THE LIBRARY OF THE UNIVERSITY OF CALIFORNIA LOS ANGELES UNIVERSr LIBRARY LOS ANGELES, CALIF. 4.*** - Administration Grad nate Los togeles 24, California XXI 1 MOD ERN BUSINESS A SERIES OF TEXTS PREPARED AS PART OF THE MODERN BUSINESS COURSE AND SERVICE OF THE Alexander Hamilton Institute Modern Business Volumes 1. BUSINESS AND THE MAN 2. ECONOMICS THE SCIENCE OF BUSINESS 3. BUSINESS ORGANIZATION 4. PLANT MANAGEMENT 5. MARKETING AND MERCHANDISING 6. SALESMANSHIP AND SALES MANAGEMENT 7. ADVERTISING PRINCIPLES 8. OFFICE ADMINISTRATION 9. ACCOUNTING PRINCIPLES 10. CREDIT AND COLLECTIONS n. BUSINESS CORRESPONDENCE 12. COST FINDING '13. ADVERTISING CAMPAIGNS 14. CORPORATION FINANCE 15. TRANSPORTATION 16. FOREIGN TRADE AND SHIPPING 17. BANKING 18. INTERNATIONAL EXCHANGE 19. INSURANCE 20. THE STOCK AND PRODUCE EXCHANGES 21. ACCOUNTING PRACTICE AND AUDITING 22. FINANCIAL AND BUSINESS STATEMENTS 23. INVESTMENTS 24. BUSINESS AND THE GOVERNMENTS EDITOR-IN-CHIEF JOSEPH FRENCH JOHNSON MANAGING EDITOR ROLAND P. FALKNER ASSOCIATE EDITORS T. COULSTON BOLTON, RALPH D. FLEMING, LEO GREENDLINGER CHARLES W. KURD, THEODORE H. RAND-MCNALLY WRITERS AND CONSULTANTS See list on page v of Volume I WRITTEN FOR THE ALEXANDER HAMILTON INSTITUTE BY JOHN THOMAS MADDEN MODERN BUSINESS VOLUME 21 ALEXANDER HAMILTON INSTITUTE NEW YORK BY ALEXANDER HAMILTON INSTITUTE COPYRIGHT IN GREAT BRITAIN 1918 1919 1921 BY ALEXANDER HAMILTON INSTITUTE The title and contents of this volume as well as the business growing out of it, are further protected by laws relating to trade marks and unfair trade. All rights reserved, including translation into Scandinavian. REGISTERED TRADE MARK REG. U.S. PAT. OFF. MARCA REGISTRADA M. DE F. MADE IN U S A Bus. / d.'.i HF ' & PREFACE In the preparation of this volume, the author has endeavored to keep constantly in mind its relation to the other volumes of the Modern Business Text, especially those dealing with accounting. For this reason, all reference to valuation and interpretation has been avoided. By the time the reader has reached this volume of the Modern Business Text he has become familiar with the fundamental principles of bookkeeping; he has, moreover, seen the application of these principles in Cost Finding. The special phases of Branch Ac- counts, Partnerships, Consignments and Joint Ven- tures, Corporations and Fiduciaries require separate consideration and for this reason, they have been dis- cussed at length in so far as accounting practice is in- volved. As member of the staff of the Alexander Ham- ilton Institute, Professor John T. Madden who has written the present Text has frequently been called upon to assist subscribers in regard to ques- tions of accounting practice. This experience has been drawn upon in large measure with a view to in- cluding in the present volume the solution of many of the more important problems that are likely to vi PREFACE confront the subscribers to the Modern Business Course and Service in their reading. The author desires to acknowledge valuable assist- ance received from Mr. Leo Greendlinger, M. C. S., C. P. A., both by constructive criticism and in the form of excellent suggestion. From the standpoint of the practitioner or student of auditing, the subject of auditing is adequately treated in the excellent works of Dicksee and Mont- gomery, but a discussion of the subject from the view- point of the executive has been overlooked. The present volume attempts to supply this need and for that reason the author has explained fully the different types of engagements. The nature and character of the work which the executive may expect of his auditor are also set forth. Here we are concerned solely with verification. Ordinarily, the executive will have no occasion per- sonally to undertake the verification of assets and liabilities, and he will, as a rule, do well to leave such tasks to those who are by reason of training and ex- perience better qualified to perform them. How- ever, the rules and methods employed by practicing auditors have been stated so that the executive may, if he desires, undertake simple work of this character or so that he may at least know how one employed by him for such work should usually proceed. THE EDITORS. TABLE OF CONTENTS PART I: ACCOUNTING PRACTICE CHAPTER I PROPRIETARY ACCOUNTS SECTION PAGE 1. Proprietorship Defined 1 2. Proprietary Accounts Under Sole Ownership . . 1 3. Proprietary Accounts of a Partnership ... 5 4. Firm Capital 6 5. Partnership Good-Will 7 6. Unincorporated Associations and Societies . . 8 7. Joint Ventures 13 8. Associations and Societies 14 9. Proprietary Accounts of Stock Corporations . . 15 10. Capital Stock with No Par Value 15 11. Proprietary Accounts of Non-Stock Corporations 16 12. Reserves as a Part of Proprietorship .... 17 13. Capital in the Economic Sense Distinguished from Capital in the Accounting Sense .... 18 CHAPTER II REPAIRS, RENEWALS, DEPRECIATION AND FLUCTUATION 1. Difficulty of Distinguishing Between Capital and Revenue Charges 20 2. Intentional Confusion of Capital and Revenue Items 20 3. Surplus Produced by Wrong Classification . . 2-1 viii ACCOUNTING PRACTICE SECTION PAGE 4. Definition of Terms . ... . . . . . 21 5. Capitalization of Additional Equipment ... 23 6. Adjustment of Inventory Valuations on Change of Management 25 7. When Shrinkage in the Value of Capital Assets Is to Be Ignored 26 8. Capital Expenditures Are Extended or Acquired Assets 26 9. Accounting Practice in the Case of Replacements 27 10. Objection to Capitalization on Basis of Last Cost 28 11. Who Should Pay for the Cost of Progress? . . 30 12. Extraordinary Reconstruction Costs Where Re- serve for Depreciation Is Inadequate ... 30 13. Danger Involved in Giving Revenue the Benefit of Doubtful Expenditures 32 14. Gauging Repair and Renewal Expenditures by Profits Made 33 15. Repairs and Renewals 34 16. Replacement Fund 36 17. The Advantages of a Plant Ledger 37 18. Moving and Altering a Plant 38 19. Improvements Made upon Leased Property . . 39 20. Transfers of Equipment from One Station Unit to Another 39 21. Separation of Depreciation and Renewal Reserves 40 22. Capitalization of Machinery Made for Its Own Use by a Concern 40 23. Conclusion 42 v CHAPTER III PARTNERSHIP PROBLEMS AT ORGANIZATION 1. The Importance of Properly Drawn Articles of Copartnership 44 CONTENTS ix SECTION PAGE 2. Other Important Provisions 46 3. Difference Between the Accounts of a Business Controlled by a Sole Proprietor and Those of a Partnership 46 4. Opening Entry for Partnership Books ... 47 5. Subsequent Entries 48 6. Division of Profits and Share in the Partnership Distinguished 49 7. Illustration of Purchase of an Interest in the Profits 52 8. Other Illustrations 52 9. Division of Profits 53 10. Illustration of Division of Profits in Proportion to the Capital Invested and the Time Such Capital Has Been Employed 54 11. Solution of Problem 55 12. Division of Profits on the Basis of the Amount of Capital Originally Contributed by Each Partner 58 13. Division of Profits on the Basis of Capital Orig- inally Contributed and Accumulated by Each Partner 58 14. Distribution of Profits on a Ratio Different from That of the Capital Ratio 58 CHAPTER IV PARTNERSHIP PROBLEMS DURING OPERATIONS 1. The Importance of the Partnership Contract . . 60 2. Interest Allowed on Capital, First Illustration . 60 3. Interest Allowed on Capital, Second Illustration . 61 4. Interest Allowed on Capital, Third Illustration . 62 5. Advantages of a Fixed Rate of Interest on Capital 63 6. When Interest on Capital Should Not Be Charged to Profit-and-Loss Account . 64 x ACCOUNTING PRACTICE SECTION PAGB 7. Adjusting Interest on Capital Through the Part- ner's Accounts Direct 65 8. Comparison of the Two Methods 67 9. Interest on Excess or Deficit of Capital Contribu- tion 67 10. Treatment of Good-Will in Partnership Accounts 69 11. Retirement of a Partner from the Firm ... 72 12. Problem 72 13. Interest on Drawings 73 14. Loans of Partners 74 15. Interest on Partners' Loans ....... 75 CHAPTER V PARTNERSHIP DISSOLUTION 1. Types of Dissolution 76 2. Application of Assets at Dissolution in a Solvent Firm 76 3. Application of Partnership Assets of an Insolvent Firm 77 4. Status of a Partner's Loan in Liquidation . . 77 5. Expenses of Liquidation 78 6. Treatment of Partners' Loans Illustrated . . 78 7. Comments on the Solution of the Problem ... 80 8. Repayment of Partners' Capital 80 9. Adjustment of Capital Ratio to Profit-and-Loss- Sharing Ratio in Liquidation 81 10. Method by Which the Liquidator Can Easily De- termine the Amount to Be Distributed ... 83 11. Other Examples of Partnership Adjustment . . 85 CHAPTER VI PARTNERSHIP DISSOLUTION ILLUSTRATED 1. Adjustment of Affairs upon Retirement of a Part- ner 86 CONTENTS xi SECTION' PAGK 2. Preparation of Necessary Statements for Adjust- ments 87 3. Trial Balance and Profit-and-Loss Account . . 89 4. Preparing a Profit-and-Loss Appropriation Ac- count 91 5. Verifying the Profit-and-Loss Account and Exam- ining Financial Conditions 92 6. Analysis of Transactions in the Problem ... 93 7. Debiting or Crediting Partners' Accounts for Ad- justments 94 CHAPTER VII CONSIGNMENTS AND JOINT VENTURES 1. Legal Relation Between Consignors and Consign- ees 103 2. The Factor; His General Rights and Liabilities . 104 3. Factor's Responsibility for His Goods . . . 104 4. Factor's Responsibility to His Principal; Credit . 105 5. Factor and Secret Profit ; Books of Account . . 105 6. Expenses for Which the Principal Is Accountable 106 7. Del Credere Agency 107 8. Why Goods Are Shipped on Consignment . . . 107 9. Goods on Consignment; the Consignee's Liability 108 10. Goods on Consignment; Live Stock and Farm Pro- duce 108 11. Consignment and the Retail Merchant . . . 109 12. Brokers Distinguished from Factors .... 109 13. Mill Agents 110 14. Joint Ventures 110 15. Accounting Procedure in the Commission Busi- ness; General Ill 16. Sales on Approval, and Allowance for Deteriora- tion . Ill xii ACCOUNTING PRACTICE SECTION PAGE 17. Freight and Storage ; Consignments Occasional and Frequent 112 18. Minimum Prices on Goods Shipped . . . .114 19. Accounts to Be Kept on the Books of the Con- signee 114 20. Del Credere Agency and Its Effect upon the Bal- ance Sheets of Both Parties 115 21. Consignment Accounts of Live Stock and Produce Commission Merchants 116 22. Abstract Sales Journal 117 23. Posting Abstract Sales Journal 117 24. Illegitimate Sources of Profit 119 CHAPTER VIII CONSIGNMENTS AND JOINT VENTURES (Concluded) 1. The Accounts to Be Kept in the Books of the Con- signor 121 2. Accounting Procedure Not Difficult .... 123 3. How to Enter Joint Transactions 124 4. Equation of Accounts 126 5. Simple Equation 126 6. Rule for Finding the Equated Date Under the In- terest Method 127 7. Rule for Finding the Equated Date of an Account Under the Product Method 128 8. Illustration of Product Method 128 9. Compound Equation 129 10. Rule for Finding the Equated Date of Payment of an Account Having Both Debit and Credit Items Under the Product Method . . . .129 11. Determining the Due Date of the Net Proceeds of an Account Sales 131 12. Accounts Current 132 CONTENTS xiii PAGE L3. Another Method of Finding the Cash Balance . . 134 L4. Interest on Partial Payments 134 CHAPTER IX FIDUCIARY ACCOUNTING 1. Examples of Fiduciary Relations 137 Legal Duty of Fiduciaries to Make Accountings . 