expense from year to year.
This distinction makes the reserve for doubtful accounts closely
approximate to a contingent reserve, as will be seen later. It seems
best, however, to hold to the original classification and include the
bad debts reserve with the other valuation reserves.
Under-and Over-Estimate of Reserves
Inasmuch as these reserves must from the nature of things always be
estimates, the probability exists of an under-or over-estimate. It
is apparent that an under-estimate effects an inflation of profits
due to an overvaluation of the assets. Equally apparent is it that
an over-estimate brings about an understatement of profits due to
an undervaluation of the assets. The effect of this is to make the
valuation reserve account a mixed account. Instead of its content being
solely a suspended credit to an asset, it includes also a true reserve
of profits. If at any time the facts indicate a too liberal or too
parsimonious estimate in the past, adjustment should be made to accord
with the newly determined facts of experience. An immediate adjustment
is usually preferable to a gradual one effected by an allowance below
or above the new basis determined for the estimate.
Depletion Reserves
Similar to the depreciation reserve is the depletion reserve. On
the basis of the value at which the wasting or depleting asset was
originally brought upon the books, a periodic estimate of the portion
used up in operation is necessary to show the true present value of the
asset. Thus, timber and mining properties require for their periodic
appraisal an estimate of the extent of exhaustion of the natural
product. This is neither required by law nor always by business policy.
But when the estimate is made it is in the nature of a valuation
reserve and will be so classed here.
Operating Reserves for Accrued Costs
Another group of items, frequently carried under the title reserves,
includes estimates of expenses the exact amount of which is not known
at the time of closing the books, and sometimes those of which the
exact amount is known but which are unpaid as on that date. Among the
first are such items as taxes, sales discounts, and the like. Among the
second are wages, salaries, rents, etc., accrued. These two classes are
together sometimes called “operating reserves.”
There is some difference of opinion with regard to the proper
allocation of taxes and estimated sales discounts. Inasmuch as taxes
are not usually determined, or at least payable, during the period
covered by them, there is a temptation to defer their incidence to a
later period. If the taxes become a claim of the state against the
property as on a given date, certainly they should be treated as
applicable to the period covered by the claim even though the amount of
them cannot with accuracy be determined.
With regard to sales discount, the situation is somewhat analogous.
At the close of any fiscal period, some of the open claims against
customers are by the sales contract subject to discount, and experience
proves that some of these discounts will be taken advantage of. Here
also, difference of opinion prevails as to the proper allocation of
the expense. Should the period in which the sale is made suffer the
loss, or should it be charged to the one in which the discount is
taken? If sales discount is looked upon either as a direct deduction
from sales or as a selling expense, certainly it should be charged to
the period making the sale. On the other hand, if it is regarded as an
item of financial management, a means of securing ready funds, it is
sometimes argued (though this is not the usual point of view) that the
period enjoying the benefit should also be charged with the expense of
securing the benefit. Against this argument it may be pointed out that
the current period carrying the customers’ accounts which are subject
to discount fails to show its liability, based on the sales agreement,
to accept something less than the face amount of the claims. A balance
sheet in which no suitable provision is made therefor is one which
does not reflect the true status of all items, and to that extent is
not a good balance sheet. Provision should be made not only for those
expenses which are known to have been incurred and which remain unpaid,
but also for those which the statistics of experience show will have
to be met. Conservative practice, therefore, requires the inclusion
of this estimate and applies it as an expense of the period in which
the originating transaction took place. All the costs of the contract
entered into, of which expected sales discount is one, are made to
apply to the period giving rise to the contract.
Collection Costs not under Contract
The above argument is occasionally made use of in support of the
inclusion of expected collection costs on claims against customers
outstanding at the close of a period. From a theoretical aspect the
point may be argued, but, unlike the item of sales discount, these
are not costs which the concern is liable for _under contract_. From
a practical standpoint, except under very unusual conditions, it is
an undesirable refinement of the principle of allocation of costs as
between periods. Where a collection department is maintained, costs of
collection are practically uniform from period to period and are best
considered as expenses of the period in which the cost is incurred.
Sales Discounts on the Balance Sheet
As to the manner of showing expected sales discounts on the balance
sheet, practice is not uniform. It is sometimes shown added to
the reserve for doubtful accounts and the sum of the two deducted
from claims against customers, indicating thus the amount which it
is expected can be realized therefrom. Others show it among the
liabilities, on the ground that it differs from the estimate for bad
debts in that it is an expense for which the concern has made itself
liable under its sales contract. The distinction is finely drawn but
probably well taken.
Distinction between Reserves and Accrued Items
The use of the title reserve for some of the items included as
operating reserves is unfortunate and leads to confusion both in
terminology and in understanding. Why unpaid expenses of any kind
should be called reserves for expenses when the amount of them is
definitely known has never been satisfactorily explained; yet the
practice is sometimes met. There is some excuse in the case of expense
items the amount of which cannot be definitely determined either
from the nature of the item itself or other conditions over which
the concern has no control. Thus, “Reserve for Wages” is usually a
misnomer, the title “Wages Accrued” showing the item correctly; but
“Reserve for Taxes,” while just as true a liability as the other item,
may be justified on the ground that the latter is only an estimate
subject to correction when the exact amount is known, whereas the
former is already definitely known.
Contingent Reserves
So-called contingent reserves are sometimes handled as a part of this
group, although best classified by themselves. A contingent reserve is
one which represents an effort to provide for certain contingencies,
such as guarantees on work done or products sold, lawsuits pending
adjudication, etc. As R. H. Montgomery[62] so pertinently says: “the
reserve should be based on evidence more tangible than a mere desire
to be conservative. A vague feeling that something might have been
overlooked which would decrease the assets or increase the liabilities
is not the proper subject for a reserve. Conservative management
‘reserves’ part of its surplus for such contingencies, but it appears
as surplus and not as a liability.” As mentioned above, sometimes the
reserve for bad debts is classed as a contingent reserve. Contingency
is inherent in the item but the certainty of its occurrence cannot be
reasoned away. The use of contingent reserves may therefore well be
limited to provision against contingent liabilities. In other words,
they represent the best available estimate of the amount of such
liabilities. To draw a dividing line between operating and contingent
reserves is extremely difficult; both are created by charges to various
expense accounts. It is merely a matter of degree as to the certainty
of the events’ happening for which provision is being made. On the
border line between the two are such items as reserves for insurance
where the concern carries its own insurance and must make a periodic
expense charge in lieu of the usual premiums; reserves for pensions
where a pension policy is in effect, the charge creating it being here
viewed as a part of the wages expense—the share of wages to be paid in
the future which must be borne by the current period; reserves for sick
benefits, which are in all respects similar to pension reserves; and so
on. In some cases reserves for supersession of patents, or other assets
whose length of service life is dependent on extreme contingency, are
classed with this group.
[62] In “Auditing, Theory and Practice.”
Deferred Income—Misuse of Term
Deferred income is sometimes classed as a reserve. Thus, insurance
companies carry the portion of their unearned premiums as on a
given date, as a reserve. The use of the title is well established
in that connection and the nature of the items is well understood.
On commercial balance sheets where no outside authority can give a
definite meaning to the term, its use for deferred income is to be
deprecated and discouraged. Deferred income is a liability and not a
reserve; the current period has not rendered the service to earn the
income and is liable to the period in which the service is rendered.
Proprietorship Reserves
This disposes of all the asset and liability reserves and leaves
for consideration the true profits or proprietorship reserves. As
between these two main classes of reserves, as their titles indicate,
the proper allocation of the one is among the assets or liabilities,
while the other must be shown as a part of the net worth of the
corporation. As to the nature of proprietorship reserves little more
need be said. There are just two classes of items met here, viz., those
shown as such openly on the balance sheet and those which are hidden
or secret, latent among the various other items on the balance sheet.
Proprietorship reserves represent profits reinvested in the business.
Any profits, operating or capital, not paid out as dividends give rise
to proprietorship reserves.
Secret Reserves
So-called secret reserves are brought about in various ways. Their
creation may be intentional or accidental, but their source is the
same in either case. Reserves of profits may be hidden either by
undervaluation of the assets or overvaluation of the liabilities.
Undervaluation of the assets may point to an ultra-conservative policy
of management. Thus, some concerns write off the value of their fixed
equipment of various kinds as rapidly as the net profits can absorb
it and still leave sufficient for a reasonable dividend. Financial
institutions in this way carry their furniture and fixtures and
sometimes even banking houses, at ridiculously low figures or do not
show them at all.
Undervaluations are accomplished in various ways. Charging an
excessive rate of depreciation; making unnecessarily large reserves
for uncollectible accounts, sales discounts, etc.; showing a more
rapid depletion of natural assets than justified by the amounts used;
charging the sums spent for assets to an operating expense; setting up
an excessive cost of goods sold by means of inventory valuations of
stock-in-trade at a figure lower than cost or market; crediting items
of income to asset accounts instead of to income accounts, such as
rentals on properties owned; crediting interest and dividends received
to the stocks and bonds accounts—all of these serve the purpose of
creating hidden reserves by means of a misstatement of fact.
Items wrongfully included among the liabilities bring about the
same result. Here, however, the procedure is somewhat more patent
because the creditors themselves check up on all actual liabilities.
Liabilities can be settled only by an actual reduction of assets.
Manipulation of the operating and contingent reserves explained above
offers, however, an easy means of overvaluing the liabilities. A too
liberal estimate of the amounts of these reserves makes them represent
in part true proprietorship reserves but the proprietorship element
in them is obscured by their title and their inclusion among the
liabilities on the balance sheet.
It is, of course, apparent that no balance sheet containing secret
reserves is a true statement of condition and the practice of creating
secret reserves must usually—perhaps always—be condemned.
Argument for Secret Reserve
In justification of the secret reserve, it is sometimes said that in
certain lines of business where the maintenance of unquestioned credit
or the promotion of a stability ordinarily lacking in speculative
enterprises is highly desirable, there is a very pressing need for the
secret reserve. Through its use, extraordinary losses, which otherwise
would result in very unfavorable fluctuations of stock values, may
be absorbed by means of a charge to some undervalued asset and so
bring it to its true value; or by a charge against an over-estimated
liability reserve and so bring it to a true showing. This frees the
current profit and loss from the charge, maintains a regularity of net
profits, and prevents the disasters sometimes attendant upon violent
fluctuations of stock values brought about by the knowledge of these
extraordinary losses. That is the strongest case which can be made out
in favor of the secret reserve.
Argument against Secret Reserve
The fact, however, must not be overlooked that without any
understatement or misrepresentation of property values at any time
there could just as easily be created an open “surplus” or margin of an
amount equal to the secret reserve, against which these losses could
as well be charged. The creation of such a margin can be justified on
the same grounds on which the justification of the secret reserve is
attempted, viz., the maintenance of high credit and stability. The
reduction of the margin through its absorption of the loss would,
of course, be somewhat more patent than the reappearance of values
previously written off, although analysis of a balance sheet will
invariably bring the true state of affairs to light. Furthermore,
present stockholders, and certainly prospective investors and
creditors, have a right to know the true condition of affairs. The
appearance of a large proprietorship in addition to capital stock,
revealed by a sizable margin, gives the stock a value in addition to
that based solely on the dividend rate. A stockholder has a right to
his share of the profits during the period of his ownership. If it is
not received in the form of dividends, he should at least be partially
recompensed when he disposes of his holdings, by an increased price
for the stock as reflected by the portion of profits reinvested in the
business.
The attitude occasionally taken that directors know best what
information as to true condition of affairs should be given to
the owners and what should be withheld, should, in these days of
increasing publicity, be given no serious consideration. In the hands
of unscrupulous directors, the secret reserve is an instrument for the
covering up of questionable and even fraudulent practices. Stock values
can be intentionally hammered down by a false showing of profits and so
inure to the benefit of a group of prospective purchasers desiring to
“freeze out” unsuspecting stockholders. All in all, therefore, little
can be said in justification, but much in condemnation, of the practice
of accumulating secret reserves.
Earmarking of Reserves
According to the definition of surplus laid down in the beginning of
this chapter, limiting the term strictly to the profits available for
dividends, those profits which are applied to reinvestment for specific
purposes must be separated from the “surplus” and given distinguishing
marks to indicate their purpose. Thus, profits reserved for the purpose
of acquiring a fund of assets out of which to pay off debt obligations
maturing in the future may be set aside under the title “Sinking Fund
Reserve”; those set aside for the purpose of extension of plant as
“Building Fund Reserve”; those for the purpose of providing a pension
fund as “Pension Fund Reserve”; and so on. This is sometimes called
“earmarking” the reserve.
Separation into differently named reserves serves no other purpose,
however; it does not in any way insure the inviolability of the
reserve; it acts merely as evidence of the intention and purpose of
the board of directors which authorized the application of profits to
that purpose. It is the expression of a business policy and as such is,
without other compelling force, subject to the approval and continuance
or to the disapproval and nullification of any subsequent board. These
reserves are profits and as such belong to the shareholders and may
be distributed among them as dividends. A reasonably conservative
policy as to reserves usually has the support of stockholders, and a
subsequent board will not risk loss of position and standing with the
stockholders by a change of policy as to reserves without good and
sufficient reasons for doing so.
Continuity of Reserve Policy
Effort is sometimes made to secure continuity of the reserve policy.
This may be accomplished in several ways. Oftentimes it is made
compulsory by outside regulatory authority, as in the case of national
banks which are required to set aside annually a certain part of their
profits until these have accumulated to an amount equal to 20% of their
capital stock. Similar conservatism can also be compelled by contract
entered into with creditors. It is a frequent provision of the trust
agreement covering an issue of bonds that “there shall be set aside
out of profits” a certain amount at the close of each fiscal period
for the purpose of creating a fund with which to redeem the bond issue
when it falls due. The funds may be placed in the hands of a trustee,
which guarantees the application of them to their intended use but does
not, of course, insure the retention of profits to an equal amount
in the business. Finally boards of directors may be compelled by the
stockholders to adhere to a certain policy by provision in the by-laws
for the accumulation of reserves. This policy is, of course, subject
to change by the stockholders themselves. Where the power to make and
change by-laws is put in the hands of the directors, this last method
is not applicable.
Reserves may always be made a part of the permanent capital through
their distribution in the form of a stock dividend. This secures the
continuance of profits reserved to date but does not guarantee either
a similar application of future reserves or even a continuance of the
present reserve policy.
Covered Reserves
When a reserve is spoken of as being covered, it is meant that specific
funds have been set aside for the purpose named, in amount equal to
the reserve. As in the case of sinking funds, the assets set aside
may be invested in stocks and bonds control of which remains with the
company itself; or the assets may be turned over to a trustee who then
has control of their investment and use. The student is referred to
Chapter XXV on sinking funds for a full discussion of the merits and
disadvantages of the two methods as to control over the funds.
In connection with covered reserves, attention is called again to the
use, in the interest of standard practice, of the caption “reserve
fund” as a suitable title for the assets placed in the fund, and the
caption “reserve,” with suitable descriptive phrase, as the title for
the reserved profits, the proprietorship element of the transaction.
Classification of Reserves
Before leaving the subject of reserves, it is purposed to give
several classifications of the various kinds of reserves. Paul-Joseph
Esquerré[63] classifies reserves under the following heads: (1)
Reserves for Depreciation; (2) Operating Reserves; (3) Reserves for
Surplus Contingencies; (4) Reserves for Redemption of Debt; (5) Secret
Reserves; and (6) Reserves for Exhaustion of Physical Assets. Their
titles well indicate the kinds of items included under each head.
H. R. Hatfield[64] classifies them on the basis of the use to which
they are to be put, not attempting a classification to include all
items shown on the balance sheet under the caption of a “reserve,” but
limiting it to reserves of profits. His classes are:
“1. Reserves created to provide a permanent increase
of capital.
(a) As an additional guaranty to creditors.
(b) To provide for extension of its fixed or
other capital assets.
2. Reserves created to provide an additional capital
which can be used to cover unusual losses or to
provide for other emergencies without encroaching
on the nominal capital.
3. Reserves created to provide for equalizing dividends
by retaining part of one year’s profit to be used
to make up scanty profits for other years.”
[63] In “Applied Theory of Accounts.”
[64] In “Modern Accounting.”
The classification used here has as its basis the place of allocation
of the various reserves in the balance sheet because their nature
determines their place, which after all is the important consideration.
From that point of view two broad classes may be marked off as
discussed in the preceding pages, viz.: (1) valuation reserves, using
the term with a somewhat more extended meaning than is customary;
and (2) proprietorship reserves. Under valuation reserves will be
included all reserves shown either as deductions from the assets or
as liabilities. Here the term reserve will be limited to those items
which are estimated, as distinguished from those the amount of which is
definitely known. The other items which are sometimes wrongly called
reserves, as discussed on page 415, will not be included here, other
titles being more accurately descriptive of them.
1. Valuation Reserves
(a) Asset Valuation Reserves
1. Depreciation Reserves
2. Depletion Reserves
3. Bad Debts Reserves
4. Appreciation Reserves
5. Market Fluctuations Reserves, etc.
(b) Liability Valuation Reserves
1. Operating Reserves
2. Contingent Reserves
2. Proprietorship Reserves
(a) Secret Reserves
(b) Open Reserves
1. Reserves for Debt Extinguishment
2. Reserves for Plant Extensions
3. Reserves for Working Capital, etc.
Legitimate Use of Surplus Account
There remains only a consideration of the Surplus account. The manner
of handling the surplus as a clearing account for the appropriation
of net profits has already been treated. After profits have been
appropriated or reserved out of it for specific purposes, the surplus
shows by its balance the portion still available for dividends. As
has been indicated, it is not usually desirable to use all of it for
dividends, a sufficiently large balance being always maintained for
such purposes as stabilizing the dividend policy, strengthening credit,
and other surplus contingencies.
Surplus account is frequently as badly abused as the proverbial
“general” expense account, by being used as a dumping ground. It has,
however, a legitimate and an illegitimate use. As the Profit and Loss
account is strictly limited to use as a clearing account for the
normal items of income and expense applicable to the current period’s
operations, manifestly all other charges and credits to proprietorship
must be cared for elsewhere. With very few exceptions—such as premiums
and discounts on capital stock, donated working capital, etc.—these
charges and credits are made to Surplus. High accounting authority
deprecates the use of Surplus for these purposes, on the ground that
too often it is used as a convenient place in which to hide items
properly chargeable to the current Profit and Loss but which would
not make a favorable impression if shown there. Just as with many
other abused accounts, its wrongful use hardly constitutes sufficient
grounds for withholding sanction of legitimate use. Where it is felt
that certain items should not go directly into Surplus they should
be recorded in a final section of the Profit and Loss account, just
before its balance is shown transferred to Surplus. As the financial
statements are usually published, this method secures more certain
publicity to these items.
Occasionally, instead of the use of either Profit and Loss or Surplus
for this purpose, an account is set up on the books called “Surplus
Adjustments” through which these items are cleared into Surplus. The
objection raised above to this use of Surplus applies with equal force
to “Surplus Adjustment.”
Statement of Surplus
At the close of each period account must usually be taken of a
group of items which cannot properly be treated as belonging to that
period. Some of these may be items which were overlooked at the close
of previous fiscal periods and cannot now be taken into the record
for that period. Some things may wrongfully have been included in,
or omitted from, the inventory; the inventory may have been under-or
overvalued; errors may have been made in the separation of capital
from revenue expenditures; wrong depreciation and bad debts estimates
may have been made—these and similar items call for adjustment at the
close of the current period. Where adjustments are few and simple, the
statement of surplus on the balance sheet may be extended sufficiently
to include them. Much better, however, is it to append as a schedule
or statement in support of the balance sheet, a statement of surplus,
showing therein the detail of all entries affecting it during and at
the close of the current period. Particularly is this desirable when
the statements of financial condition are prepared for internal use.
Such a statement of surplus should start with the amount of surplus as
at the close of the previous period. Then the adjustments applicable
to that period should be shown, thus determining the true surplus for
the period. Following that should appear the entries made directly to
Surplus for the current period, the net profit transferred thereto, and
finally all appropriations of profit, leaving as the balance of Surplus
the same amount which appears in the balance sheet. In skeleton form
the statement should appear somewhat as follows:
X Y Z COMPANY
STATEMENT OF SURPLUS, JUNE 30, 1918
Balance of Surplus as on December 31, 1917 $.....
Adjustments applicable to period ending December 31, 1917:
Additions:
Inventory omissions, undervaluations, etc. $.....
Items wrongly charged to Revenue .....
Over-estimate of Depreciation, etc. ..... $.....
-----
Deductions:
Inventory overvaluations, etc. $.....
Items wrongly charged to Capital .....
Under-estimates of Depreciation, etc. ..... .....
----- -----
Net Increase (or Decrease) .....
-----
True Surplus as on December 31, 1917 $.....
Extraordinary Profits (or Losses) this period $.....
Net Profit this period ..... .....
----- -----
Amount available for appropriation $.....
Appropriations of Surplus:
Reserves (shown in detail) $.....
Dividends ..... .....
----- -----
Net Balance in Surplus as on June 30, 1918 $.....
=====
CHAPTER XXIV
DIVIDENDS
Introduction
Dividends, as the term is generally used, may be defined as those
profits of a corporation which are divided among the owners. Except
in the case of wasting assets, the law is very explicit in limiting
dividends to profits. Therefore profits need to be determined with
painstaking care. Most of the major problems met in the determination
of profits were discussed in Chapter XXII. Here it is purposed to limit
the discussion to one phase of the disposition of profits, viz., as
dividends, having treated in Chapter XXIII other appropriations of
profit for reserves and surplus.
Disposition of Corporation Profits
The profits of a solvent going corporation, whether current profits or
those reinvested in the business, are owned absolutely by the owners
of the corporation and are subject to their disposition and control,
except where the law imposes restrictions. Oftentimes, the stockholders
themselves impose restrictions by incorporating restrictive provisions
in the charter or by-laws of the corporation. Of course, the same power
which made them has power to remove them, though the exercise of the
amending power is usually more difficult than the original expression
of that power in enacting rules. The nature of a corporation is such,
however, that many acts and privileges which are _per se_ rights of the
stockholders must in their exercise be delegated to others. Thus, while
the right of ownership and control of the profits of a corporation is
inherent in its proprietorship, the control is indirect—through the
medium of a board of directors subject to periodic review and election
by the owners. This board, during the period of its incumbency, acts
for the stockholders and, during the prosecution of its duties, if
performed in good faith, with sound judgment, and without fraudulent
intent, is free from interference.
Shareholders’ Rights as to Profits
Shareholders’ rights in regard to sharing in the profits are therefore
dependent upon the action of their elected board of directors. As soon
as that board authorizes a dividend, however, its control over the
portion of the profits so appropriated ceases except as to the routine
of payment of the dividend. The right which the stockholder thereafter
possesses is of the same nature as the claim of an outside creditor,
and in the event of dissolution the assets of the corporation must
be applied to the liquidation of this claim equally with all other
unsecured claims. Thus, a claim for dividends must be met before the
determination of the net assets with which the ownership of capital
stock is liquidated.
Directors’ Control over Profits
As stated above with regard to profits generally, the directors
have entire control of the declaration of dividends, except where
limitation is specifically imposed by the state or by the owners
as expressed in charter or by-laws. The following expression of
directors’ power over profits and dividends, contained in the English
Companies (Consolidation) Act of 1908 is typical of most laws covering
the question: “The directors may, before recommending any dividend,
set aside out of the profits of the company such sums as they think
proper as a reserve or reserves which shall, at the discretion of the
directors, be applicable for meeting contingencies, or for equalizing
dividends, or for any other purpose to which the profits of the company
may be properly applied, and pending such application may, at the like
discretion, either be employed in the business of the company or be
invested in such investments (other than shares of the company) as the
directors may from time to time think fit.”
Provisos as to Declaration of Dividends
Specific provision may be made in the by-laws covering the declaration
of dividends. Thus, the directors may there be ordered to set aside
for specific purposes a certain amount of the profits earned and to
declare dividends only from any residue. This may represent a permanent
policy but usually only temporary; that is, periodic reservation of
profits may continue until a definitely named reserve (or surplus) has
been created, after which all profits become free for such disposition
as the directors may see fit to make. A somewhat different policy is
occasionally prescribed by which the directors are ordered to pay out
of each period’s profits dividends of a named amount, after which any
residue shall be carried to a reserve (or surplus). The objection to
this latter policy, as ordered in the by-laws, is that it ties the
hands of the directors to the division of profits among the owners
regardless of the exigencies of new situations, as they arise, bringing
very different conditions from those under which the policy was
originally ordered.
The power of the directors as to declaration of dividends extends not
only to common stock but also to preferred. No dividends, common or
preferred, can be declared except from profits. Legal inhibition of
the payment of dividends out of capital is one of the chief points
of difference between the corporate and other forms of business
organization.
As stated in a preceding section, regulatory bodies and commissions
sometimes impose rules compelling corporations over which they have
authority to set aside to surplus some portion of the profits before
the declaration of any dividend.
Stockholders’ Rights to Dividends
Where profits exist, either earned currently or accumulated, the matter
of a declaration of dividends is thus seen to be always a question
of financial policy. In view of the other problems confronting the
corporation—its policy of growth and expansion to meet competition
and enter other markets, its specific and pressing requirements for
funds—the question of the wisdom of a declaration and payment of
dividends frequently demands careful consideration. If under the
circumstances, in the exercise of their discretion, the directors do
not declare dividends, their action is final and, in the absence of
fraud or an abuse of discretion, will not usually be interfered with by
the courts.
Courts do sometimes intervene, however, as in Matter of Rogers, 161
N. Y. 108 (1899): “The directors must act in good faith. If they fail
to do so and it clearly appears that they have accumulated earnings
not required in the prosecution of the business which they withhold
from the stockholders for illegitimate purposes, a court of equity
may interfere and compel a distribution of such earnings.” Again, in
Hunter v. Roberts, Throp & Co., 83 Mich. 63 (1890), the court said:
“Courts of equity will not interfere in the management of the directors
unless it is clearly made to appear that they are guilty of fraud or
misappropriation of the corporate funds or refuse to declare a dividend
when the corporation has a surplus of net profits which it can, without
detriment to its business, divide among its stockholders, and when a
refusal to do so would amount to such an abuse of discretion as would
constitute a fraud or breach of that good faith which they are bound to
exercise towards the stockholders.”
In the case of preferred dividends, the courts are somewhat readier
to act because of the ease of a fraudulent retention of profits.
Where stock is non-cumulative and non-participating and particularly
if non-voting, it would be possible for a board of directors to
refuse dividend declarations for a number of years and then pay to
common stockholders most of the profits so saved. Such a policy is so
manifestly unfair and fraudulent as to warrant immediate intervention
of the court. When stock is cumulative as to unpaid dividends, such
a policy could not be practiced, as the corporation cannot declare
dividends unless profits are made, nor, except as above stated, need it
declare dividends even when profits are made. But upon the declaration
of a dividend, the rights of cumulative preferred shareholders require
the payment of all accumulation of unpaid dividends before the other
classes of stockholders can share.
Declaration of Dividends
The matter of a declaration of dividends is usually a formal one. The
minute book record must always show the authorization. It may appear as
a formal resolution or merely as a statement of the declaration. Such
resolution or statement will usually carry the amount of the dividend,
which may be either a named per cent on the par value of the stock (or
the amount paid up on the stock where stock is not full-paid), or it
may be a named amount on each share; the date on which it is effective;
the date and manner of payment; and to whom payable, i.e., to the
stockholders as of a given date. Dividends may be declared to become
effective on some future date but never on a past date. Antedating a
dividend so as to make it apply to past stockholders who may no longer
have any interest in the corporation would manifestly be unfair,
opening the way to manipulation and fraud.