138 3. General Duties of All Fiduciaries 138 4. Corpus and Income Distinguished 139 5. Accounting Procedure for Executors .... 140 6. Executor's Accounting 142 7. Difficulty in Differentiating Between Corpus and Income 144 8. Additional Duties of Executor 145 9. Commissions of Executors 146 10. Status of Real Property 146 Heirs-at-Law and Next-of-Kin Distinguished . .147 12. Definition of Trust ; . . 148 13. Express and Implied Trusts 149 14. Passive and Active Trusts 149 15. Who Can Be a Trustee 150 16. Powers and Duties of Trustees 150 17. Investments by Trustees 151 18. Compensation of Trustees 153 19. The Law of Trustees' Accounts 153 CHAPTER X INSOLVENCY ACCOUNTS 1. Insolvency Described 155 2. Voluntary and Involuntary Bankruptcy . . . 155 3. The Duties of the Receiver 156 4. Status of Creditors 157 5. Definition of the Term "Statement of Affairs" 158 xiv ACCOUNTING PRACTICE SECTION PAGE 6. Relation of Balance Sheet to Statement of Affairs 158 7. Parties at Interest 159 8. Mechanism of the Statement of Affairs . . . 160 9. The Deficiency Account 162 10. Preparation of a Statement of Affairs for Sole Proprietorships or Partnerships . . . .163 11. Theoretical Value of the Statement . . . .163 12. Realization and Liquidation Account .... 171 13. Form of Realization and Liquidation \ccount . 172 CHAPTER XI CORPORATIONS 1. The Varied Aspect of Corporations . ... 177 2. Difference Between Accounting Practice of Cor- porations and That of Partnerships . . . 177 3. Books Incidental to a Corporation .... 177 4. Minute Book 178 5. Subscription Book 178 6. Instalment Book 181 7. Instalment-Scrip Book 181 8. Stock-Certificate Book 181 9. Stock Ledger 181 10. Stock-Transfer Book 183 11. Dividend Book 183 12. Illustration of Stock-Transfer Book .... 183 13. Illustration of Stock Ledger 184 14. More than One Form of Stock Ledger Possible . 186 15. Opening Entries for Corporate Books ; First Illus- tration 187 16. Opening Entries for Corporate Books; Second Illustration 188 17. Third Illustration , . 190 CONTENTS xv CHAPTER XII CORPORATIONS (Concluded) SECTION PAGE 1. Other Illustrations of Opening Entries . . . 191 2. Procedure When a Partnership Is Converted into a Corporation 194* 3. How Entries Are Opened in Books of a Corpora- tion . . ' . .200 4. Liquidation of a Corporation 204 5. Reduction of Capital Stock Resulting in the Crea- tion of a Surplus 205 6. Surplus Is Available for Distribution .... 206 CHAPTER XIII BRANCH ACCOUNTS Reasons for the Establishment of Branches . . 208 Types of Branches 209 Simple Type; General Characteristics . . .210 Method of Taking Inventory 210 Accounts Kept by Branch Offices 212 6. Relation Between the Home Office and the Branch Offices 212 Complex Type Branches Keeping Their Own Fi- nancial Records 215 Duplicate Records 216 9. Solution of the Problem General Comments . . 223 10. Relations with Branches in Consolidated Balance Sheet 223 11. How the Home Office Treats Shipments to Branches 224 12. How Branch Accounts Handle Goods from Home Office 224 13. Closing the Branch Books 225 XXI 2 XVI SECTION PAGE 14. Profit-and-Loss Account; the Branch Office . . 226 15. Solution of the Problem; Comments .... 228 16. Valuation of Branch Inventories . 229 17. Stock-Taking; the Inventory . . . . . .229 PART II: AUDITING CHAPTER I 1. Introductory 233 2. Definition of Auditing . 234 3. What Auditing Embraces 235 4. The Economic Function of the Professional Au- ditor 235 5. Auditors Classified 236 6. Laws Regulating the Profession Are Not Uniform 237 7. Qualifications of an Auditor 237 8. Natural Qualifications 237 9. General Training and Education Required . . 238 10. Professional Training and Education .... 239 11. Danger in Employing Unlicensed Auditors . . 240 12. Whom Not to Employ 240 13. Some of the Difficulties Experienced in Estimating Fees 242 14. Incompetents Are Gradually Being Eliminated . 243 CHAPTER II SCOPE OF AUDITOR'S ACTIVITY 1. Widening the Scope of the Auditor's Activity . 247 2. Audits and Examinations 248 3. Corporate Auditors Should Be Elected by Stock- holders . 249 CONTENTS xvii PAGE Auditors of Partnerships Should Be Named in the Articles 250 5. Advantage of Certified Statements in Securing Bank Loans 250 6. Certified Statements Aid in the Sale of a Business or in the Raising of New Capital .... 251 7. Auditor's Duty in the Matter of Estimating An- ticipated Economies 252 8. Value of Auditor's Services to Promoters . . . 253 9. Value of Auditor's Services in the Case of Fire Losses 254* 10. Importance of Audits of the Accounts of Em- ployes Under Financial Bond 254* 11. Proprietor Requires an Impartial Review of Busi- ness Conditions 255 12. Necessity of Familiarity with the Business on the Part of the Auditor 256 13. Summary of the Auditor's Functions .... 257 CHAPTER III PROCEDURE AND METHODS 1. Advance Notice to Employes Whose Accounts Are to Be Audited 259 2. The Initial Step in the Audit 260 3. First Audits Are Usually More Thoro and Com- plete 260 4. Audit Program 261 5. Cooperation with the Auditor in His Work . . 262 6. Relation Between Employes of the Client and the . Auditor's Staff 263 7. The Auditor's Working Papers 264* 8. Treatment of Information Secured Thru "Leaks" in the Auditor's Office 265 The Doctrine of Privileged Communication . . 267 xviii AUDITING SECTION FAQS 10. Information Prepared in Advance Which Will Shorten the Labors of the Auditors . . . 267 11. Schedules of Notes and Investments Should Also Be Prepared 268 12. Bank Checks and Vouchers to Be Arranged Also . 269 13. The Auditor's Responsibility for the Inventory . 269 14. The Auditor Will Request a Bank Certificate . . 270 15. Special Points to Be Noted in the Audit of Part- nerships 270 16. Procedure in the Audit of Corporations . . . 271 17. Communication with the Debtors as to the Validity of Outstanding Balances 271 18. Duties of Auditors Serving in Capacity as Wit- nesses 272 19. Procedure of an Auditor Taking an Engagement Previously Filled by Another 273 CHAPTER IV CLASSES OF AUDITS 1. Classes and Types of Audit 275 2. Detailed Audits 275 3. Testing the Accuracy of the Work in Detailed Audits 276 4. Danger in Making Tests 277 5. Detailed Audits Desirable in Small Concerns . . 278 6. Completed Audit 278 7. Continuous Audit 279 8. Advantages and Disadvantages of Continuous Au- dits 279 9. Completed and Continuous Audits Compared . . 280 10. Balance Sheet Audits or Examinations . . . 281 11. Investigations 282 12. Investigations on Behalf of a Prospective Pur- chaser of a Business 282 CONTENTS xix SECTION PAGE 13. Investigation for Receivers and Those in Charge of Reorganizations 284 14. Investigation for the Benefit of a Retiring Partner 285 15. Investigation for Banks 285 16. Investigations for Special Purposes .... 286 17. General Considerations ..... . 287 CHAPTER V VERIFICATION OF THE ASSET SIDE OF THE BALANCE SHEET 1. General Duties of an Auditor in the Verification of Assets 289 2. Procedure Will Depend on Circumstances . . 289 3. Auditing Before a Balance Sheet Is Prepared . . 290 4. Verification of Cash in Hand . . . . . . 291 5. Cash in Bank 292 6. Should the Auditor Check All Footings? . . .292 7. Checking the Postings 298 8. Verification of Purchase-Journal Entries . . . 295 9. Methods to Be Used in Checking Sales Journal . 295 10. Verification of the Accounts Receivable . . . 296 11. Sales on Approval and Their Treatment . . . 298 12. Debts Due from Officers, Stockholders and Em- ployes . . 298 13. Verification of Individual Ledgers with Control- ling Account 299 Advances to Subsidiaries 299 Inspection of Bills and Notes Receivable . . . 300 Proving the Accuracy of Inventory Values . . 301 Securities and Investments Should Be Examined . 302 Verification of Real Property Owned .... 303 Verification of Plant and Machinery .... '304 Valuation of Intangible Assets ...... 305 Verification of Deferred Assets 306 xx AUDITING SECTION PAGE 22. Sinking Fund, Cash and Investments .... 306 23. General Rules as to Verification . 307 CHAPTER VI VERIFICATION OF LIABILITIES 1. Liabilities to Be Verified ....... 310 2. Procedure in Verifying Outstanding Accofhits Payable 311 3. Other Liabilities That May Be Omitted . . .313 4. Procedure in the Verification of Notes Payable and Acceptances Outstanding 81 4 5. Examination of Public Records ..... 315 6. Verification of Bonds Outstanding 316 7. Service Liabilities Outstanding 316 8. Liability on Uncompleted Contracts .... 317 9. Liability for Containers or Returnable Packages . 317 10. Auditor's Duty Regarding Reserves .... 318 11. Verification of Capital Stock Outstanding . . 318 CHAPTER VII 1. Contents of Auditor's Report 321 2. The Scope of the Auditor's Report .... 322 3. The Right of an Auditor to Make Suggestions and Recommendations 322 4. Eliminating Extraneous Matter from an Auditor's Report 322 5. Auditor's Mistakes in Preparing Reports . . . 323 6. Restrictions Placed by Auditors on the Use of Their Reports 323 7. Difference of Opinion Between Client and Auditor an Illustration . CONTENTS xxi SECTION PAGE 8. Graphic Method of Presenting Financial Results . 325 9. Auditors as Arbitrators 326 10. Is an Auditor Justified in Relying upon State- ments Made by the Proprietors or Officers of an Undertaking? 326 11. Attitude of an English Court with Regard to Au- ditors' Responsibility in Accounting Practice . 327 12. Moral Responsibility of the Auditor .... 328 13. Abuses in the Profession 329 14. Forms of Certificates 329 15. Importance of the Auditor's Work .... 331 Index . 333 PROPRIETARY ACCOUNTS 1. Proprietorship defined. The excess of assets over liabilities constitutes proprietorship, or owner- ship. The ledger accounts that represent and meas- ure this excess are known as the proprietary accounts. Broadly speaking, there are two general classes of undertakings. The first class consists of those un- dertakings in which the prime purpose is to increase the proprietary interest thru profits resulting from the employment of wealth in business enterprise. The second class consists of those undertakings in which the principal object is not to make a profit, but to render service, either to the members of the par- ticular organization or to the community at large. The legal phases of the various classes of under- takings, together with the legal rights and duties of the members Composing them, have been fully dis- cussed in the volume on "Business Organization." 