A stockholder is entitled to notice of every dividend declaration.
This may come to him by published notice in the newspapers or through
the mails. A dividend check mailed to his last-known address has been
held to constitute sufficient notice.
Liability of Directors
Together with the power and control over dividends by the directors
is a responsibility and liability for those wrongly declared. The
law is very specific and emphatic in its refusal to allow dividends
except from profits. The State of New York in its Stock Corporation Law
has this to say with regard to the liability of directors for making
unauthorized dividends: “The directors of a stock corporation shall
not make dividends, except from the surplus profits arising from the
business of such corporation, nor divide, withdraw, or in any way pay
to the stockholders or any of them, any part of the capital of such
corporation, or reduce its capital stock, except as authorized by
law. In the case of any violation of the provisions of this section,
the directors under whose administration the same may have happened,
except those who may have caused their dissent therefrom to be entered
at large upon the minutes of such directors at the time, or were not
present when the same happened, shall jointly and severally be liable
to such corporation and to the creditors thereof to the full amount of
any loss sustained by such corporation or its creditors respectively by
reason of such withdrawal, division, or reduction.”[65]
[65] Ch. 59 of the Consolidated Laws (Ch. 61, Laws 1909).
In some states the liability of directors is made to include, in
addition to restitution of the amounts wrongfully paid, liability
for all debts contracted during their term of office and even to a
body judgment for misdemeanor. The stockholders receiving such a
dividend are held to have known of its illegality and are liable for
restitution. While payment of dividends out of capital is the most
frequent source of illegality, a declaration of dividends contrary
to the provisions of the charter or by-laws relative thereto, or a
declaration which disregards the rights of other stockholders, is
equally illegal. Thus, a dividend paid before reserving profits, where
the by-laws require antecedent reservation or one paid to common
shareholders ahead of an accumulated dividend to cumulative preferred
stockholders, is classed as illegal.
Revocation of Dividends
A dividend once legally declared and of which _notice_ has been given
cannot be revoked. As stated above, such a dividend becomes a claim
against the corporation and ranks with the claims of outside creditors.
Even further than this, it has been held that if actual funds have been
set aside, as by deposit in a bank, for the payment of these dividends,
these funds cannot be touched by other creditors in case of insolvency,
but must be applied to the payment of dividends.
With regard to the revocation of dividends, such action is held to be
possible only until the fact of declaration has become known outside
the board of directors. The revocation of a dividend is merely looked
upon as a reconsideration of business policy. In case of illegally
declared dividends, they may be revoked by the directors any time
previous to payment and the directors may be enjoined from making
payment of them.
Payment of Dividends
Inasmuch as a declared dividend becomes a debt of the corporation, it
may be settled by whatever means another debt might be. Thus, if a
stockholder owes anything to the corporation, the debt for dividends
may be used as an offset and only the net payment be made or received,
as the case may be. In this way dividends may be made to apply to
unpaid subscriptions on capital stock.
After the declaration of dividends provision must be made to pay them.
Before the declaration, a report from the treasurer will have probably
shown the financial condition of the company to be such as to warrant
the payment. Unless specifically ordered otherwise, payment in cash
is understood. Payment of the dividend is a duty of the treasurer. If
present at the board meeting when the dividend is declared, that is
sufficient notification to him to make arrangement for paying it. If
not, notice may come to him verbally, by an inspection of the minute
book, or by formal notice from the secretary.
Dividends may be paid by check through the mail or by notifying the
stockholders to appear at a designated place to claim their dividends.
Under this latter procedure, receipt for the dividend is usually made
by signature of a form of receipt in the dividend book. Where payment
is made by check, the signing of a formal receipt may or may not be
required. In a large corporation the stock of which is widely held,
a distinct series of checks formally marked “Dividend Check” is made
use of. If these checks bear an identification phrase on their face,
as Dividend No. ..., indorsement by the holder upon receipt of payment
by the bank and the bank’s cancellation stamp undoubtedly constitute
sufficient receipt for payment. However, if desirable, a formal
receipt may be issued with the check and its return requested. In a
small corporation, the regular check series may be used and marked as
dividend checks.
Dividends Paid as Salaries
A peculiar method of payment of dividends is by means of excess
salaries—which is largely a matter of bookkeeping. In a close
corporation where all the stockholders are officers of the corporation,
salaries, in addition to those regularly paid, may be voted in lieu
of dividends. The courts have held that, so long as all the parties
interested—incorporators, stockholders, directors, and officers—assent
to the scheme for the distribution of profits by the payment of
salaries, the plan is not objectionable. Salaries so paid would usually
be in proportion to holdings of stock and as such become dividends,
merely booked as salary.
Methods of Paying Dividends
An interesting point is raised in the question as to whether it is
legal or wise to borrow funds to pay dividends. This question in its
turn raises the point as to the various ways in which dividends may be
paid. In addition to the payment of dividends in cash, other property
owned, such as the stock and bonds of other concerns, even the more or
less fixed assets if these can be apportioned, may be used for this
purpose. The issue of the company’s obligations in the form of its
own bonds, or in a special form of promise to pay known as dividend
scrip; and, furthermore, the absorption of the dividend by the business
through the issue of its own shares—both these methods have been
employed to liquidate the dividend obligation.
It will be noted that payment by cash or other asset has the effect of
decreasing the assets in order to decrease the liability for dividends;
that payment by the issue of bonds or scrip cancels one kind of
liability by the issue of another kind; whereas payment by the issue
of the company’s own shares liquidates the liability by increasing
proprietorship through the issue of stock, thus reinvesting in the
business the portion of profits distributed as dividends.
Borrowing to Pay Dividends
The answer to the question as to the legality of borrowing funds to
pay dividends may be inferred from the discussion above as to the
status of a declared dividend. Where the question of legality is not
involved in the _declaration_ of dividends, i.e., where a declared
dividend is legal in all respects, the legality of borrowing to
pay the dividend is no more open to question than the legality of
borrowing to pay any other legally contracted debt. Though there may
be ample profits, the affairs of a corporation may be in such shape
financially that the payment of a dividend would result disastrously
to the shareholders and even to the creditors. Here it is possible to
enjoin the directors from making payment. Action cannot be based on the
illegality of making payment but on the abuse of discretion amounting
to illegality in the _declaration_ of the dividend.
If by so doing the finances of a corporation are not crippled, there
is no more legal objection to borrowing to pay a dividend debt than to
borrow to pay other debts. The courts have not always held so, however,
but the weight of authority seems to be that where profits have been
earned but become tied up in the enterprise the corporation may “borrow
money on the faith of it and divide that,” may sell the property in
which the profits are tied up and distribute the proceeds, or may
borrow funds on the general credit of the corporation sufficient to
meet the dividend payments.
It has even been held that where the income has been applied to the
extension and betterment of the plant but the expenditure has been
wrongly booked as an expense charge instead of being capitalized, the
income so used may be recreated on the books by proper correcting
entries and dividends declared and paid therefrom. To the accountant
such a procedure seems perfectly correct, though the courts usually
look askance at anything savoring of a payment of dividends out of
capital.
The chief question involved, therefore, in borrowing funds for the
payment of dividends is purely a financial one and the wisdom of such
a procedure must be based on financial considerations. If from that
standpoint, it is deemed feasible to borrow, the further question as to
the form of the loan must be considered. Is it for the best financial
interest of the company to borrow on short or long time, to create a
floating or a funded debt, etc.—these points require consideration
and can, of course, be answered only in the light of the conditions
prevailing in each case as to the status of the working capital
requirements.
Dividends Paid in Property, or by Borrowing on Property
Payment of dividends by means of property is unusual. It is seldom
that the property held can be so divided as to serve this purpose
without loss of value. Exception is found in the case of liquidating
dividends, discussed on page 445, for which purpose often the shares
of stock and bonds of the vendee may be distributed as payment to
the vendor’s stockholders. More often, the stocks and bonds will be
used as collateral for a loan with which to pay the dividend, or the
real estate will be mortgaged for the same purpose, thus effecting a
borrowing of funds, a discussion of which has just been given. Plots
of land may sometimes be so divided as to be acceptable as equitable
shares of a dividend, where the stock of a corporation is held in
comparatively large blocks.
Bond and Scrip Dividends
Reference also has been made to the issue of the company’s own
obligations for payment of the dividend. If financial policy dictates
a long-term obligation, payment may be made out of any unissued bonds
which the company may possess or by means of a bond issue for this
specific purpose.
More usual, however, is the payment of dividends by means of
short-term obligations known as scrip or dividend scrip. Scrip takes
many forms. It is usually so drawn as to constitute the corporation’s
promise to pay. It may be unconditional, and so negotiable, or it
may be hedged about with limiting conditions. Date of payment may be
absolute or contingent. Scrip may be convertible into the bonds or
stock of the company at the option of either party. Unredeemed scrip
may even bear dividends. Usually, however, the issue of scrip is for
the purpose of deferring date of payment of the dividend until cash can
be accumulated from sale of property or from the profits of the new
period.
Stock Dividends
The one remaining method of settling the dividend claim is by the
issue of stock. As pointed out above, the effect of this is to convert
some portion of the “margin” or surplus into capital stock. This
change in the _form_ of proprietorship is accomplished by a reduction
of proprietorship through the declaration of a dividend and an equal
increase of proprietorship through payment of the dividend in stock of
the company. The effect of a stock dividend, therefore, is to _fix_
a portion of the “margin” so that it becomes a part of the permanent
capital of the corporation and, as such, is no longer subject to the
direct control of the board of directors. Excepting in states which
expressly forbid the stock dividend—and even here the same result is
accomplished by other means—its legality is thoroughly established.
Thus, in Howell v. Chicago, etc., Ry. Co., 51 Barb. (N. Y.) 378
(1868), the court said: “It becomes immaterial whether such increase
(in _capital_) is made by awarding the stock to stockholders as
dividends in lieu of money, retaining the money for the purpose of
the company, or by paying the stockholders the dividends in cash from
the earnings of the company and selling the stock in the market to
raise money for the use of the company.” In Williams v. Western Union
Telegraph Co., 93 N. Y. 162 (1883), the court ruled: “If it [the
corporation] can issue stock in payment of property to be obtained
by it as part of its capital for its legitimate uses, why may it not
issue stock in payment for property in effect purchased of them [i.e.,
the shareholders] and added to its permanent capital and which they
relinquish the right to have divided? So long as every dollar of stock
issued by a corporation is represented by a dollar of property, no
harm can result to individuals or the public from distributing stock
to stockholders.... All that can be required in any case is that there
shall be an actual capital in property representing the amount of share
capital issued.”
Any unissued or treasury stock in the possession of the company may
be used for this purpose and, in the case of unissued stock, becomes
full-paid if the property against which it is issued is of equal value
to it. If the necessary legal requirements are met, even authority for
an issue of new stock may be given and the stock used for the purpose
of paying the dividend.
_Stock Dividends in Estate Accounting._ An interesting point is raised
in estate accounting as to whether a stock dividend should be treated
as principal or income as between the life-interest party and the
remainderman. In such a case, the _income_ from the stock which yields
the dividend belongs to the life-interest party, while the _stock_
itself is the principal and belongs to the remainderman. Of course,
any dividend declared before the decedent’s death, though not payable
until after it, is a part of the principal of the estate. The original
fund of principal being established, all dividends, whether in cash
or stock, which disburse current earnings belong to the life-tenant
as income. Where a dividend partakes of the nature of a liquidating
dividend—i.e., represents a return of some portion of the net worth as
at the decedent’s death—the portion so returned should, in equity, be
looked upon as principal.
Any stock dividend has the effect of lessening the value of the stock
previously outstanding by the circumstance that it, while issued at
par, after issue takes on its pro rata share in any accumulated margin.
Thus, by the very fact of payment of a dividend in stock, the principal
of the estate diminishes in value. Courts have usually held this
proper, however, but in cases of manifest injustice, as where profits
have been reserved in large amounts and thus have come to be treated as
a part of the permanent capital, the “cutting of the melon” in the form
of a stock dividend would work so markedly to the injury of the value
of the principal that exception would be made here.
Dividends Proportional to Holdings
Dividends must be exactly proportional to the holdings of stock. If
there is but one class of stock outstanding, each share must bear the
same dividend as every other share. Any other basis of distribution
is sufficient cause for asking the intervention of the court. If
several classes of stock have been issued, the same requirements hold
within each class; but as between the classes themselves the dividend
rates may vary, this variation frequently being the differentiating
mark. Among the members of any class, therefore, distribution must be
made with absolute impartiality, the number of shares held by each
determining the amount of dividend for each owner. Also, time and
manner of payment, except by special consent, must be the same for
every member within each class.
To Whom Payable
As stated above, the formal resolution declaring the dividend
prescribes where it shall go, so there can be made up a list of those
to whom the dividends are to be paid. To accomplish this it is usually
stated that the stock records for transfer of stock ownership shall
be closed between certain named dates and that dividends will be paid
to those who appear as shareholders as on the initial date of the
closed period. This makes it possible to bring the stock record up to
that date and determine who are owners at that time. Thus, a dividend
resolution may read somewhat as follows:
A dividend, No. 94, of two and one-half per cent
(2½%) for the quarter ending March 31, 1918, has
been declared by the Board of Directors out of past
earnings, payable April 1 to stockholders of record
at the close of business March 23. Stock transfer
books will be closed from March 23 to April 1 inclusive.
The stock records may, however, remain open, the matter being one of
convenience only.