2. Proprietary accounts under sole ownership. When a sole trader begins business operations, the amount of his investment, represented by the differ- ence between his assets and his liabilities at that time, should be credited to his capital account. If this is 2 ACCOUNTING PRACTICE done, the effect is the same as that which would have resulted from crediting the proprietor's account with the sum total of his assets, and debiting it with his liabilities. The proprietor's investment will include only those assets that are actually employed in the business ; that is, he will not merge his purely personal assets with those that are used in the business. His liabilities should include only those debts which are created in carrying on the business. His capital ac- count will thus represent his net investment. This distinction is important because, while it is proper for a sole proprietor, in furnishing a statement of his assets and liabilities for credit purposes, to include as- sets and liabilities which do not belong to the business, such procedure would not be proper if the proprie- tor were merely making a statement of the accounts of his business. In comparing the profitableness of different busi- ness operations, the proprietor must take into con- sideration only the assets which have been employed in securing such profits. If he includes other as- sets, not employed in the business, he will reduce the ratio of earnings on the invested assets which are used in the business. During the year, the proprietor will perhaps with- draw for his personal use either funds or merchan- dise. In order that a proper record may be kept of the withdrawal of such values, and in order that the proprietor may be able to determine accurately the profits which result from his business, he must charge PROPRIETARY ACCOUNTS 3 to a special drawing account the amounts withdrawn in cash as well as the cost of the merchandise which he may have consumed for his personal use. At the end of the period, the balance of this account should be transferred to the debit of his investment or capital account. The change in the proprietorship during the period, measured by the net loss or the net profit from business operations, at the end of the period un- der review, will be carried to the credit or to the debit of his capital account, according to whether they have resulted in a gain or in a loss. In order that the true profit resulting from business operations may be reflected in his accounts, the proprietor may prop- erly charge, as an expense of the business, the rea- sonable value of his personal services. A sole trader should also provide for the adequate depreciation of his fixed property during the period, by charging the amount thereof against the profits of the period. The amount of depreciation sustained will be credited either to the asset account direct or to an appropriately ear-marked reserve account. The latter method is preferable, and if followed, the reserve account should always be considered as an offset to the relevant asset. It should not be shown as a part of the proprietorship. The proprietor may also set aside out of his profits ther reserves as prudence may dictate. The use of such reserves, however, is more common in the business of partnerships and corporations. In brief, then, the proprietary interest of a sole trader will be represented 4 ACCOUNTING PRACTICE by the aggregate of his capital and salary accounts- including the reserves that may have been created, as a result of prudence and conservatism, eliminating the reserves for depreciation minus any balance that remains in the drawing account. The fact that the law does not recognize the busi- ness undertaking of a sole trader as an entity separate and distinct from the proprietary account, is impor- tant enough to bear repetition. If the assets of John Jones, proprietor, are not sufficient to liquidate the liabilities of John Jones, proprietor, the creditors have a right to satisfy themselves out of any other assets that John Jones may own in any other capacity. This point is important because of the fact that there is considerable discussion as to whether or not the pro- prietorship constitutes a liability or an accountability. While this discussion is more theoretical than prac- tical, it may in some instances help to determine whether a business organization is solvent or insolvent. For illustration, let us assume that a corporation has assets amounting to $10,000, liabilities to out- side creditors of $4000, and capital stock outstand- ing to the amount of $6000. Let it be assumed that at the end of the period the assets are found to be $9000, while amount of the liabilities and the outstand- ing capital is the same as it was. Clearly, the $1000 loss sustained during the period must be charged against the capital. A business organization is in- solvent if its assets are less than its liabilities; and if, in this case, capital is a liability, the organization is PROPRIETARY ACCOUNTS 5 clearly insolvent. On the other hand, if capital is not a liability, the organization is still solvent, but the capital has been impaired to the amount of $1000. It was decided by the court in a very important New York case that the capital stock of a corporation is not a liability. This is not only good law but sound accounting. The late Colonel Charles E. Sprague, one of the foremost thinkers of his time, stated the matter very clearly in his volume entitled, "The Phi- losophy of Accounts" : Thus the right-hand side of the balance sheet is entirely composed of claims against or rights over the left side. "Is it not true," it will be asked, "that the right-hand side is entirely composed of liabilities?" The answer to this is that the rights of others, or the liabilities, differ materially from the rights of the proprietor, in the following respects : (1) The rights of the proprietor involve dominion over the assets and power to use them as he pleases, even to alienating them ; while the creditor cannot interfere with him or them except in extraordinary circumstances. (2) The right of the creditor is limited to a definite sum which does not shrink when the assets shrink, while that of the proprietor is of an elastic value. (3) Losses, expenses, and shrinkage fall on the proprietor alone, and profits, revenue and increase of value benefit him alone, not his creditors. For these reasons, the proprietary interests cannot be treated like the liabilities, and the two branches of the right-hand side of the balance sheet require distinctive treatment. Furthermore, as Colonel Sprague has pointed out in another place, those who consider capital a liability are put in the position of treating insolvency as an asset. 3. Proprietary accounts of a partnership. The 6 ACCOUNTING PRACTICE proprietary accounts of a partnership are similar to those of a sole trader, and present no difficulty if we bear in mind that the proprietary interest is sub- divided in accordance with the partnership agreement. The accounting records must reflect the intention of the parties as evidenced by their articles of copartner- ship. There will be for each partner a capital ac- count, a salary account and a drawing account; there will also be the firm's reserve accounts. Interest on partners' capital may be allowed, under the partner- ship agreement, as a means whereby to equalize capi- tal, and the proper method of treating this in the accounts will be fully discussed in a later chapter of the present volume. 4. Firm capital. The firm capital consists of the amount of money or property that the partners have agreed to contribute to their joint enterprise. Some- times one or more of the partners will contribute to the enterprise only their skill or labor, and not infre- quently these contributions of skill and labor are rela- tively more valuable than money and property. It is not possible, however, to register in books of account the value of these latent or hidden assets, so that the labor or the skill which such a partner may contribute can be considered as capital only in a restricted sense. For this reason, when a firm is dissolved a partner who has contributed only skill is not entitled to share in the ultimate distribution of the capital of the firm. Accordingly, when the firm's debts are paid the cap- ital remaining is returned to the other partners in the PROPRIETARY ACCOUNTS 7 proportion in which they contributed it. But the partner who has contributed only ability or skill is still liable for his share of the loss in capital. It should also be noted that the expression, firm property, is not synonymous with firm capital. The amount of firm capital is specified by the articles of copartnership ; it is a fixed sum. But the firm prop- erty varies from time to time; it may be greater or less than the firm capital. The firm capital may, however, be increased or decreased, provided the con- sent of all of the partners is obtained. 5. Partnership good-will. The good-will of a trad- ing firm is an asset in which it is only right that the estate of a deceased partner should share. Accord- ing to the old common-law doctrine, the good-will of a firm reverted, upon the dissolution of the firm, to the surviving members, but this extremely harsh and unjust rule has now been modified. It is well to pro- vide in the partnership articles for the method to be employed in valuing the good-will of a business upon the death or retirement of a partner. It seems, however, that in the case of a non-trading partnership, good-will, as a firm asset, is not recog- nized. The following is the opinion of Judge Storey on the subject: It seems that good-will can constitute a part of the part- nership effects or interests only in cases of a mere commercial business or trade, and not in cases of professional business, which is almost necessarily connected with personal skill and confidence in the particular partner. XXI 3 8 ACCOUNTING PRACTICE 6. Unincorporated associations and societies. La- bor unions, societies, clubs and charitable and edu- cational institutions are frequently organized as un- incorporated associations. The capital funds of such associations are obtained thru contributions, bequests, legacies, and membership dues. The proprietary in- terest will be represented by the balance standing to the credit of the dues account, augmented by the surplus of operations of the preceding period carried to the credit of the capital surplus account, and fur- ther increased by any balances that there may be in re- serve accounts. Organizations of this type frequently receive gifts, which may be restricted or unrestricted. The former will include gifts for special purposes, or permanent funds created by the organization itself. The latter will include gifts made with the stipula- tion that they be used to meet the current expenses of the organization. The amounts contributed for spe- cial uses to organizations of this type are sometimes credited to reserve accounts. The term "reserve" is not appropriately applied to items of this character, because that expression has a special meaning in ac- counting terminology it suggests a reservation of profit or surplus. Furthermore, the term, as it is gen- erally used, does not convey the idea of the organiza- tion's responsibility in accepting gifts that are given with the understanding that the organization shall use the principal or income for a certain purpose, which is specified. PROPRIETARY ACCOUNTS 9 For example, let us assume that John Smith left by will to the Memorial Hospital the sum of $2,000,000, of which $1,500,000 was to be used for the purpose of erecting a new surgical building to be known as the Smith Memorial Surgery. The will also provided that the balance of the bequest was to be used for the purpose of establishing an endowment. Only the in- come of this endowment was to be applied to the maintenance of the new building. Upon the accept- ance of such a gift, the trustees of the institution would have a duty to preserve intact the principal of the endowment for the building, and to invest the gift in accordance with the provisions of the trust. The accounts of the institution should at all times reflect the amount of the gift, as well as the disposition which is made of it. It will be noted, also, that the gifts are of a different nature. The larger is for a permanent endowment to be invested in a non-pro- ductive asset non-productive in the sense that it is not to be invested in interest-bearing securities. The smaller gift must be invested in interest-bearing se- curities; the principal sum must be preserved intact, and only the income from it is to be used for the cur- rent purposes of the organization. Institutions of this character usually have a large number of such endowments, and it is probably incon- venient to carry the detailed record of each endow- ment in the general ledger of the organization. In- stead, a controlling account could be carried in the 10 ACCOUNTING PRACTICE general ledger, and to this account should be credited the amounts which are donated to the institution for specific purposes and which are to be invested in fixed and non-productive assets. Supporting this account there should be a subsidiary ledger in which should be recorded the details of each gift, each ledger account containing a full and complete explanation of the terms of the gift. Money or property given to the institution, which is to be invested in income-bearing securities, could be handled in a similar manner; in other words, it should be credited to a controlling ac- count in the general ledger and should be supported by a subsidiary ledger showing the specified condi- tions attaching to each gift contributed for the pur- pose of productive endowment. As the gifts are invested by the trustees from time to time, the amount invested should also be carried in appropriate controlling accounts. There should be one controlling account for the investment of the non- productive endowment, supported by its subsidiary ledger showing the details of the investment ; and there should be another controlling account for the invest- ment of the productive endowment, supported by sub- sidiary records showing the details of the investments. The following journal entries will illustrate the procedure as regards non-productive endowments, in cases of this kind. Of coiirse, similar entries should be made for the productive endowment, for which the journal entries would be the same; the only difference would be the substitution of the word "productive" PROPRIETARY ACCOUNTS 11 for the word "non-productive." As soon as the in- stitution received the cash from John Smith's execu- tors, the following entry should be made: Special Cash Funds $1,500,000 To Principal of non-pro- ductive endowment . . . $1,500,000 (John Smith Memorial Surgery Endowment) To record the receipt of this gift under the will of John Smith, which is to 'be used to erect a new surgical building to be known as the Smith Memorial Surgery. Special Cash Funds $ 500,000 To Principal of produc- tive endowment $500,000 (John Smith Memorial Surgery Maintenance Endowment) To record the receipt of this sum under the will of John Smith, which is to be used to create an endowment, the income of which is to be used for the maintenance of the Smith Memorial Surgery Building. The foregoing journal entry indicates that the cash fund of $1,500,000 has been set apart in a restricted cash account and has been credited to the principal of non-productive endowment. The credits should also be posted in the subsidiary record which is provided for the purpose of showing the detailed amounts that stand to the credit of each of the individual endow- ments. The amount of $500,000 should be credited to the principal of productive endowment in like man- ner. We will assume that the trustees have immediately proceeded to erect the Memorial Surgery and that they have from time to time expended various sums, amounting to a total of $1,200,000. The journal en- 12 ACCOUNTING PRACTICE try necessary to record this progress would read as follows : Investment or non-productive endowment. . . . $1,200,000 (John Smith Memorial Surgery Building) To special cash funds $1,200,000 For the cost of the Smith Memorial Surgery Building. The "investment of non-productive endowment" ac- count constitutes a controlling account supported by a subsidiary ledger in which will be found the detailed accounts that show the investment of the respective non-productive endowments. It is possible at all times, thru the medium of the controlling account, to tell how much of the non-productive endowment has been invested and how much remains uninvested, since the difference between the total standing at the credit of the principal of non-productive endowment and the total standing at the debit of the investment of non-productive endowment will be the uninvested principal of non-productive endowment. This unin- vested principal will be represented by cash in the spe- cial cash fund, which is the cash account thru which all trust funds pass. In order to ascertain the details of the various endowments, and the portion of each which has been invested or which remains uninvested, it is necessary only to turn to the subsidiary ledgers. The first step is to make a list of the principals of the various endowments. This can be compiled from the subsidiary ledger controlled by the principal of the non-productive endowment account in the general ledger. Then in a parallel column, an entry should PROPRIETARY ACCOUNTS 13 be made of the details of the respective investment accounts that are shown in the subsidiary ledger con- trolled by the general ledger account, "Investment of Non-Productive Endowment." The difference between these two sums should be carried to a third column which should include the uninvested portion of each individual endowment. The total amount shown in the third column will be the uninvested por- tion of the non-productive endowment. This should be reflected in the special cash fund. It is to be noted that in certain cases it is not neces- sary, according to law, to keep the investments of the different productive investments separate. Some- times it is allowable to provide for the productive in- vestments a consolidated investment account which shall take the place of the individual investment ac- counts that are a part of the method suggested above. The income from the consolidated investments should be apportioned to the income accounts of the various funds on some equitable basis, usually according to the ratio of the principal of the individual funds to the total invested principal. In regard to keeping the accounts of a hospital, or other similar institutions, it is also important to note the fact that certain funds are legal trusts and must be invested in securities that are legal investments for trust funds, under the laws of the particular jurisdic- tion involved. 7. Joint ventures. Because the joint venture is al- ays of short duration, and because its operations are 14. ACCOUNTING PRACTICE restricted, it is not generally necessary, in the conduct of such an enterprise, to keep a separate set of books for such ventures. The accounts may be conveniently kept according to the method explained in a later chapter. If, however, it is decided to keep separate accounts, the proprietary accounts may be managed as they would be in the case of a partnership. 8. Associations and societies. The income of an association or a society consists principally of the dues and fees. Against these will be charged the expenses of the association, and the balance that remains in the current dues account at the end of any period will be transferred to an appropriately ear-marked surplus or reserve account. In other cases, the dues account may be transferred to the credit of a revenue-and- expenditure account, and the expenses of the period will be charged against this account. The balance of the revenue-and-expenditure account may be trans- ferred to surplus or to a special reserve account, which should in some way be distinguished from the other accounts. It is better to call the surplus account of an organization that is not conducted for profit, "Capital Surplus," in order to differentiate it from the profit-and-loss surplus of corporations. The sur- plus of associations is sometimes in part restricted. Life memberships, for example, usually form a part of the restricted surplus, because the money paid in is generally credited to a special account and the in- come of the funds only is used for the general busi- ness of the organization. * PROPRIETARY ACCOUNTS 15 9. Proprietary accounts of stock corporations. The capital-stock account in a corporation represents the original contribution of the members. It may be increased or decreased only by means of the method that the law provides. The profits from operation are carried to a surplus or undivided profits account, out of which the distribution of profits, in the form of dividends, is made. If, instead of a profit being made, a loss is sustained, the amount of the loss is charged to a deficit account. When a corporation is organized with a capital stock that has a stated par value, the deficit account cannot be charged against the capital account. In such a case a situation arises which seems to involve a contradiction that of in- cluding a deficit among the assets in a balance sheet. In order that the deficit may in no way be mistaken for an asset, the deficit account should be very care- fully marked as such. 10. Capital stock with no par value. The laws of some states permit the organization of a corporation that has capital stock with no par value. In the case of such a concern, certificates are made out which represent fractional shares of the total capital of the organization, but which bear no statement as to the par value of these shares. Thus, if A pays into the company $1000 and receives in exchange 12 shares of stock out of a total issue of 1000 shares, his certificate will state that he has a 12 /woo share of the capital of the company. Any assets acquired by the concern will be placed upon the ledger at the value 16 ACCOUNTING PRACTICE decided upon by the board of directors, and the capital account will be credited with this value. The stock- certificate book and the stock ledger will reveal the number of shares issued in exchange for the assets. If this method of operating the capital account is used, assuming that the organization has not begun operations, the capital account represents the total of the contributions made by the members, and the book value of the stock will be the par value of the shares. This book 'value may be found by dividing the amount standing to the credit of the capital ac- count by the number of shares issued and outstand- ing. There is no necessity for maintaining a surplus or an undivided profits account, since the surplus from current operations will be transferred directly to the credit of the capital account. In a like man- ner a deficit from operations will be debited to the capital account. If it is desired, a surplus account or a deficit ac- count may be carried by means of the same method as is customary when capital stock has a fixed par value, but this is unnecessary. The only advantage would be that in this way the average book value of the shares at the time of organization could be shown. Under either form of organization any portion of the free surplus set aside in specific reserves, such as sinking fund reserve, reserve for the redemption of debt, or reserve for renewals and betterments, should be stated separately. 