If a transfer of stock should take place subsequent to the named date
of record, sale is usually made ex-dividend. If, however, sale should
be made with right to the dividend, notification of the assignment
of the dividend before the mailing of the dividend checks by the
secretary or treasurer constitutes an order for him to pay the dividend
to the new party. The same rule would obtain in the case of a sale
made previous to the declaration of dividends but not recorded till
afterwards; so also in the case of pledged stock, although payment
should be made to the pledgee. Unless the corporation is notified, its
list of stockholders according to its records governs in determining
the owners of the dividend.
Accounting Record
Little need be added to what has been said in other places as to
the method of handling dividend transactions on the books. Their
declaration is booked as a charge against either the current Profit and
Loss or the Surplus account, with a credit to Dividends Payable. Their
payment by any of the methods already discussed in this chapter cancels
the Dividends Payable account and is reflected either by a decrease of
assets, an increase of liabilities, or an increase of proprietorship.
In setting up the entries, ample explanations should be made in the
record itself or by reference to the minute book.
As to handling the payment of the dividend, methods vary somewhat. The
secretary’s list of stockholders made up from the stock records should
show the stockholders according to the kinds of stock they hold, the
amount of the holdings of each, the dividend rate on each class, and
the amount of the dividend payable to each stockholder. This list, with
its calculations verified by the treasurer, is the schedule according
to which the dividend checks are made out. Where a separate series of
checks is made out for this purpose, it is best to draw a check on
general cash for the full amount of the dividend and deposit it to
dividend account with the bank. The individual dividend checks are
drawn against this account and so the detail of the transaction is kept
off the general books.
If all checks reach their destination, the dividend liability is
canceled. If any are unclaimed, a liability exists on account of them
offset by funds appropriated and set aside for its cancellation. If the
fund is in the hands of a trustee—which is not usual—and so beyond the
control of the corporation, there would be no reason for including the
liability on account of such dividends on a balance sheet as of that
date. Under most circumstances, the cash in the fund should be counted
as cash on hand and the liability shown. When in this way an unexpended
balance of cash is shown in dividend account, subsequent charges
against it must be carefully watched to see that they are properly
authorized, otherwise the way to fraudulent practice is opened.
Relation of Capital Losses to Dividends
Reference was made in Chapter XXII on “Profits” to the relation of
capital losses to dividends. The laws are very explicit in their
declaration that dividends shall not be paid out of capital. In this
connection two problems treated in Chapter XXII must be reconsidered.
Here it is purposed simply to restate them and summarize conclusions.
These problems are: (1) the interpretation of the law’s requirements
in relation to the payment of dividends without providing for the
depletion of wasting assets; and (2) the bearing of the law on dividend
payments without making good all previous encroachments on capital.
With regard to the first problem, law and practice are pretty well
established and are in accord. The decision in the case of Lee v.
Neuchatel Asphalte Co., L. R. 41, Ch. D. 1 (1889), has been followed
quite generally. There it is held that “if the objects of the company
include the sinking of capital in the acquisition of wasting property,
even depreciation by waste is not necessarily a revenue charge, but
may by the regulations be thrown upon capital.” And again, if a
company is formed “to acquire and work a property of a wasting nature,
for example, a mine, a quarry, or a patent, the capital expended in
acquiring the property may be regarded as sunk and gone, and if the
company retains assets sufficient to pay its debts, it appears to me
that there is nothing whatever in the Act to prevent any excess of
money obtained by working the property over the cost of working it from
being divided amongst the shareholders.”
The inclusion in the periodic dividend of the return of a portion of
the capital thus legalized is approved from a business standpoint on
the ground that from its very nature the enterprise is speculative in
greater or less degree and creditors are therefore sufficiently warned
in their dealings with such a concern. Of course, if any such company
expects to be permanently engaged in such enterprises it may be the
part of wisdom to reserve from distribution all the capital or whatever
portion of it may be necessary to finance each new undertaking.
This is solely a matter of business policy, however. “It is for the
shareholders to say whether or not they will put by a sinking fund to
meet the waste.... They may if they like, but they are not bound so to
provide.”[66]
[66] Lee v. Neuchatel Asphalte Co.
As to the second question raised above, the general rule and practice
in this country requires the making good of such losses first and the
payment of dividends only from a resulting surplus. Shields v. Hobart,
172 Mo. 491, 517 (1902), states the prevailing law in the matter as
follows: “Dividends can properly be declared only from the profits over
and above the capital stock and the debts of the company.”
There may be circumstances in which this rule may work a very real
hardship, and there is some support both in law and in a sense of
justice under given conditions for the view that each period stands by
itself so far as dividends are concerned, and that there is no need to
use the profits of one period to make good the encroachments on capital
of a previous period before paying a dividend. In such cases, the
remedy is provided by a reduction of capital stock by the amount of the
encroachment upon it. The payment of dividends on the remainder is then
above question of law or the best business policy. In this connection
the student is referred to page 395, Chapter XXII, for an often-quoted
decision of the English courts.
Liquidating Dividends
Any dividend which represents a return of any portion of the capital
is to the extent of the portion returned a liquidating dividend. In
other words, a payment to a stockholder on account of capital invested
is a liquidating dividend. Such a dividend is met when the affairs of
a corporation are being wound up. The liquidation of a corporation is
discussed in a later chapter. Here the term is only defined because
of its relationship to the dividend paid by a corporation which is
operating a wasting asset of some sort. Usually the dividends paid by
such a concern are not separated as to content, showing how much is
profits and how much is a return of capital. A commendable exception
to this is seen in the recent dividend notice of the Shattuck Arizona
Copper Co., reading as follows:
The Board of Directors of Shattuck Arizona Copper
Company has this day declared a dividend of
Twenty-Five (25c.) cents per share, and a capital
distribution of Twenty-Five (25c.) cents per share,
payable January 19, 1918, to stockholders of record
at the close of business December 31, 1917. Stock
Transfer Books do not close.
November 30, 1917.
If a reserve for depletion of the property is set up, the offsetting
charge to Profit and Loss results in that account’s balance showing the
true profit. Dividends declared in excess of this represent the part
of the capital being returned. In booking these liquidating dividends,
the charge must, in strict theory, be made directly against Capital
Stock account. A charge to an account called “Capital Liquidated as
Dividends,” “Capital Returned to Stockholders in Dividends,” “Capital
Payments,” or other self-explanatory title, may be made instead of
the direct charge to Capital Stock. If so, such an account should be
carried as a valuation account for Capital Stock and shown on the
balance sheet as a deduction from Capital Stock.
Where, as has been allowed in connection with income tax returns,
there has been a revaluation of properties operating wasting assets,
and values in excess of the capital stock are established, such excess
may be brought onto the books as a charge to Property or Plant and a
credit to an account called “Property Surplus” or other similar title.
Dividends thereafter declared, provided the depletion charge is made
periodically, will be charged as to their profits against Surplus and,
as to their return of capital portion, against Property Surplus until
that is exhausted, after which the charge should be made as indicated
above.
CHAPTER XXV
THE SINKING FUND
Origin and Use
The sinking fund is a recognized and well-established instrument for
the financing of business. A great deal has been written about the
subject, and over some of its phases much wordy warfare has raged. As
usual, however, the controversy has had little or no effect on the
practical application of the principle of the fund.
The sinking fund seems to have been first used as a practical
instrument for the repayment of debt in the year 1716, although the
idea germinated some time before this. At first its application
was limited entirely to public finance. Through the efforts of Sir
Robert Walpole, legislation was enacted in England which made certain
specified taxes perpetual. Any surplus remaining after applying
them to the purpose for which they were levied was to be put into a
sinking fund for the purpose of paying off the public debt. Due to
bad administration of the fund, it was not successful. Its use was
attempted a second time in 1786 by William Pitt, at the instance of a
Dr. Price. Since then it has had a rather checkered career in public
finance. In some fields, notably among municipal corporations, the
device has been very successful. Through the extension of the principle
to the field of business the sinking fund found the use to which it was
best adapted.
Definitions
A sinking fund may be defined as “a fund formed by the investment
of annual savings or other contributions with a view to the ultimate
application of the moneys so accumulated in the payment of a previously
incurred ... debt.” An English accounting authority defines a sinking
fund as “a fund set aside out of _assets_ and accumulated at interest
for the purpose of meeting a debt.”[67] This latter definition draws
attention to the fact that the sinking fund is a fund of assets—not
simply a book account set up to indicate recognition by the board of
directors of the _need_ of providing for payment of a debt, but certain
definite assets set aside and, after accumulation, to be used for that
purpose. Attention should also be called to the fact that usually the
fund is not dependent solely for its increase upon interest accretions.
As generally handled, the fund is added to at regular intervals by
setting aside more or less regular amounts of assets to be applied
to the same purpose. Frequently the contract agreement entered into
between the company and the creditors holding the debt to be repaid
governs in detail the way in which the fund is to be provided and the
way in which it is to be handled.
[67] George Lisle in “Accounting in Theory and Practice.”
A sinking fund may be used for other purposes than the payment of debt.
Thus, occasionally one finds it created for the purpose of providing
funds for the retirement of capital stock issues, notably preferred
stocks of various kinds.
It may be well again to point out the unfortunate lack of uniformity
in the use of the term. Thus “Sinking Fund” as an item in the balance
sheet is found sometimes among the debits and sometimes among the
credits. Other titles under which the item appears are: Sinking Fund
Account, Sinking Fund Reserve, Sinking Fund Investments, Sinking Fund
Trustee, and Sinking Fund Cash. While in this chapter the term will be
used to indicate assets set aside in a definite fund—and limitation to
this use is growing among the best authorities—explanation will also be
given of what the other uses indicate as to financial policy and the
manner of booking such policy.
Mathematical Principles on which Based
The mathematical principles on which the computation of the sinking
fund rests will first be explained. The problem involved here is the
calculation of the amount which set aside periodically and invested at
compound interest will provide a sum sufficient to pay off the debt
when it matures. Needless to say, the sinking fund is usually applied
only to the redemption of long-term debts, as only over a comparatively
long period is the real potency of the compound interest principle
secured. For the solution of the problem it must be known whether the
periodic increments to the fund are set aside at the end or at the
beginning of the period. It is usually understood to be at the end of
the period unless otherwise specified.
Assume, therefore, that a bond issue is made with maturity in n years
and that the contract with the bondholders calls for the creation of a
sinking fund with payment thereinto at the end of each period. It is
required to find the amount to be paid into the fund periodically. We
will assume that:
P = the principal sum to be redeemed at maturity
n = the number of periods till redemption
A = the amount paid into the sinking fund at the end of each period
r = the rate per cent per period at which the moneys in the
sinking fund are invested at compound interest
R = 1 + r
Reference to Chapter XV, page 271, gives the amount, A, of a sum of
money put at compound interest at r% for a term of n years, as A(1 +
r)ⁿ⁻¹. It is evident here that the sum, A, paid into the fund will
accumulate for n-1 years and that each succeeding payment remains at
interest one year less than the next preceding amount, the last amount
earning no interest. Accordingly, the first A—we will denote it as
A₁—will amount to A(1 + r)ⁿ⁻¹; A₂ will amount to A(1 + r)ⁿ⁻²; A₃ to A(1
+ r)ⁿ⁻³; etc. The sum of all these amounts must be equal to P, the debt
to be redeemed. Therefore, the equation may be formed:
A(1 + r)ⁿ⁻¹ + A(1 + r)ⁿ⁻² ... + A(1 + r) + A = P or
A(Rⁿ⁻¹ + Rⁿ⁻² ... + R + 1) = P, whence
( Rⁿ - 1)
A(--------) = P and
( R - 1 )
P(R - 1) Pr
A = -------- or ------,
Rⁿ - 1 Rⁿ - 1
which being interpreted means that the theoretical amount to be set
aside at the end of each period can be found by multiplying the amount
of the debt by the fraction
r
------- .
Rⁿ - 1
If the annual payment is made into the fund at the beginning of each
period instead of at the end, then
Pr r
A will be -------- and the multiplying fraction --------- .
R(Rⁿ - 1) R(Rⁿ - 1)
It is evident that in practice some allowance will usually have to
be made for failure to keep all payments in the fund and interest
accretions thereto constantly invested at the calculated rate. This is
not a matter of serious import, however, for small inaccuracies can be
adjusted during the last period or the last few periods by increasing
or decreasing the annual payments as may appear necessary at those
times. From a financial standpoint it should be borne in mind that
there is no absolute necessity for the accumulations in the fund to be
sufficient in all cases to retire the entire debt. Refunding a portion
of it may be resorted to. Other conditions being equal, it should be a
much easier task to borrow only a portion as compared with borrowing
the original amount.
Accumulation Based on Agreement
It is necessary to call attention to the inapplicability of the above
method to all cases. Of course, where the contract between the borrower
and the lender makes definite provision for the manner of creating
and handling the sinking fund, that contract must therefore govern.
However, in the case of a concern operating wasting assets, a frequent
provision of the trust agreement in the case of a bond issue is that
the periodic payments into the fund shall be proportional to the amount
of the natural product extracted or used. Thus in the coal mining
industry the trust agreement may provide that, say, five cents for
every ton mined shall be placed in a sinking fund. In determining the
amount for each ton, the total amount of the debt to be extinguished
is divided by the estimated number of tons of coal in the mine. This
gives the amount of the debt which each ton must bear. Conservatism
and business prudence require an ample allowance for mistakes in the
estimate of tonnage which it will be profitable to mine and, also, for
a liberal margin of safety. The relation between the life of the bonds
and the estimated annual output has an important bearing also, for the
charge per ton must be sufficient on the basis of the tonnage mined
during the period covered by the bonds to retire the bonds at their
maturity, regardless of how much coal there is still in the mine at
that time—unless a refunding operation is contemplated.
Similarly in the case of timber properties, sinking fund payments are
usually roughly proportional to the amount of timber cut; in earthwork
or quarry enterprises, to the amount of material removed or quarried;
in real estate development companies, to the number of divisions made
ready for the market. In such cases the compound interest method,
scientifically accurate, often gives place to annuity methods more or
less roughly calculated, under which, by trust agreement, definitely
named sums, approximately sufficient to accomplish redemption at
maturity, are set aside periodically.