11. Proprietary accounts of non-stock corporations. PROPRIETARY ACCOUNTS 17 A non-stock corporation, as the name implies, does not keep accounts for dividends, profit-and-loss sur- plus or capital stock. Otherwise, the accounts of this kind of corporation are the samfc as those of associa- tions and societies. 12. Reserves as a part of proprietorship. Reserves are generally divided into two broad classes those which represent losses actually sustained in the value of assets or anticipated losses; and those which are a portion of the surplus, and which are created by charges to operating expenses or surplus. A third class is sometimes included reserve for taxes, etc.; but such accounts are really liabilities. Good examples of the first class of reserve accounts are the reserve for bad debts and the reserve for de- preciation. Theoretically at least, these reserve ac- counts are created to offset a decline in the value of the relevant assets, and they are increased as rapidly as the assets which they offset shrink in value. But this may not always be the case. Reserves for deprecia- tion and reserves for doubtful debts are sometimes created for greater amounts than are necessary to take care of the losses sustained. Where, however, the re- serves are created to measure actual losses, they can- not be proprietary accounts and should not be consid- ered as part of the net wealth. Thus, if a reserve for depreciation has been created to take care of the ac- crued depreciation to date, it represents that portion of the asset value which has disappeared. It cannot, therefore, be said to be a portion of the proprietorship, 18 ACCOUNTING PRACTICE because a certain amount of the original capital, cor- responding to the amount of the reserve, has been consumed in operating. On the other hand, those reserves which are not created for the purpose of measuring losses actually sustained, but which repre- sent funds set aside out of surplus and locked up so effectually as to prevent their distribution as divi- dends, are part of the proprietary interest. 13. Capital in the economic sense distinguished from capital in the accounting sense. In the volume on "Economics" in the Modern Business Text the reader learned that capital, in terms of economics, is a fund or stock of wealth which is used in the produc- tion of other wealth. The economist regards capital only from this point of view; capital to him means as- sets. From the accountant's standpoint, the term capital means proprietorship, or ownership in other words, the equity in the assets. Altho the terms are often used interchangeably in legal decisions, it is important to bear this distinction in mind in reading business literature. Because of the liability of con- fusion in the terminology, the word proprietorship is coming more into use. If a business had no liabili- ties the. economist's conception of capital would agree with that of the accountant, but since such a situation seldom occurs, it is well to keep clearly in mind the different meanings of this term. REVIEW In what respects are the proprietary accounts of a partnership different from those of a corporation? PROPRIETARY ACCOUNTS 19 Could you outline a system of accounts for a charitable organ- ization, whereby it would be enabled to control its investments and endowments properly? What class of reserves do not constitute a part of the pro- prietorship ? What are the proprietary accounts of a corporation? Of a non-stock corporation ? CHAPTER II REPAIRS, RENEWALS, DEPRECIATION AND FLUCTUATION 1. Difficulty of distinguishing between capital and revenue charges. Whether a certain item of expendi- ture should be charged to capital or to revenue ac- count is a perplexing question for both accountants and business managers. It is also a question for which it is easy to prescribe general rules but diffi- cult to provide for their practical application. The importance of this distinction may best be shown by two hypothetical cases. 2. Intentional confusion of capital and revenue items. In the first case, a corporation has an issue of income bonds bearing interest. Now if the board of directors should charge improvements which ma- terially increase the earning capacity of the corpora- tion against earnings, instead of to capital account, there may be nothing left for the holders of the in- Come bonds. As this interest is payable only when there are earnings, one can readily see the difference which such a charge makes. The peculiar feature of income bonds, as shown in the Text on "Corporation Finance," is that the inter- est is not a fixed charge as in the case of mortgage bonds, but only a lien against the income of the cor- 20 REPAIRS AND RENEWALS 21 poration. Moreover, the holder of income bonds re- ceives interest only where there are earnings left after all fixed charges have been defrayed. 3. Surplus produced by wrong classification. In the second case the situation is reversed. A corpora- tion has made repairs and improvements which do not increase the earning capacity of the company but which are actual replacements of assets which were wasted during operation. The board of directors are in a quandary. On account of business depression they fear they will be unable to declare the usual yearly dividend. But if they withhold the dividend, serious fluctuations in the stock of the company may be noted in the market quotations. To guard against such a contingency, the directors order the repairs and improvements charged to capital and treat them as acquisitions of property and hence assets, leaving to the corporation a surplus which may be used for the payment of dividends. It is not intended here to discuss the propriety or impropriety of the action of the directors in either case, but merely to cite these illustrations that the reader may understand the importance of proper classification of capital and revenue items. 4. Definition of terms. "Capital receipts" repre- sent sums contributed to a business with the intention of using them to carry on the enterprise. "Capital expenditures" is a term given to expendi- tures incurred for the purpose of acquiring, extending or completing the equipment of an enterprise in order 22 ACCOUNTING PRACTICE to place it on a revenue earning basis, or to increase its earning capacity. "Revenue receipts" are the receipts of business op- erations, i.e., earnings. The cash revenue receipts will generally be less than the actual earnings, as prac- tically no line of business is conducted on a strictly cash basis and, therefore, the credit to revenue ac- count, and not the receipts in cash, will show the true earnings for the period. "Revenue expenditures" are those expenditures which are incurred in the operation of the business. Indeed, any expenditure of a business that does not improve the fixed assets, increase the earnings, enlarge the field of operations, reduce the cost of doing busi- ness, or any expenditure the life of which does not extend beyond one year, should be charged to revenue. "Additions" are amounts which are expended for additional buildings or equipment or facilities; in brief, those expenditures made for structures or equip- ment which do not take the place of anything previ- ously existing. "Betterments" may be distinguished from addi- tions in that they include the improvement or enlarge- ment of buildings, machinery or equipment already in existence. "Replacements" is the term used to designate the removal of a capital asset which has become exhausted or inadequate in service and the substitution of an- other of the same or greater capacity. Where the new unit has a capacity substantially greater than that REPAIRS AND RENEWALS 23 for which it was substituted, it is proper to charge the cost of replacement to capital account. The unit dis- placed should be credited to capital account. "Renewals" include the cost of extending the life period of some capital asset already existing thru a process of extensive repairs; renewals may gener- ally be termed extraordinary repairs. Minor renew- als are generally included under the heading "repairs." The term "repairs" embraces expenses incurred in replacing any part of a unit the replacing of which is made necessary thru wear and tear or thru acci- dent. Repairs are distinguished from replacements in that replacements are charged to the capital ac- count and the value of the article displaced is credited to that account. Repairs are strictly revenue items and are not to be charged to the capital account, but should be charged to operating expenses for the reason that the replacement or renewal is a minor one and does not cause a substantial change of identity in the unit of equipment upon which the expenditure has been made. 5. Capitalization of additional equipment. There is usually little difficulty in determining whether charges for additional equipment should be capitalized or not. However, problems sometimes arise in the case of the purchase of the entire assets of another or- ganization. Let us assume that company "A" pur- chases the assets of company "B" at a flat price and that before purchasing these assets company "A" has carefully considered the value of each of them and XXJ 4 24. ACCOUNTING PRACTICE has determined the purchase price accordingly. It* may happen that with the equipment are certain units of no use to company "A" but which the company is obliged to buy in order to secure the remainder of the equipment. It would be proper for company "A" to value the assets acquired at the purchase price, treating the undesirable units as scrap material. If, on the other hand, a mistake was made in the first valuation of the assets, and upon revaluation it is discovered that the equipment purchased will require considerable expense to prepare it for operation, it is evident that the capital account should be charged with only the cost price of the units acquired. The loss due to the mistake in valuation becomes a proper charge against surplus account, because it is not al- lowable to capitalize mistakes in judgment. How- ever, if it was known at the time of purchase that these amounts would have to be expended, the situation would be different and the expenditures on the pur- chased equipment would then become capital charges. The repairs which company "A" must make on any equipment purchased in this manner may therefore be capital or revenue expenditure depending upon the conditions under which the units were purchased. Occasionally, in reorganizations of manufacturing and trading concerns a new manager takes over a much neglected plant. The old management has failed to provide properly for depreciation and has indulged in the pernicious economy of neglecting the necessary repairs and renewals which should have been REPAIRS AND RENEWALS 25 made on the equipment. The new management might very properly object to charging in the revenue account the cost of repairs and renewals on wornout equipment, and it might claim also that such repairs should be capitalized and not charged against the revenue account. This procedure would, of course, be improper and would result in a false profit being shown, but inasmuch as the expenditures should have been made by the previous management, the amount necessary to bring the equipment into proper operat- ing condition should be charged to surplus account. If there is no surplus account against which the items can be charged, the expense of making repairs can be carried as a deferred charge in an appropriately ear- marked account on the balance sheet and be written against surplus in succeeding years. 6. Adjustment of inventory valuations on change of management. While not directly connected with the property account, it may be noted in this connec- tion that the new management may also object to the inventory valuation of merchandise carried on the books by the former management. It frequently hap- pens that the old management in order to make a good showing may have appreciated the inventory, or it may have carried at inflated values merchandise that is shopworn, out of fashion or not in proper con- dition to sell. If these conditions obtain and the mer- chandise is overvalued, the adjustment in the accounts should be made thru surplus at the beginning of the period and not thru the current revenue ac- 26 count. It is only fair to the new management to see that at the commencement of its operations all equip- ment shall be in good operating condition and the merchandise inventory properly valued. 7. When shrinkage in the value of capital assets is to be ignored. Capital assets, however, may de- crease in value without affecting revenue. For ex- ample, a shrinkage in the value of assets may occur owing to causes outside of the ordinary operations of the business. Therefore, as long as these assets are not disposed of, such shrinkage can only be an esti- mated item and may properly be ignored in the ac- counts. 8. Capital expenditures are extended or acquired assets. Most of the errors in principle that occur in practical work show a lack of effort to discriminate strictly between capital and revenue items. One needs to bear in mind in this connection that all expenditures recorded as capital expenditures must be represented by actual assets. Nothing remains to represent ex- penditures that have been incurred upon revenue ac- count. Has the particular expenditure, in any indi- vidual case, been incurred for the sake of improving the earning capacity of the enterprise? If so, it is a charge against capital and should be classed as one. If, however, the result of the expenditure has been merely to put the earning capacity of the undertaking on the same footing as before a decline such decline being due to ordinary wear and tear then it must be charged against revenue. Not mere renewals but REPAIRS AND RENEWALS 27 only the extension or acquisition of new assets can be recorded as capital expenditures. If an asset for which an expenditure was made exists at the end of the current period as an asset, such expenditure should be charged to capital. On the other hand, if the asset is consumed during the current earning period, it must then be charged against the revenue of that period. We frequently have examples of expenditures that may or may not result in a direct increase in the earn- ings of an organization; thus where a railway com- pany tears down an old station and replaces it with a larger, more commodious and more modern structure, considerable doubt exists as to whether such expendi- ture could be properly capitalized. It is granted that the earnings will not increase; nevertheless the exist- ing structure was inadequate, and undoubtedly the building of the new station will result in a continuance of public favor and patronage. In such a case it is considered proper to capitalize the new structure and displace the cost of the old station from the asset ac- counts. 9. Accounting practice in the case of replacements. From the definition which has been given for re- placement, it is evident that the term conveys the idea that one article is substituted for another of the same or greater value or capacity as distinguished from a renewal which renews some existing article by manu- facture or extensive repair. Some accountants, how- ever, claim that inasmuch as variations in cost are to be expected, therefore only bona fide investments 28 ACCOUNTING PRACTICE should be capitalized. To illustrate : If assets which originally cost $200,000 were to cost in renewals $250,- 000, the whole cost of such renewals would be a reve- nue charge. If, however, the assets which ordinarily cost $200,000 were replaced by assets of a higher revenue earning capacity, due to the superior quality of the materials used for the making of such assets, the method of apportioning would be as follows : ascertain what the exact cost of replacing the existing asset would have been and then charge only that sum to revenue and capitalize the excess. Many accountants follow the policy of considering the "last cost" as a capital charge. If assets which originally cost $10,000 are replaced at a cost of $12,000, the excess is charged against capital. In other words, they claim that the last cost is the only correct basis because each concern will replace its plant at the least possible expense to itself. 10. Objection to capitalization on basis of last cost. -The latter plan appeals to the writer as a most de* sirable and fair method to be followed in all caseSj because under this practice the plant always appears in the accounts at the last cost, that is, the cost of the plant as it stands at the present time. Therefore, the reconstruction cost would be charged to capital and the cost of the construction or equipment formerly on the books would be displaced. The principle is of importance in the case of public utilities where the question is involved of determining a rate which is fair to the consumer and yet will yield REPAIRS AND RENEWALS 29 to the utility a reasonable rate of return on its invest- ment. It is urged that it is only fair to the utility that the investment in plant shall appear at the present cost of the plant and not at that of some earlier date when perhaps material and labor charges were much less. Opinions differ in this matter but it is worthy of note that most of the commissions charged with the duty of regulating public utility companies favor a provision for the payment of extraordinary replace- ments out of earnings. In the volume on "Corporation Finance," the reader has seen that prior to the declaration of dividends, the board of directors of a conservatively managed corporation will set aside a reserve for the replace- ments of an extraordinary nature that are not fairly chargeable against the revenue of the year in which they may be made. Thus, a railroad which was by law compelled to abolish grade crossings on its right of way, might find it more economical to build a new right of way instead of attempting to abolish the present grade crossings. Under the ruling of some of the regulatory commissions, the new right of way would be a proper charge to capital and the cost of the old right of way should be credited to the prop- erty account and charged to an abandoned property account to be written away over a series of years. Pending its final elimination from the balance sheet it would be carried as a deferred charge to future operations. If a reserve for such contingencies had been provided, the cost of the abandoned property 30 ACCOUNTING PRACTICE would be charged to that account. If the ledger did not disclose the cost of the abandoned property, the estimated replacement cost would be the amount used in the credit to property account and the charge would be made to abandoned property account. 11. Who should pay for the cost of progress? The evils attending overcapitalization are much greater than those attending undercapitalization. When a railway company builds a new station and capitalizes the cost, we have an example of the cost of progress. Many public service corporations are com- pelled to pay annually large sums for the improve- ment of facilities which may not cause a direct in- crease in revenue or at least may only realize the in- crease after a series of years. If good material and efficient working equipment are scrapped and better operating equipment or more improved inventions substituted, should not these be considered as a part of the cost of progress? Should not this tendency be encouraged? Is it fair to compel the stockholders to pay for the entire cost of industrial progress thru the practice of charging all such expenditures to earn- ings? Possibly a solution to the problem will be found in keeping two sets of records ; one on the basis of original cost, under which all increased costs of re- placements will be charged to revenue or surplus; the other on the basis of "last costs" which basis will be used in determining a fair rate of return. 12. Extraordinary reconstruction costs where re- serve for depreciation is inadequate. The situation REPAIRS AND RENEWALS 31 iferred to in the preceding paragraph must be dis- tinguished from that in which failure to provide ade- quate provision for depreciation in prior years re- sults in extraordinary expenditures for reconstruc- tion. In this case, the failure to provide properly for the declining value in fixed assets, due to realization of their service-units, has resulted in stockholders re- ceiving profits that were not earned. When condi- tions require large expenditures for the purpose of restoring capital facilities, these costs should be assessed against the surplus ; and if no surplus exists, and the amount of the expenditures is so great as to make it unfair to charge the cost against the profits of one year, the amount must be clearly shown in the balance sheet in a properly ear-marked suspense ac- count. Moreover, in practice, the new equipment substi- tuted is frequently more valuable and capable of ren- dering more efficient service than the old. The re- placement charge is then made up of three elements; first, a part which represents the increased value of the equipment or its greater service-rendering capacity; second, a part which represents deferred main- tenance charges, and third, a part which represents the current depreciation applicable to the period in which the replacement is made. The first is a proper charge to capital account; the second is chargeable to the surplus account or if there is no surplus account, to a suspense account properly ear-marked; the last should be charged to the current income account. 