Other methods fix the amount as so many per cent of gross or net
profit, of the bonds outstanding, of total business done, etc.
Oftentimes, scientific accuracy, even if desirable, is impossible
because of provisions in the trust agreement to the effect that the
moneys in the sinking fund are to be used for the purchase of the
company’s own bonds at market but providing a maximum price above
which none are to be bought. This involves purchases at a premium,
or possibly a discount, unknown at the time the periodic amount
must be calculated. An amount figured on the maximum price would be
conservative; or the amount may be based on par with the stipulation
that the difference between par and market shall be handled each period
through the profit and loss.
Effect of Settlement of Debt
As an introduction to the discussion which will follow of the relation
of the sinking fund to profits, we will first consider the several ways
in which a debt may be settled. For that purpose there is nothing which
makes clear the principle involved better than the fundamental schedule
of debit and credit, showing the interplay of all transactions as they
are brought onto the books. At the risk of unnecessary repetition, that
schedule is accordingly set up here for ease of reference.
SCHEDULE OF DEBIT AND CREDIT
===============================================================
_Debit:_ | _Credit:_
(1) Increase of assets | (a) Decrease of assets
(2) Decrease of liabilities | (b) Increase of liabilities
(3) Decrease of proprietorship | (c) Increase of proprietorship
From this it is seen that the redemption of a debt—a number (2)
transaction—may be accompanied, and therefore accomplished, by any one
of the three offsetting credits or by a combination of them. A debt may
be settled (a) by the conversion of an asset; (b) by the creation of
another liability; or (c) by an increase in net worth. Cash or other
assets may be used for the purpose, resulting in a decrease of assets,
as in (a) of the schedule. It should be noted that the borrowing of,
say, $1,000 and its repayment in cash leaves the borrower in the same
relative financial condition as before, except for the gain derived
from the use of the money borrowed. Such loans, to be repaid in this
way, are usually of a temporary nature, to tide over an emergency—such
as the handling of the load of seasonal activity, or other similar
situation. This method of settlement is, of course, not confined to
payment of debts for money borrowed, but includes debts contracted for
merchandise purchased on credit and other current liabilities.
Again, a debt of one kind may be settled by the creation of a debt of
another kind, as in (b) of the above schedule. Thus, an open account
payable may be converted into a note or acceptance payable. Here, the
liability canceled and the new one created are usually of the same
class, viz., current liabilities, and the need for a more or less
permanent increase in working funds is not contemplated. So also, a
current liability, or a group of them, may be converted into a funded
debt. This may be deemed advisable when it is seen that there will
be a permanent, or at least a long-term, need for funds which have
up to this point been provided by short-term borrowings and credits.
Again, a refunding operation would have the effect of a decrease of one
liability offset by the increase of another.
Finally, a debt may be canceled through an increase of proprietorship,
as in (c) of the schedule. By this means the redemption of the debt may
be direct or indirect. Capital stock, either treasury or previously
unissued stock, may be accepted by creditors in satisfaction of their
claims. They thus change their status from creditors to proprietors and
the result is an increase of the concern’s net worth. Indirectly a debt
may be settled by the reservation of profits. Instead of distributing
the profits as dividends, they may be retained in the business and so
provide funds, i.e., assets, for the redemption of debts. In either
case the settlement of the debt has been effected by means of increased
net worth evidenced by new issues of stock or by reserved profits.
In these various ways, therefore, a debt may be settled. As pointed out
above, the first method contemplates no permanent need for increased
working funds and the extinguishment of the debt leaves the borrower in
approximately the same position financially as before its incurrence.
Under the second method, the relative positions before and after are
the same excepting in the case of funding a floating debt. Here a
permanent or long-term increase in working funds is secured. With the
third method a permanent increase is secured in the capital funds
available for use in the business. Financial policy, governed by the
needs of the business and its markets, will always dictate the method
to be used for extinguishing or contracting a debt.
Relation of Fund to Profits
The relation of the sinking fund to profits will next claim our
attention. This point has been much debated, reaching the acrimonious
stage at times. It is variously contended: (1) that there is a
necessary relationship between profits and the payment of a debt; (2)
that for final settlement only assets will suffice; and (3) that the
policy of reserving profits to an amount equal to the sinking fund is
a policy not dictated by any fundamental principle of relationship
between profits and debt redemption.
With regard to the first claim, it is sufficient to call attention
to the discussion above where the various ways of paying a debt were
considered. As there pointed out, a reservation of profits may offer
the only available means of providing assets with which to redeem
debts. Accordingly, at least an indirect relationship between profits
and debt redemption is established.
As regards the second point, that only assets can be used for the
final payment of debts, this also is seen to be too broad a claim, for
the issue of new stock may accomplish the same end—directly, as where
issued to creditors, or indirectly, as where sold and the proceeds
applied to liquidate the claims of creditors.
As to the third claim, it might be said with equal relevance that there
is no basic relationship between debt redemption and any _method_ of
settlement. The assertion can be made with little fear of contradiction
that so long as the claims of creditors are satisfied, the manner
of doing it is of small importance. Of course, only the currency of
the realm is a legal tender for debts but, if other forms of payment
prove satisfactory and are accepted, the matter ends. It is therefore
solely a question of financial policy, no principles of accounting are
involved, and the only point in which accounting is concerned is in
making the record so as truthfully to show what is taking place, i.e.,
to reflect accurately the financial policy adopted.
If the needs of the business require a permanent addition to the
capital, as mentioned above, that can be secured in only two ways,
viz.: (1) the sale of stock and (2) the reservation of profits. If,
on the other hand, the debts to be repaid have provided funds for the
emergency or purpose for which they were contracted and that emergency
or purpose no longer exists, then the repayment of those funds to the
creditors is the business policy dictated. Under these circumstances,
to load the business with capital funds not needed in the enterprise
might well be the height of business folly. According to the conditions
to be faced, there may or may not be any necessary connection between
debts and profits.
It should be pointed out that the kind of debt—i.e., the long-term
obligation—for the settlement of which the sinking fund method is
often employed, is almost invariably an indication of the need of a
larger capital fund. Recognition of this is frequently evidenced by
the provisions of the trust agreement requiring the payment into the
sinking fund _out of profits_ of the periodic contributions. This
forces the ultimate increase of capital to be made by the owners. Two
other alternatives are open, viz.: borrowing again at the maturity of
the debt—a refunding operation—and securing additional capital through
the sale of stock. Conditions of the financial market at the time the
funds are needed, the policy of the concern as to the admission of
other owners, and the relative bargaining strength of the two parties
to the loan—these are determining factors in the financial policy to be
adopted.
Accounting for Sinking Fund
The various problems met in accounting for the sinking fund will now
be discussed. First among these is the manner of showing its status
on the balance sheet. This may be done in four different ways. Here,
also, the chief problem involved is an accounting problem only so far
as it concerns the best manner of setting forth truthfully the facts of
financial policy.
1. The sinking fund, then, under suitable title, may appear only among
the assets. As to financial policy, this indicates the creation of a
distinct fund of assets for the purpose of the sinking fund but it does
not show definitely the way in which they are being provided. They may
be secured by cutting down certain assets previously carried in larger
amount than is now deemed necessary; by a reinvestment of profits; or
by the sale of additional capital stock. The balance sheet is silent as
to what method is being employed.
2. The balance sheet may record the sinking fund status among the
assets as a definite fund and also among the items of net worth as a
sinking fund reserve. As to financial policy this not only indicates
the creation of a fund of assets, but shows that this was accomplished
by a withholding of profits from the stockholders and a reservation of
them for this very purpose.
3. There may appear on the balance sheet as the only evidence of a
sinking fund policy the sinking fund reserve among the net worth items.
This shows a reservation of profits for this purpose and therefore
their investment in the business. The reserve is not a covered reserve,
however, no definite assets being set apart as representing these
profits, or, if set apart, as having been already applied to the
cancellation of a portion of the debt. This latter phase is explained
more fully on page 458 following. Unless the assets have been applied
in this way, the balance sheet gives no assurance to the creditors that
funds will be available for the settlement of their claims at maturity.
It may be that the reserved profits are being used for further
extensions of plant and so will not be easily available at maturity
of the obligations. Again they may be invested in increased stocks of
current assets and so be readily available. Only an analysis of the
balance sheet will show the financial policy that is being pursued.
4. There may be no record of the sinking fund transactions shown on
the balance sheet. This might come about through the cancellation of
some portion of the debt by the conversion of assets. The balance
sheet, except by comparative analysis, carries no indication of the way
in which it is accomplished. It may be that it is being done at the
expense of current activities—a poor policy—or through the withholding
of owners’ profits. The balance sheet is non-committal.
Whatever method indicates the policy being followed with regard to the
sinking fund is the one which should be employed. So far as possible
indefiniteness of expression as well as nomenclature should be avoided;
not only does an indefinite statement fail to show the policy but it
may be misleading.
The Sinking Fund on the Balance Sheet
In drawing up the balance sheet, the sinking fund assets usually
appear under the caption “Investment of Sinking and Other Funds.”
Occasionally one finds the Sinking Fund account treated as a
debit valuation account, being shown as a deduction from the Bond
account. Such treatment indicates the amount of bonded indebtedness
not yet provided for by the sinking fund—an item of hardly enough
importance to justify its separate showing, particularly when an easy
comparison, under any other method, will give the same information.
The cancellation of assets against liabilities or of liabilities
against assets is not good accounting practice. Where, however, the
trust agreement provides for the investment of the sinking fund cash
in the company’s own bonds and the cancellation of these bonds as
purchased instead of holding them in the fund for the sake of their
income accretions, the bonds so canceled would, of course, be deducted
from the amount previously outstanding and only the present liability
for bonds be shown. There is no objection to showing this deduction on
the face of each balance sheet, as it thus shows the amount redeemed
during the current period. If the company’s own bonds are purchased but
kept live, it is better to show the sinking fund among the assets. All
sinking fund _reserves_ should, of course, be listed in the net worth
section of the balance sheet.
Entries to Sinking Fund
Accounting for the sinking fund presents nothing new in principle.
There are, in the main, three kinds of entries to be made, viz.:
1. Those dealing with the original and subsequent
periodic payments into the fund.
2. Those required to book the trustee’s periodic
report of his handling of the fund.
3. Those to show the redemption of the debt and the final
disposition of the accounts relating to the fund.
In the illustration, for the sake of definiteness, it will be assumed
that the governing financial policy is the second one discussed above,
according to which not only is a sinking fund created but also an equal
amount of profits is reserved each period; that the funds are placed
in the hands of a trustee for investment and that any income from the
investments is to go into the fund; and that it is desired to show both
the investments of the trustee and the unexpended balance of cash in
his possession. The account titles are suggestive only, many varying
titles being used. The entries required to show the original payments
into the fund are:
(1) Sinking Fund Cash in Hands of Trustee $.....
Cash $.....
To record payment to trustee of first
payment into the sinking fund created
according to terms of trust agreement
to retire the first mortgage 6% bonds.
(2) Surplus
Sinking Fund Reserve
To show the creation of a reserve to
provide funds for the redemption of
bonds.
Subsequent payments into the fund would be recorded in exactly the
same way as the original payments.
Booking the Trustee’s Report
Upon receipt of the trustee’s report on the handling of the fund,
entries must be made to bring a summary of the report onto the books.
This report should cover a full accounting of the funds turned over to
the trustee, his investment of them, all expenses of the trust, and
any income received or accrued. The funds may be left for accretion in
a savings bank; they may be used to purchase high-grade securities;
or with them the very bonds which they are to redeem may be bought
and canceled immediately, or allowed to run, the interest accretions
going into the fund also. Securities for investment may be bought at a
premium or a discount. Expenses will be incurred by way of commission
or salary for the trustee, expenses of the trust, advertising, brokers’
commission, etc.; and income will be received by the trustee from the
securities held and even from the unexpended balance of cash.
As to the purchase of securities at a premium or discount, the
problem involved is the proper handling of the premium or discount.
Theoretically, whether in the hands of a trustee or under own control,
premiums and discounts on securities bought for long-term investment
should be amortized. The reader is referred to Chapter XV, page 267,
for the various methods of booking such investments. Oftentimes,
however, the premium is charged at once against the sinking fund income
along with all other expenses.
To book the investments of the trustee, the entries needed are:
(3) Sinking Fund Investments $.....
Sinking Fund Cash in Hands of Trustee $.....
(List here the securities purchased
and their price.)
(4) Sinking Fund Expenses
Sinking Fund Cash in Hands of Trustee
(Itemize here all expenses chargeable
against the fund or its income.)
(5) Sinking Fund Cash in Hands of Trustee $.....
Sinking Fund Income $.....
(Record here the income from interest
on unexpended cash balance and from
securities, with proper adjustments on
account of amortization of premium or
discount.)
Treatment of Income and Expense
Practice varies as to the proper handling of the income and expense
of the sinking fund. Sometimes they are treated as affecting—i.e.,
increasing or decreasing—only the sinking fund reserve and as having no
place in the current profit and loss. That seems a mistaken view; the
fact that the investment is beyond the company’s control none the less
renders its income and expense a fact of current profit and loss, and
it should be so shown. Accordingly, the sinking fund expense and income
accounts above should be closed into profit and loss, after which their
net result will be transferred from surplus to Sinking Fund Reserve,
to show the net increment or decrement as a result of the trustee’s
operations. Thus:
(6) Sinking Fund Income $.....
Profit and Loss $.....
(7) Profit and Loss
Sinking Fund Expenses
(8) Profit and Loss
Surplus
Entry (8) is not strictly a sinking fund entry but transfers the
entire balance of the period’s profit and loss to surplus, out of
which the net increment or decrement of the sinking fund operations is
transferred to Sinking Fund Reserve by entry (9):
(9) Surplus $.....
Sinking Fund Reserve $.....