32 ACCOUNTING PRACTICE The suspense account, in the last event, represents an impairment of capital and this condition should be remedied before any dividends are paid. 13. Danger involved in giving revenue the benefit of doubtful expenditures. It must be admitted that there is great danger in capitalizing charges for bet- terments which do not increase earnings nor decrease operating expenses. Some accountants favor giving revenue the benefit of all doubtful expenditures and increasing capital by the amount of those expendi- tures and adding a corresponding increase to the amount of profits for the period. This practice in- vites two dangers; first, that a dividend might be de- clared out of a fictitious surplus which might render the board of directors personally liable, and second that the organization itself may be seriously handi- capped by a lack of capital thru improper dividend disbursements, and might eventually have to retire from business. The board of directors might pro- tect itself from these dangers by setting aside a por- tion of the surplus to prevent the payment of un- earned dividends where it is deemed best to capitalize such doubtful charges. It should not, of course, be lost sight of, that where items are charged to capital that should have been charged to revenue, the matter is equalized over a period of years because the increased amount in the capital account makes necessary a larger provision for depreciation. This is charged against income with the result that when items are erroneously capi- REPAIRS AND RENEWALS 33 talized or carried in a suspense account for a series of years as abandoned property, the ultimate effect is to load the income account in the succeeding years with these amounts. The procedure results in charg- ing future earnings with amounts which should have been charged against surplus created out of past earn- ings. The outcome of this practice is that the stock- holders of the future are robbed for the benefit of those of the present. The Federal Income Tax law, which permits a deduction from income for deprecia- tion, has brought the advisability of providing for de- preciation more keenly to the attention of operating managers. The result is that many who formerly op- posed depreciation allowances or provisions for re- newal and contingency reserves now favor the more conservative practice. 14. Gauging repair and renewal expenditures by profits made. Many business executives claim that the depreciation factor is negligible in their respective businesses because thru liberal allowances for repairs and renewals they endeavor constantly to keep the organization up to one hundred per cent efficiency. On this basis they claim that the equipment is always as good as new. The argument is sometimes used that increases in the value of the intangible properties of railways is greater than the depreciation of physical properties and that for this reason no depreciation or renewal reserve need be provided. Other executives provide large amounts for depre- 34 ACCOUNTING PRACTICE elation in prosperous years and set aside either small amounts or nothing in lean years, with the result that the true earnings of the individual years are not stated in their respective income accounts. While in prac- tice this haphazard method in many cases may not result in the overstatement of property values the procedure cannot be recommended. Pernicious econ- omy in the expenditures for repairs often increases the depreciation of machines so that the ultimate cost of the repairs and renewals is greater than if the neces- sary disbursements had been made at the proper time. 15. Repairs and renewals. During the early years of the life of a new machine the charges for repairs and renewals will be slight, tending to increase as the machine grows older. When a plant has been operat- ing for some length of time, the constant addition of new machinery has a tendency to average, from year to year, the charges for repairs and renewals. In other plants, the item is a fluctuating one. It would seem desirable in some cases to attempt to predeter- mine the cost of the repairs and the renewals during the life of the machine, and to make a periodical charge against income and a credit to a reserve for repairs and renewals for the annual pro rata amount. The actual cost of the repairs and the renewals made on a machine over the first few years of its operation would prob- ably not amount to the sum set aside with the result that there would be a credit balance in the reserve for repairs and renewals account; later, as the cost of re- pairs and renewals increased and exceeded the an- REPAIRS AND RENEWALS 35 nual sum charged to income and credited to the re- serve account, the excess credit balance in the reserve account would be consumed gradually. Under this method of procedure a repairs and renewals account would receive the charges for the actual cost of the repairs and the renewals made during the period. The income account would be charged with the prede- termined amount based upon the estimated cost of re- pairs made during the life of the machine and this amount would be credited to the reserve account; the amount charged against income would appear in the profit-and-loss account; the amount charged to the repairs account, which represents the actual cost of the repairs made during the period, would be trans- ferred at the closing of the books to the debit of the reserve for repairs and renewals account. If the amount of repairs was underestimated at the begin- ning, the undertaking in the succeeding years would, naturally, be under the necessity of increasing the amount to be charged against income. This operation does not of course take care of the depreciation which goes on irresistibly even tho proper amounts are expended for repairs. While de- preciation has been discussed both in the volume on "Accounting Principles" and in the volume on "Cost Finding" it may be well to state here that the question of the depreciation charge, for such depreciation as accrues irrespective of operations, is one that creates considerable discussion. Some accountants state that depreciation should not be considered a charge against 36 ACCOUNTING PRACTICE operations, if it goes on irrespective of operations. It is also pointed out that, during enforced idleness, cer- tain equipment might depreciate much more than if properly cared .for during a longer term of actual operation. The difficulty, perhaps, may best be ad- justed by charging depreciation against cost of op- eration while the factory is in operation, since ma- chinery is purchased with the view of wearing it out as it is operated. If, however, due to enforced idle- ness, there is no production and consequently no units of production against which the depreciation may be charged, this charge may well be made against the profit-and-loss surplus accounts, but it cannot be ig- nored. The excessive undistributed overhead ac- cumulated during a period of dull business, if charged against the production of the following period, im- properly inflates costs and also results in erroneous inventory valuations. 16. Replacement fund. In order that the needed capital may be on hand when it is necessary to pro- vide for replacements, a fund may be provided by setting aside out of cash an amount equivalent to the annual charge for depreciation. If this fund is in- vested in safe interest-bearing securities the neces- sary cash will be provided from which to purchase new equipment without the need of additional financing or without crippling the working capital of the busi- ness. The objection to this plan is that the busi- ness can earn very much more profit from the em- ployment of capital in production, than it can in in- REPAIRS AND RENEWALS 37 terest from money invested in this manner; further- more, as the replacements will probably be made gradually, they can be provided for from the general cash funds of the business without interfering with the business in any way. The replacement fund or depreciation fund is very seldom found in ordinary manufacturing organizations. 17. The advantages of a plant ledger. Much of the difficulty that surrounds this general question will be dissipated if the organization maintains a plant or equipment ledger wherein each article or unit of equip- ment is given a separate account in which is shown the original cost, the cost of annual repairs and renewals, the amount of depreciation provided an- nually, and the residual or book value at the end of each year. In large undertakings the use of such a ledger is almost an absolute necessity if anything re- sembling accuracy is desired in the plant account. As an illustration of the difficulties that are encountered in handling the property accounts on the books and in arriving at the approximate life of machinery, the following case which came within the experience of the writer, may prove of interest : A manufacturing corporation desiring to instal a new stationary engine, removed the one in use and set up another in its place ; the old engine was shipped to a subsidiary com- pany having a smaller capacity than the parent com- pany, and was charged to the subsidiary company at its book value on the books of the parent com- pany. The engine continued to give good service for 38 ACCOUNTING PRACTICE a number of years and only ordinary repairs and re- newals were necessary. Owing to a flaw which had remained undetected for a number of years, the crank shaft broke and the plant manager, giving the engine number, wired the engine builders for a new shaft. The manager found to his dismay that the engine builders had destroyed all patterns of this type of en- gine because of their belief that such an old style was no longer in existence. This being the case, it was necessary for the builders to send machinics to the plant in order to get the measurements necessary to make a new crank shaft. 18. Moving and altering a plant. It may be neces- sary to move a plant or to rearrange the machinery within it. Undoubtedly this expense would not be undertaken by a business concern unless it was felt that a saving thru operating efficiency, or other economies in management would result. This raises the question as to whether or not such expense is properly capitalized. It is probably inexpedient to capitalize such expense but a better plan is to charge it off against the revenue account in the year in which the expense was incurred. If, however, it is felt by the management that a distinct benefit will be real- ized, it may be proper to spread the expense over several years, carrying it in the balance sheet as a de- ferred charge to future operations. This would be the advisable course if the expense were considerable and if it were reasonably certain that economies in management expense would result /rom the change. REPAIRS AND RENEWALS 39 19. Improvements made upon leased property In connection with improvements made upon leased property and permanent machinery and fixtures pur- chased, the provisions of the lease must always be given consideration. If the lease provides that the machinery and equipment cannot be removed at the expiration of the lease, it is evident that the life of the asset is coterminous with the life of the lease, and that the value thereof must be written away against profits during the number of years that the lease has to run. 20. Transfers of equipment from one station unit to another. In the electric light industry the ques- tion of the transfers of equipment from one station unit to another frequently raises interesting questions ; thus, if a certain type of generator becomes inade- quate and it is considered desirable to instal a larger type and remove the old generator to a new station where it will adequately serve the purpose, the ques- tion will be raised as to what value should be used in charging the old generator to the new station unit. It is urged by some that the book value should be taken ; others hold that the market value of the equip- ment should be employed. The market value of sec- ond-hand electrical equipment is very low and usually under its actual value. Furthermore, no one can tell the market value of the equipment because it has not been offered for sale. It would seem better to trans- fer such equipment at its book value provided that proper depreciation charges have been made during XXI 5 40 ACCOUNTING PRACTICE prior years based upon the estimated operating life of the equipment. The expense of the second instal- lation should not, however, be capitalized. 