An amount equal to the compound interest increment must always be
transferred to the reserve, if accurate results are desired.
Practically the same entries will serve if the investments are the
company’s own bonds. If the bonds are canceled, instead of entry (3)
the following entry would be made:
(10) First Mortgage 6% Bonds $.....
Sinking Fund Cash in Hands of Trustee $.....
Here the item of premium or discount is usually to be found and the
question then arises as to whether the item is not better handled as a
charge or credit direct to Sinking Fund Reserve rather than through the
current profit and loss.
Final Disposition of Fund
There remain to be considered the entries recording the payment of the
bonds at maturity and the disposition of all sinking fund accounts.
The securities of the trustee must be reconverted into cash to be used
for redeeming the bonds, often resulting in a difference between the
book value of securities and the actual amount realized therefrom. This
must be adjusted by charge or credit to the Sinking Fund Reserve. After
cancellation of all the bonds, any cash balance is turned back by the
trustee to the company. The entries on the books would be:
(11) Sinking Fund Cash in Hands of Trustee $.....
Sinking Fund Investments $.....
To record sale of securities in
the sinking fund.
(12) Sinking Fund Reserve
Sinking Fund Investments .....
or
(13) Sinking Fund Investments .....
Sinking Fund Reserve .....
To adjust the difference between book
and realized values of the securities.
(14) First Mortgage 6% Bonds .....
Sinking Fund Cash in Hands of Trustee .....
To record redemption of all bonds.
(15) Cash .....
Sinking Fund Cash in Hands of Trustee .....
To record transfer to company of cash
balance in hands of trustee.
Treatment of Sinking Fund Reserve
Only the Sinking Fund Reserve account now remains on the books. Having
served its purpose of providing funds by retaining profits in the
business for the redemption of the bond issue, resulting in an addition
to the net worth of the business, this reserve is now free to be used
as deemed best. It may be thrown into surplus and so become available
for dividend purposes; or it may be used as the basis for an increase
in capital stock and be distributed as a stock dividend, thus making
the increase in net worth permanent. The following entries respectively
accomplish these ends:
(16) Sinking Fund Reserve $.....
Surplus $.....
(17) Surplus
Stock Dividend Payable
(18) Stock Dividend Payable
Capital Stock
Relation between Depreciation and Sinking Fund
A final problem deals with the relation between depreciation and the
sinking fund. If the trust agreement requires that a sinking fund
reserve shall be created by charge against profits, must provision
be made also for the depreciation of the mortgaged property held as
security for the bonds? The fact of depreciation is omnipresent and
cannot be escaped. Also, the trust agreement must be lived up to. To
carry out both requirements simultaneously would manifestly result
in a double charge. The charge for depreciation is an expense charge
which must be made before net profits can be determined. The charge
for the creation of the sinking fund reserve is against surplus, i.e.,
it takes effect after the determination of net profits. Theoretically,
therefore, the provision for depreciation must be made, else true
profits cannot be determined. Equally certain must be the provision
for the sinking fund reserve. Authorities seem to agree that not only
is there no need for provision for both but that to provide for both
places an unnecessary burden on the stockholders during the periods of
the creation of the sinking fund.
It is true that if the periodic amounts of the estimate for
depreciation and the sinking fund are practically the same, and if
provision is made only for the sinking fund reserve, there will be in
that reserve a sufficient amount to care for the depreciation. Assuming
the life of the asset and the life of the bonds to be the same, such
a policy means simply that the asset, usually a fixed asset, has been
converted by use into current funds which have been applied to the
liquidation of the bonds. There has been no reservation of real profits
for this purpose. Upon the complete depreciation of the asset, the
book value not having been written down in the meantime because no
depreciation has been booked for it, the asset must be charged against
the reserve, thereby mutually extinguishing each other. No principles
of accounting are necessarily violated.
Failure to book the depreciation as such results, however, in an
inflated showing of net profits. If the sinking fund reserve is charged
against current profit and loss instead of surplus, the showing of
net profits is thus corrected but there has been no real reservation
of profits, the sinking fund reserve being in reality a valuation
account for the depreciating asset, and thus the letter of the trust
agreement is violated. If the intent of that agreement was to increase
proprietorship, as discussed on page 456 above, this procedure will not
accomplish that purpose.
Provision for both depreciation and the reserve does not effect a
double charge against _profits_. As pointed out above, the one is an
expense charge without which true profits cannot be shown, and the
other is a charge against real profits, resulting in a lessening of
dividends. Where there is no trust agreement to compel the creation
of a sinking fund reserve, it is merely a matter of financial policy
as to how the bonds shall be redeemed, and there is no objection in
theory to the conversion of the depreciating asset to that purpose.
Much more is this the case when the mortgaged asset is a wasting asset,
the exhaustion of which is inevitably bound up with the operation of
the business. Here there is no need either to increase proprietorship
or even to maintain capital intact, and the conversion of the wasting
asset, without providing for its replacement, to the payment of the
bond issue is legitimate and wholly unobjectionable as a financial
policy.
CHAPTER XXVI
PROBLEMS IN CONNECTION WITH THE PROFIT AND LOSS SUMMARY
Interrelation of Profit and Loss and Balance Sheet
Because of the supplemental character of the profit and loss summary
to the balance sheet, no study of the latter is complete or adequate,
whether viewed from the standpoint of valuation or from any other
aspect, without at least a consideration of the profit and loss summary
in its larger bearings. Some general features of the summary will here
be considered, followed in the next chapter by a discussion of its
terminology, form, and content.
Every change in an asset which is not reflected among the other assets
or the liabilities relates to proprietorship; or, as stated from the
profit and loss point of view, every change in proprietorship, except
it be merely a transfer between proprietorship items, is reflected as a
change in assets or liabilities. The original contribution of capital
is reflected among the assets. Other items of vested or permanent
proprietorship have been discussed in Chapter XXIII, “Surplus and
Reserves,” leaving for consideration here the temporary proprietorship,
i.e., the profit and loss items. Of these, every income item results
either in an increase of assets or a decrease of liability, while every
expense shows as a decrease of assets or increase of liabilities.
The relation of the profit and loss phase of an enterprise to the
problem of valuation is apparent—the majority of the changes in value
of the assets being connected with profit and loss activities. Thus
sales result in cash or claims against customers, and a valuation of
these claims gives the amount of bad debts expense. The valuation of
fixed assets determines the amount of depreciation expense. On the
valuation of the stock-in-trade depends the cost of goods sold and
therefore the gross profit. Only those profit and loss items which
are realized or settled in cash are not dependent upon the valuation
of related assets, and even here, in so far as cash must under some
circumstances be valued, these may be, at least remotely, dependent
upon valuation. As, therefore, the balance sheet is primarily an
expression of opinion and judgment, rather than a statement of fact, so
also in large measure must the profit and loss summary be regarded as
an expression of opinion. The same factors which enter into appraisals
and valuations determine profits and losses.
Periodic Adjustments
In Chapter XXIII, on “Surplus and Reserves,” attention has been
called to the use of a statement of surplus for the purpose of showing
the changes which take place in surplus from period to period. These
changes are due to profits earned, dividends declared, extraordinary
profit and loss items not handled through the profit and loss summary,
and adjustments in profit and loss applicable to previous fiscal
periods—such adjustments being necessary because of errors in the
profit and loss summaries of those periods, due to insufficient
information for making an accurate summary at the time. The periodic
profit and loss summary is limited in its purpose and scope to the
activities of the current period and to an equitable share of those
income and expense items running over a number of periods. Because
the adjustments just mentioned are frequently necessary, the periodic
profit and loss summary as it appears on the books is never an
entirely accurate reflection of the profit and loss activities for
any period, but it is usually sufficiently so to serve all current
needs. When, however, the earning capacity of a concern needs to be
judged with great accuracy, over a number of periods, it is not safe
to depend entirely upon the periodic profit and loss summaries. It
may, for example, be necessary to judge earning capacity because of
a contemplated sale or merger. Here the basis for determining value
should be not the earnings of one period but the average of several
periods. It then becomes necessary to reconstruct the periodic profit
and loss summaries as carried on the books in the light of any
additional information that may have become available later.
The adjustments to be made in such cases comprise not only the most
obvious ones, caused by the oversight of accruals and deferred items
of various sorts, changes in inventory valuations due to an incorrect
inclusion or exclusion of some items, etc., but also changes in those
items which in the light of a longer experience are shown to be
inaccurate. This latter class of adjustments embraces particularly the
estimated items the amounts of which are not definitely determinable.
As time passes, more complete knowledge may indicate insufficient or
excessive estimates of such items as depreciation, bad debts, provision
for contingent liabilities, and similar reserve items, the valuation of
which must be corrected for an accurate showing of earning capacity.
Thus a distinction must be made between summaries compiled to show the
current profit and loss results and those which give a true index of
earning capacity over a longer period.
Interest as a Cost of Manufacture
A controversial point with a bearing on the profit and loss summary
is whether or not interest on invested capital should be included as
an item of manufacturing cost. One school of thought on the subject
maintains, with a considerable degree of argumentative warmth, that
interest should be included; while another school takes the opposite
point of view. An attempt will here be made to summarize the arguments
for and against the treatment of interest as an item of manufacturing
cost. The one school bases its main contention on the economic theory
of profits; namely, that profits represent the balance remaining after
deducting the cost of land, capital, and labor. The function of the
entrepreneur, it is contended, does not in itself involve the owning
of capital. Profit is the reward for combining the other factors of
production and assuming the risk involved. Interest is a cost for the
use of capital and it does not matter who owns the capital.
It is further contended that, in order to bring a fair return on the
capital invested, the selling price must include interest on capital
investment. While this contention is true, the fact remains that no
manufacturer would think of fixing selling price as a matter of general
policy at a figure which would not return a fair rate of interest
on his investment. But why that necessitates taking into the books
interest as an element of cost is not explained by this theory.
It is also argued that to determine whether it is better to
manufacture or to buy goods in the open market, and whether it is
better policy to manufacture by means of expensive machinery and
other equipment or by manual labor, interest on investment must be
considered. While these arguments also are well taken, they again offer
no satisfactory justification for the showing of interest on the books.
It is furthermore contended that the cost of carrying the inventories
for which the purchasing, stores, and planning departments of a
manufacturing concern are responsible, should be shown with interest
on the money invested in them taken into consideration—this for the
purpose of providing a check on the efficiency of these departments.
Where also both old and new machinery is used side by side and it is
desirable to compare their costs of production, the element of interest
should be considered.
Further argument for the inclusion of interest as an item of cost is
the fact that in numerous processes time is an important element. Thus,
the smelting of ore, the tanning of leather, the curing of tobacco, the
seasoning of lumber, etc., are examples of relatively lengthy processes
the cost of which should include interest on the capital invested.
Interest on investment is also a factor that may sometimes determine
manufacturing and selling policies, especially during slack periods
when production is curtailed, part of the plant stands idle, and the
fixed charges on the unused manufacturing capacity need to be taken
into consideration. The same argument also applies to the accumulation
of a large inventory of raw materials or finished stock during a period
of low prices. The soundness of such a policy can only be judged when
the item of interest on the capital investment is considered.
Arguments against the Inclusion of Interest
The majority of accountants are, however, opposed to the inclusion of
interest as an item of manufacturing cost. The chief objections raised
to its inclusion are:
1. The difficulty of determining the rate at which
interest should be charged.
2. Inasmuch as the amount of investment in current
assets is difficult to determine since it fluctuates
daily, is interest to be charged both on fixed
investment and on current investment, or only
on the fixed?
3. If interest is to be charged, how shall the offsetting
credit be handled on the books?
4. The introduction in production costs of a more or
less constant element tends to obscure fluctuations
in actual cost due to causes which may be
corrected, and thereby partly defeats the very
purpose of cost-keeping.
5. As the business world is accustomed to consider
interest and dividends as of the same nature,
namely, as a return on capital invested, to treat
interest as a cost of operation would produce
financial statements which are misleading.
With regard to the rate of interest, three different theoretical rates
have been suggested: (1) a so-called “pure” interest rate, i.e., one
yielded by the safest investment; (2) the rate at which money might
be borrowed for the particular type of industry; and (3) a rate
sufficient to attract permanent investment in the enterprise. From the
practical standpoint of results there are serious objections to all
these suggestions. As it is beyond the scope of this chapter to discuss
this phase of the question, the interested student is referred to the
numerous writers who deal with the question.
Problem of Charging Interest on Books
Where interest is treated as a manufacturing cost, the booking of it
raises a perplexing accounting problem. The charge has to be made to
some factory expense account, while the credit must be carried over to
possibly a financial management income account. If the entire output
of the factory were sold out by the close of the fiscal period and
no product was in process of manufacture at that time, the result of
booking interest in this way, so far as net profit is concerned, would
be nil. It would be like taking money out of one pocket and putting
it in another. This situation, however, is never met at the close of
the fiscal period. Almost invariably some finished stock is on hand
and goods are in process of manufacture. Where interest is added, the
result is to inflate the value at which the goods must be carried on
the inventory—a very undesirable procedure from an accounting and
financial viewpoint. By such means it is conceivable that a factory
might be made to show a handsome profit even before any of the product
had been sold.
Considering both the ends to be attained by, and the defects and
disadvantages of, the inclusion of interest as an item of factory cost,
its exclusion seems best. In this connection it is to be noted that all
government contracts on a “cost-plus” basis do not allow the inclusion
of interest as one of the cost items. Furthermore, all the ends aimed
at by its inclusion may be secured almost if not equally as well by
statistical records, thus eliminating the objections to the bringing of
interest as an item of cost onto the financial records.
Unrealized Profits
A similar problem to the above is the practice of charging a
manufacturing profit to the selling department. The practice is
prevalent in some concerns, of transferring the output of the factory
to the selling department at a value above the cost to manufacture.
The purpose of such a transfer is to show on the books the profit
arising from the policy of manufacturing the product instead of buying
it on the open market. The value at which the product is transferred
from the factory to the selling department is usually the wholesale
market value, though it may be at a fixed per cent above the cost of
manufacture. The effect of this is, of course, to limit definitely the
showing of factory profit. Where the compensation or the efficiency of
the factory management is measured by the savings effected over the
wholesale market price of the output, there is perhaps some practical
advantage in the allowance of a manufacturing profit.
The main objection to charging the factory output to the selling
department at any price other than cost is that such a policy
introduces an element of unrealized profit. This objection is not
serious if, at the time the books are closed for the purpose of showing
results for the fiscal period, the unrealized profit is eliminated from
the stock-in-trade inventory. So far as the profits on the portion of
the output which has been sold are concerned, the net result is the
same. The effect is to diminish the profit of the selling department
by the amount of profit allowed to the factory. To bring assets onto
the books at inflated values is, however, always objectionable, both
because of the temptation to inflate profits by valuing the goods for
the inventory at an inflated figure, and also because of the ease with
which the adjustment of such items may be overlooked or forgotten at
the close of the fiscal period. Where the adjustment is made with care,
correct results can be shown as well by the one method as by the other.
The adjustment needed applies only to the inventory of goods remaining
unsold at the close of the period, which adjustment is usually shown by
means of a valuation reserve account, by means of which the book value
of the inventory is brought down to the factory cost value.
The whole problem of profit between departments is one phase of the
larger problem of the intercompany profits of a holding company. In
such a case it usually happens that one of the subsidiaries with
separate corporate organization turns over its product to some other
subsidiary company at a price which returns a fair rate of profit.
As the product passes through the hands of the various subsidiaries,
by the time it is ready for final distribution to the public the
accumulated profits represent those of all the companies engaged in its
production. If, now, all these subsidiaries belong to the same parent
company, the book value of the unsold product shows, at the close of
the fiscal period, a large unrealized profit which must be adjusted in
order not to show the stock-in-trade at an inflated value. This problem
is discussed more fully in Chapter XXXIV where the main problems of the
holding company are taken up.
Corporation Dividends
In addition to these general problems of the profit and loss summary,
some further questions arise at the time of closing the records of
a corporation for the fiscal period. Much more care must be taken
in closing the books of a company than is necessary in the case of
either of the other general types of business organization. Thus, the
corporation authorized to issue a number of different kinds of stock
must see that the dividend declaration is based only on the amounts of
the various classes of stock outstanding, and not on the stock unissued
or brought back into the treasury. It is customary to set up separate
dividend accounts for each class of stock. Oftentimes the terms of
issue covering the various kinds of stock introduce complexities in
the calculation of the dividend. This is particularly true in the case
of stocks which have the privilege of participating in all dividends
over a certain amount. Some stocks are cumulative as to their dividend,
while others may be non-cumulative. All these conditions of issue must
be considered carefully at the time of the declaration of the dividend.
Discount on Bonds
Another problem requiring care is the treatment of discount or premium
on bonds as they are related to the bond interest charge. In Chapter
XV where bonds are discussed, the relation between the bond premium or
discount and the bond interest rate is brought out. This necessitates
at the time of the payment of the bond interest an entry to bring about
the gradual amortization of the bond premium or discount so that by the
expiration of the life of the bond issue the premium or discount is
written off the books. Where the interest period does not coincide with
the close of the fiscal period, for an absolutely accurate showing not
only must the accrued bond interest be taken into account but also the
accrued amortization of bond premium or discount.
Sinking Funds
A third problem at the time of closing the corporation’s books relates
to bringing the sinking fund transactions up to date. Where the sinking
fund is in the hands of a trustee, the corporation’s books can show
the status of the fund only upon the receipt of the report of the
trustee showing the changes in the fund for the current period. Care
must be exercised to demand a report from the trustee as on the date of
the closing of the corporation’s fiscal period. The character of the
adjustments needed and the entries necessary to book them have been
explained in Chapter XXV.
Working Capital
A fourth problem which sometimes needs to be considered is that of
“working capital.” Technically the working capital of a business is
represented by the excess of current assets over current liabilities.
As pointed out in Chapter XXV, a credit account called “Sinking Fund
Reserve” is frequently set up to indicate the financial policy pursued
in making provision for the retirement of a bond issue at maturity. At
the time of the retirement of the bonds this reserve need no longer
be shown as a separate item to indicate financial policy and should
therefore be closed out. It may be thrown back into general surplus or
it may be transferred—to indicate that it is a part of the permanent
capital of the corporation—to an account entitled “Working Capital”
or “Working Capital Surplus.” In all cases where an item of surplus
is created for a specific purpose, care must be exercised to see that
the conditions surrounding the creation of the item are lived up to
in its final disposition. In cases of surplus created by gift, as in
scholastic institutions or hospitals, this problem is particularly
important.
A similar problem is also met at the time of the redemption of an
issue of preferred capital stock, inasmuch as such redemption is
usually at a figure above par.
The Correction of Closing Errors
A final consideration has to do with the correcting of errors in the
closing work of previous periods. Any omissions and wrong valuations
of items in previous periods demand correction, but such correction
must not be allowed to affect the results of the current period. These
corrections must therefore be made either direct through surplus or by
means of an entry in the final section of the profit and loss account
as will be indicated in the next chapter. Sometimes where entries of
this kind are numerous an account called “Profit and Loss Adjustment”
is opened as a clearing account through which these items are carried
net into surplus. The chief objection to this procedure is that the
adjustments are too easily lost sight of when only the net results
appear in surplus. These entries usually carry information of value to
shareholders and they should therefore be set forth as a part of the
statement of condition rendered at the close of each fiscal period.
CHAPTER XXVII
THE PROFIT AND LOSS SUMMARY—FORM AND CONTENT
Standardization of Form
As stated in Chapter XXVI, the profit and loss summary is
supplementary to the balance sheet and should always accompany it
whenever it is desirable to make a full and comprehensive showing of
condition. This summary is given various titles and is shown in various
forms, depending somewhat upon the general class of enterprise to
which it relates, the particular purpose for which it is compiled, and
sometimes on the predilection of the person who draws it up or for whom
it is drawn. With the passage of time the form of the summary, and to a
less degree its content, tend to become standardized. The regulations
of various governmental bodies have given an impetus in this direction.
The Interstate Commerce Commission, the Comptroller of the Currency,
public service commissions of various states, superintendents of
state banks and of insurance—all require standardized reports from
the concerns under their jurisdiction. The Federal Reserve Board has
recommended certain forms of statement of both balance sheet and
profit and loss to be submitted as the basis of credit by merchants
and manufacturers. Investigations made by the Federal Trade Commission
point out the desirability of a more uniform method of presenting the
results of business activities than now exists. These regulations
and requirements as to standard forms of statement do not interfere
with the presentation of other forms of statement for other purposes
than those required by the regulatory bodies. As local conditions
frequently give rise to problems which are peculiar to individual
concerns, standard forms of statement will not always meet local needs.
Flexibility to meet given conditions, and deviation from set forms must
always be permissible if the accounting department is to render the
highest kind of service of which it is capable.
Synonymous Terms
Various titles are used as synonyms for the profit and loss summary,
among which are the following: Statement of Profit and Loss, Loss and
Gain, Outlay and Income, Revenue, Revenue and Expenditures, Income,
Income and Expenses, etc. Of these, the term most generally used is
“Profit and Loss.” “Business Statement” and “Statement of Outlay and
Income” are phrases seldom if ever employed nowadays, while “Loss and
Gain” finds little favor. Of the two terms, “Revenue” and “Income,”
Revenue is used more often in connection with non-profit-making
concerns, particularly in connection with state and municipal
accounts. “Income and Expenses” is usually limited to the profit and
loss statement rendered by clubs, churches, libraries, hospitals,
etc., although the term “Revenue” is frequently used in this
connection. “Income Statement” and “Account” are terms frequently
applied to the profit and loss summary of trading, industrial, and
professional concerns; but except where custom has established certain
well-defined uses, as indicated above, the title “Profit and Loss” is
all-sufficient; there is no doubt as to its meaning or content, and
its use for summarizing the temporary proprietorship items is thereby
established, particularly in connection with profit-making concerns.
Cost of Goods Sold—Manufacturing Concern
Profit-making enterprises may be roughly divided into several groups
as follows: industrial or manufacturing selling, agency and commission,
public carriers or transportation, and financial. The profit and loss
summary for these different groups is, in the main, the same although,
of course, the content of the summary depends materially upon the
nature of the business. In all cases the source of income is from
sales—whether of a commodity or of services makes little difference.
The first deduction from gross earnings under the title “Sales” or
other similar title is the cost of sales. At this point the first
marked divergence among the various groups is met. In an industrial
enterprise the cost of sales is the cost of goods manufactured and
sold as well as the cost of any goods purchased for immediate resale.
This latter cost is met only in enterprises which combine manufacture
with selling. This does not imply that manufacturing concerns have no
selling problem, but rather that in many cases they also purchase other
products for sale along with their own product, perhaps as side lines.
For a manufacturing concern which sells only its own product, the first
deduction from sales is the cost of the goods manufactured and sold.
As stated in Chapter III, the elements of the cost of manufacture
are: (1) material, (2) labor, and (3) factory expense. The cost of
goods manufactured must be combined with any unsold output at the
beginning of the period and a similar output at the end of the period,
in order to determine the cost of the goods sold. Cost of manufacture
corresponds roughly to the net purchases of a trading business.
Cost of Goods Sold—Trading Concern
For a trading business, i.e., a business which buys its commodity for
resale, the first deduction from sales is likewise the cost of goods
sold as determined by a “cost of goods sold” formula as follows: To
the goods on hand at the beginning of the period is added the full
cost of the net goods purchased, and from the sum of these two items
is deducted the cost of the goods on hand at the end of the period. In
the case of both the industrial and the trading enterprise, when the
cost of the commodity sold is deducted from the sales the result is the
first significant figure as to profits known usually as “Gross Profit.”
Among public carriers the first deduction from sales is the “Cost of
Services Sold or Rendered”; this is usually carried under the title
“Costs of Operation” or “Operating Expenses,” giving the figure of net
earnings.
For the other types of business mentioned—agency and commission
concerns, and financial enterprises of various sorts—the allocation of
the direct costs of the service rendered is much more difficult and
is seldom attempted. The so-called general and administrative expense
and the expense of selling are usually so inextricably merged with the
direct cost of rendering the service that a separate showing of the
items is seldom attempted. However, where any expenses are directly
applicable to the service rendered, they should be deducted first,
before the general administrative and selling expense.
Further Differentiation of Terms
Before going into a detailed explanation of the elements of the profit
and loss summary, it may be wise to make a further differentiation of
terms sometimes employed, such as: Income and Expenditures, Receipts
and Disbursements, Receipts and Payments, etc. All three terms are
often met and are frequently misused as titles for the profit and loss
summary. Their proper use should limit them to cash transactions or
activities only. It is true that in some instances the profit and loss
summary is mistakenly made up on a so-called cash basis, cognizance
being taken of the income and expense items only when realized in
cash. It would hardly seem necessary to convince the modern business
man that sales made on credit and not yet realized in cash are part
of his income as much as the items of income realized in cash, the
chief difference being that provision must be made in the one case
for uncollectible items, while in the other case no such provision is
necessary. Yet even today it is sometimes difficult to convince the
proprietor of a small business of the necessity, from the standpoint
of accurate accounting, of taking cognizance of accrued and deferred
expense items. Instances may sometimes, though rarely, arise in which
all income has been received in cash at the end of the fiscal period
and all expenses applicable to that period have been met in cash and
that no deferred items need to be taken into account. Where such is the
case, a statement of cash receipts and disbursements might give a fair
indication of the profit and loss for the period. In the case of clubs,
churches, and other institutions, practically all that is required
of the managing officers in accounting for their trusteeship is a
statement of trusteeship of cash, i.e., a statement of receipts and
disbursements. The point of this discussion is merely that the terms,
“Receipts and Disbursements,” “Receipts and Payments,” and, to a less
extent, “Income and Expenditure,” should be limited to a statement of
cash activities and never applied to the profit and loss summary.
Desirability of Uniformity in Terms Used
So far as the standardization of the sections of the profit and loss
summary is concerned, much the same remarks are applicable as to the
general title of the “Temporary Proprietorship Summary.” Such terms as
Gross and Net Profit, Gross Revenue or Income, Net Revenue or Income,
Gross Trading Profit, Net Trading Profit, Net Profit or Profit from
Operation, or simply Business Profit, are used with little uniformity
by the business world at large and even by the accounting profession.
While it is never desirable to lay down many hard and fast rules or
definitions because any statement or method of showing results should
always be flexible and adapted to the conditions met, still the use of
the same terms for different purposes and the use of different terms
for the same purpose or section of a statement are, to say the least,
confusing to the student. The committee of the Federal Reserve Board
which drew up tentative forms for the profit and loss account and
balance sheet, has done a good work in the interest of uniformity in
accounting terminology. Their suggested form is applicable, however,
only to the business of a manufacturer or merchant. In the case of
public carriers the regulation of their accounting systems by the
Interstate Commerce Commission has brought about a very desirable
uniformity of terminology. Other regulating bodies in various states
have performed a similar service in the case of public utility
concerns, although because of divided authority their rulings lack
uniformity.
Profit and Method of Showing
In general it may be said that the term “Gross Profit” is properly
applicable to what is left after deducting from the main income
the cost of that income. In a merchandising concern this figure is
sometimes called “Gross Trading Profit,” though the term “Gross Profit”
serves the purpose equally well and does not introduce a confusing
adjective. When, from this gross profit, the two groups of selling
expense and general administrative expense are deducted, there remains
what is termed “Profit from Operation” or “Net Operating Profit.” One
occasionally finds the group of selling expenses deducted by itself
from the figure of gross profit, leaving what is termed the “Net
Trading Profit.” Such a method of presentation serves no useful purpose
and shows a figure which has little or no significance. The net trading
profit merely represents what is left after deducting one group of
expenses, and gives no essential information which the total of selling
expenses would not give equally as well.
There is some difference of opinion as to whether the figure of net
operating profit should be arrived at before considering any of the
items of financial management, i.e., as to whether such items as
interest income and expense, cash discount items, bad debts, etc.,
which are more or less common to every business, should be included
before determining net operating profit or should be set up separately
after its determination. The best practice seems to be to use the term
“Net Operating Profit” as indicated above, and to show the financial
management items in a separate section. In public service utility
statements and also in those of some manufacturing concerns, such terms
as “Gross and Net Earnings” and “Gross and Net Income” are met. Where
these terms are used the gross earnings correspond approximately to
sales and indicate the amount of the main income before any deductions
are made. After the deduction of the direct cost of securing this
income, the item is frequently called “Net Earnings.” Alternative terms
for these two are “Total Operating Revenue” and “Total Net Revenue.”
When, to the item of the net earnings or net revenue, income from other
sources is added, the figure of total Gross Income is arrived at.
When, from this figure of total income the “Charges Against Income”
are subtracted, which are roughly the financial management expenses,
we arrive at the figure of net income which corresponds to the figure
of net profit. The use of the terms “Earnings” and “Income” in this
restricted way is illogical, and must be regarded as the outgrowth of
custom—a custom which is, as stated above, fairly uniform in the case
of public utilities.
Form of Presentation—Account Form
As to the form of the profit and loss summary, in the main, two
types are met. One is known as the account form because the items of
income and expense are set up like credits and debits in an account.
The other is known as the statement or report form. This is sometimes
referred to as the non-technical method of presentation because the
items are set up in running form without regard to a debit or credit
terminology, the order of arrangement being dictated by the logic of
the ordinary business man. In the case of the account form the sales
or main items of income are placed in juxtaposition on the one side
with the direct costs of that income on the other side, the balance of
the two sides being brought down as the gross profit. Against this are
set up the groups of selling and general administrative expenses. The
difference between the two sides is again brought down as the figure
of net operating profit to which are added other items of income. The
charges against that income, i.e., the expenses incurred in financing
the business, are then shown. The balance at this stage is the net
profit for the fiscal period and opposite this appears its disposition,
showing the portion appropriated to dividend purposes, to reserves
of various sorts, and finally to surplus of the portion remaining
unappropriated to other uses.
Non-Technical or Report Form
When the profit and loss summary is set up in non-technical form,
the figure of sales is first shown. Beneath this rather than in
juxtaposition as in the other case, the cost of sales is given, which
cost deducted from sales gives the figure of gross profit. Below this
appear the groups of selling and general administrative expenses, the
deduction of which from the gross profit figure gives the figure of net
operating profit or, as sometimes stated, the figure of “Net Profit on
Sales.” To the net profit on sales are added the other items of income,
and from the sum of these are subtracted the expenses of financial
management, leaving, as in the other case, the net profit for the
period.
Examples of Forms of Presentation
It is impossible and undesirable, as stated above, to lay down any
hard and fast form which must be rigidly followed, because a basic
principle of all accounting is that it must adapt itself to the needs
and requirements of particular conditions. Therefore, only the bare
skeleton of a form can be set up with any hope of its being applicable
to all conditions. In other words, the form of arrangement and method
of showing the statement to be presented at the close of the fiscal
period must be flexible, depending upon the use to which the statement
is to be put and also depending upon the information which it is
desired to set forth.
The skeleton form given below which is suggested by A. Lowes
Dickinson[68] follows the general lines laid down in this chapter. It
is designed to serve as a framework for all uses.
MANUFACTURING AND MERCHANDISING:
Gross Earnings from Sales $.....
Less—Returns, Allowances, and Discount .....
-----
Net Earnings from Sales $.....
Deduct—Cost of Production or Service .....
-----
Gross Profit $.....
Deduct—Cost of Selling $.....
Expenses of Management ..... .....
----- -----
Net Profit from Operations $.....
=====
AGENCY AND COMMISSION:
Commissions Earned $.....
Deduct—Expenses of Management $.....
Cost of Guarantees ..... .....
----- -----
Net Profit from Operations $.....
=====
TRANSPORTATION:
Earnings from Operations $.....
Deduct—Operating Expenses $.....
Taxes ..... .....
----- -----
Net Profit from Operations or Operating
Income $.....
=====
BANKING:
Earnings from:
Interest $.....
Commissions .....
Other Profits ..... $.....
-----
Deduct—Expenses of Operation and Management .....
-----
Net Profit from Operations $.....
=====
PROFESSIONAL:
Gross Earnings from Fees $.....
Less—Out-of-Pocket Expenses included
therein .....
-----
Net Earnings from Fees $.....
Deduct—Expenses of Operation and Management .....
-----
Net Profit from Operations $.....
=====
(The form for the remainder of the statement
will be the same in all cases, viz.:)
Net Profit from Operations $.....
Other Income ..... $.....
-----
Deduct—Interest on Bonds $.....
Other Fixed Charges ..... .....
----- -----
Surplus for the year $.....
Extraordinary Profits (detailed) .....
Surplus brought forward from preceding year .....
-----
$.....
Deduct—Extraordinary Charges .....
-----
Total Surplus available $.....
Dividends on Stocks .....
-----
Surplus carried forward $.....
=====
[68] In “Accounting Practice and Procedure.”
Form for Manufacturers and Merchants
The form suggested by the Federal Reserve Board as suitable for
manufacturers and merchants is presented below. It is shown as a
comparative statement of several years, but the same content and
order of arrangement of items would, of course, be followed for any
individual year. When presenting a single year’s activities, the money
columns should be so used as better to present significant figures and
their interrelations. The use of one column for items and another for
totals accomplishes this. The form shown presents, after the figure of
Net Income—Profit and Loss, a statement of extraordinary charges and
credits to profit and loss tied up with the former balance of surplus,
an appropriation made of profit and surplus at the end of this period,
giving as a final figure the new surplus at its close—which is the
figure carried on the balance sheet. This last portion of the statement
is often shown as a separate statement of surplus. The items which
are best handled as charges direct to surplus so as not to affect the
profit and loss showing for the current period, have been discussed in
Chapter XXIII on “Reserves and Surplus.” There the illegitimate use of
surplus as a dumping ground for items which it is desired to conceal
was mentioned. To prevent this misuse of surplus the final section of
the profit and loss statement is often shown as set forth above. Where,
however, a separate statement of the surplus is included as a part of
the exhibit of the condition for the fiscal period, the statement of
profit and loss will, of course, end with the figure of net profit, if
that profit is transferred to surplus, out of which all appropriations
of profit to its various uses are made. If, however, appropriations of
this period’s profits, as distinguished from the accumulated profits of
other periods, are to be made for specific purposes, their disposition
is best shown in a final appropriation section as a part of the current
statement of profit and loss.
COMPARATIVE STATEMENT OF PROFIT AND LOSS
Year Year Year
Ended Ended Ended
19— 19— 19—
Gross Sales $...... $...... $......
Less Outward Freight, Allowances, and
Returns ...... ...... ......
------- ------- -------
Net Sales $...... $...... $......
======= ======= =======
Inventory beginning of year $...... $...... $......
Purchases, Net ...... ...... ......
------- ------- -------
$...... $...... $......
Less Inventory end of year ...... ...... ......
------- ------- -------
Cost of Sales $...... $...... $......
======= ======= =======
Gross Profit on Sales $...... $...... $......
======= ======= =======
Selling Expenses (itemized to correspond
with ledger accounts kept) $...... $...... $......
------- ------- -------
Total Selling Expense $...... $...... $......
======= ======= =======
General Expenses (itemized to correspond
with ledger accounts kept) $...... $...... $......
------- ------- -------
Total General Expense $...... $...... $......
======= ======= =======
Administrative Expenses (itemized to
correspond with ledger accounts kept) $...... $...... $......
------- ------- -------
Total Administrative Expense $...... $...... $......
======= ======= =======
Net Profit on Sales $...... $...... $......
======= ======= =======
Other Income:
Income from Investments $...... $...... $......
Interest on Notes Receivable, etc. ...... ...... ......
------- ------- -------
Gross Income $...... $...... $......
======= ======= =======
Deductions from Income:
Interest on Bonded Debt $...... $...... $......
Interest on Notes Payable ...... ...... ......
------- ------- -------
Total Deductions $...... $...... $......
======= ======= =======
Net Income—Profit and Loss $...... $...... $......
Add special credits to Profit and Loss ...... ...... ......
Deduct special charges to Profit and Loss ...... ...... ......
------- ------- -------
Profit and Loss for period $...... $...... $......
Surplus beginning of period ...... ...... ......
------- ------- -------
$...... $...... $......
Dividends Paid ...... ...... ......
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Surplus ending of period $...... $...... $......
Content and Manner of Showing
Some problems in connection with the content of the various sections
of the profit and loss summary and also with the manner of showing the
content will now be taken up. The first item to be considered is the
handling of the deductions from sales. On the Federal Reserve form of
statement not only are sales returns and allowances deducted but also
outfreight charges and, in some instances, other expenses which are
regarded as direct selling costs as distinguished from the indirect
costs shown in the group of selling expenses. Practice is not at all
uniform in this regard. It should be stated that where the policy
of the business is to sell goods f.o.b. destination, the outfreight
charges may be regarded as a proper deduction from the figure of gross
sales, as otherwise that figure is inflated by the item of freight, the
cost of which is no part of the business organization nor is it under
its control. Where, however, goods are only sold occasionally f.o.b.
destination, the outward freight is more properly treated as a cost of
making the sale in the same way as advertising. It should therefore be
included in the group of selling expenses rather than be treated as a
direct deduction from sales.
Supporting Schedules
With the object of presenting a bird’s-eye view of the profit and
loss activities for the year, it is desirable that as little detail
be shown on the face of the statement as may be necessary to furnish
the information desired. The profit and loss statement under this
method of treatment must be supported as to its detailed content by
schedules giving the full information which may at times be valuable
to proprietor or manager. The first supporting schedule may well be
headed “Cost of Goods Sold.” Therein should be shown the statement
of inventory on hand at the beginning of the period, goods purchased
during the year, inward freight and carriage costs, purchase returns
and allowances, and goods on hand at the close of the year, the
result being the figure carried on the profit and loss summary.
Where manufacturing is also carried on, this cost of goods schedule
should include a statement of manufacturing activities, set up in
the following order: raw materials used in manufacture which will be
derived from a statement of raw materials inventory at the beginning,
purchases, inward freight, purchase returns, and raw materials on hand
at the close of the period. To this figure of raw materials consumed
in manufacture should be added the direct labor costs for the period,
the sum of the two giving the significant figure of prime costs. The
addition to this of the factory expense set up in detail gives the cost
of manufacture for the period.
Adjustment of Inventories
An adjustment should be made somewhere in this manufacturing section
of the inventories of goods in process at the beginning and end of the
period. This adjustment is usually made at the end of the manufacturing
statement, but the position depends largely on the cost system in
use and therefore the cost elements which make up the value of goods
in process. If these values include raw materials, direct labor, and
factory expense, and a separation of these elements is difficult or
impossible, the adjustment is perhaps best made at the close of the
manufacturing statement. Where, however, the elements referred to are
easily separable, the difference between the cost of materials in the
opening inventory of goods in process and the closing inventory should
be added to the materials used in manufacture during this period or
subtracted from them, as the case may be. Likewise, the difference
between the labor items in the two inventories should be added to, or
subtracted from, the direct labor cost for the current period. This
makes possible an exact showing of the prime cost for the period.
The element of factory expense in goods in process should then be
handled in the factory expense section, in this way doing away with
the adjustment at the end of the statement as in the other case.
While this method is more difficult and complicated, it is usually
to be preferred. The cost of the finished product turned out during
the period, as shown by the manufacturing section, must be added to
the inventory of the finished product on hand at the beginning of
the period, and from the sum of these two items must be deducted
the finished product on hand at the close of the period in order to
develop the cost of the manufactured product sold during the period.
If, now, other commodities are bought and sold in addition to those
manufactured, the cost of the goods bought and sold should be shown as
for a trading business.
Selling Expense and Administrative Schedules
The second schedule to be shown in support of the profit and loss
statement will be the selling expense schedule. Herein will be included
all the customary selling expense items, the total of which is carried
on the face of the profit and loss statement. It may be desirable in
some instances to omit advertising costs from this group and show them
on the face of the statement as a separate item. This is a particularly
desirable policy either where advertising is a large item, or where
results are to be shown during an advertising campaign.
The third schedule is the general administrative items. It seems hardly
worth while to attempt a separation of so-called general expense
items from those of administration, as any basis of separation must
necessarily be arbitrary.
The fourth schedule will show the financial management expense and
income items. These are the items which are shown on the statement
under the heads of “Other Income” and “Deductions from Income.”
These are the customary schedules presented. When the statement
of surplus is made a part of the profit and loss statement, as is
sometimes the case, and there are many detailed entries during the
period direct to surplus, a final schedule should present these charges
and credits to surplus during the period.
Schedules for Special Needs
It frequently happens that it is desirable to carry additional
schedules to those explained, in order to show an analysis of certain
earnings or operations which may be of special interest to the
individual concern. Thus, it might be desirable to show an analysis
of sales by departments, by geographical districts, or by branches.
Similarly, expenses might be analyzed on the same basis. A branch
organization, for example, might show all its activities, including
the net operating profit by branches, the sum of the branch operating
profits being taken into the combined profit and loss statement, after
which appear the items of financial management expense and income.
As heretofore stated, all these are problems concerning which no
arbitrary ruling can be made, the organization of the business and the
information desired being always the determining factor.
The problem of valuation as related to the commercial balance sheet
has now been completed. Some miscellaneous matters of corporation
accounting and finance follow and these complete the second year’s
course of study.