21. Separation of depreciation and renewal re- serves. It will be readily granted by most account- ants that the question of repairs and renewals and the question of depreciation must be treated sepa- rately. For that reason it would seem desirable to create two reserves ; one a reserve for depreciation and the other a reserve for renewals. The advantage of this method is that neither of the reserves can be ex- hausted without attention being called directly to the fact, whereas if the reserve for repairs and renewals is merged in the reserve for depreciation, the fact might be overlooked. It follows, then, that if the amount set aside for renewals and for depreciation of each separate unit is kept track of in the plant ledger, the information will prove of value in the sub- sequent treatment in the accounts of the individual units of plant equipment; moreover, by this means it is possible to compare the actual expense of the re- pairs of separate units with the amounts set aside on the predetermined basis for repairs and renewals. It is obvious that nothing should be charged against the reserve for depreciation on account of repairs and re- newals. 22. Capitalization of machinery made for its own use by a concern. Where a firm manufactures ma- chinery for its own use, the capital account should be charged with the cost of the material, the direct labor REPAIRS AND RENEWALS 4?1 and that proportion of manufacturing overhead ap- plicable to the machine, and the latter accounts credited therewith. It would be incorrect for the firm to add any element of profit to the capitalized value because such procedure would inflate the assets by the amount of the profit. Nor should the amount be credited to sales account since it would inflate the sales account by a corresponding amount. A profit must not be confused with a saving. No profit is realized nor is a sale effected, until goods are transferred to outsiders at an excess over cost. If a concern is able to manufacture the machine more cheaply than it can buy it in the open market, of course a saving has been made. Here the question will arise as to whether or not it would be proper to capitalize the machine at the market value. The an- swer is that capital accounts should not be charged with anything except the cost of acquiring the asset. If the concern can manufacture the machine for less than it can purchase it in the open market, it has clearly made a saving to the extent of the difference. On the other hand, if the concern has made a miscal- culation and the cost of the finished machines proved greater than their prevailing market price, the con- cern would not be justified in capitalizing the ma- chine at the cost price because to do so would be to capitalize a mistake in judgment. The market price of the machine should, in that event, be used as the basis for the charge to capital account and the difference between the actual cost and the 42 ACCOUNTING PRACTICE market price would be charged to surplus account. 23. Conclusion. The foregoing discussion is not intended to be exhaustive and the conclusions stated are subject to adjustment, due to change in sur- rounding conditions and circumstances. It requires much discrimination and experience to determine whether specific expenditures belong to capital or to revenue. Probably no other question offers greater difficulties to the accountant as well as to the operat- ing manager than this question of capital and revenue charges. If those who are charged with the duty of making a decision act with common honesty and good judgment the difficulties are not insurmountable. In cases where plant records have been inadequately kept for a series of years, where depreciation has not been properly considered, or where the proper discrimina- tion has not been employed in distinguishing between capital and revenue charges, it is undoubtedly a wise plan to have the physical assets appraised by com- petent valuers for the purpose of arriving at their true value. Once this value has been arrived at, the necessary detail plant ledger records can be installed and the accounts in the future will reflect the true financial condition of the enterprise. REVIEW How would you differentiate between capital receipts and rev- enue receipts? Between capital expenditures and revenue ex- penditures ? What effect should fluctuation in value, owing to economic con- ditions, have upon the capital assets? If a steamship company builds a larger and more commodious REPAIRS AND RENEWALS 43 dock in place of one now in use, at a greater cost, would you capitalize the cost of the new dock? What is the significance of the term replacement and how should replacements be treated in the accounts? Do you approve of the practice which some corporations adopt of using a repairs leveler by charging a stated annual sum against income for repairs and renewals and adjusting the actual cost of repairs and renewals thru the medium of a reserve account cre- ated at the time the level annual charge is made? The manager of a public utility claims that depreciation in rolling equipment should not be provided for because the annual expense for repairs more than covers depreciation sustained; moreover he urges that the increase in the value of the franchise more than covers any capital loss otherwise sustained; do you agree and if so, why, and if not, why not? In your opinion, would it be wise to establish a replacement fund?' What are the advantages of a plant ledger? What considerations affect the life of improvements upon lease- hold property? CHAPTER III 1. The importance of properly drawn articles of copartnership. The partnership relation is a fruit- ful source of litigation. Many of the disputes that arise between the members of a firm might, however, be avoided if the articles of copartnership included certain clauses dealing with the accounts. In an ar- ticle on this subject which appeared in the Journal of Accountancy, Mr. Leo Greendlinger, C. P. A., recommended that the partnership agreement contain the following accounting clauses : (a) That proper books of entry be kept. (b) That the entries be made by each partner. (c) That the books and partnership documents be kept at the place of business and be open for inspection of all the partners. (d) That the books be kept under the direction of the acting partner. (e) That all checks, drafts, acceptances, etc., be signed by the acting partner, except in the case of his sickness or absence. (f) That all drafts, acceptances, or securities be made or taken in the name of the firm. (g) That real estate purchased be bought by the acting partner in trust for the firm. (h) That . . . Bank be used by the firm, (i) That the cash book be made up ... (state time monthly, quarterly, etc.)*. 44 PARTNERSHIP ORGANIZATION 45 ( j ) That the cash collected be deposited daily. (k) That all moneys received by each partner be duly paid in. (1) That a general accounting be made yearly or half- yearly. (m) That the inventory and the balance sheet be signed by each partner and be conclusive. (n) The ledger, among other accounts, shall contain: (1) An account for each partner's partnership obligation, which shall be debited with the amount the partner obligates himself to put in the business, and credited with what he actually puts in. (2) A drawing account for each partner, to keep sepa- rately his withdrawals. (3) If there be advances made by any partner to the firm as a temporary loan, an account should be kept under the title, "A.B.'s Loan to Firm Account." (4) Before a division of profits be declared, the profit-and- loss account shall be debited with depreciation at a fair rate on the fixed capital subject to depreciation, and depreciation account shall be credited with same. The depreciation ac- count shall in the balance sheet be always treated as an offset to the fixed capital, subject to depreciation. (5) There shall also be two reserve accounts one, the reserve account for doubtful debts, and the other, the gen- eral reserve account. The former shall be credited with . . . % of the debts due the firm and remaining unpaid at the time of closing up the accounts, as a contingent fund to meet bad debts ; and the latter, the general reserve account, shall be credited with . . . % of the balance remaining in the profit-and-loss account, and the profit-and-loss account debited. (6) Extraordinary profits and losses, i.e., such as do not isually occur, but are accidental, shall, as they arise, be car- *ied to the general reserve account. The remaining profit ind loss shall now be duly divided and carried into each part- ler's drawing account (credit side). The drawing ac- 46 ACCOUNTING PRACTICE count to be then closed and the balance carried to each partner's capital account. 2. Other important provisions. In addition, the author would recommend that the articles state whether or not interest is to be allowed on capital contributed by all the partners, or only on the deficit or excess capital contributions, or whether any interest at all is to be allowed on capital. If interest is to be charged on withdrawals, a clause to that effect must appear in the partnership agreement. Since the death of a partner works a dissolution of the firm, the partnership agreement should provide against the abrupt termination of the business at a time when dissolution on account of death would result in un- usual loss. If, for example, a member of a firm of silk merchants should die in the middle of a season, the consequent dissolution of the firm might work a serious loss to all the partners. This contingency is usually provided for by inserting in the articles of copartnership a provision to the effect that if death occurs it shall be considered to have occurred at the end of the season or at the end of the current fiscal period. The method to be employed in valuing the good-will of a business at the death or retirement of a member of a firm ought to be stated. The profit- and-loss-sharing ratio should invariably appear. 3. Difference between the accounts of a business controlled by a sole proprietor and those of a partner- ship. With the exception of the opening entries and the closing entries at the end of a fiscal period, the PARTNERSHIP ORGANIZATION 47 accounting principles are the same for a business under a sole proprietor as for a partnership. It is necessary to show the subdivisions of the proprietor- ship at the beginning, in order that each partner's equity in the net assets may be properly stated. The division of the net profits at the end of the fiscal pe- riod will be governed by the articles, and the capital accounts at the end of each period will reflect the status of the individual members of the firm. There may be further differences in the accounts of the in- dividual partners, such as, for example, a difference in the salary paid, dependent, perhaps, upon whether or not a partner gives his entire time to the business ; and also differences which arise from the fact that one partner may have contributed more capital than the other partner to the venture, or may have loaned money to the business. Therefore, before the final distribution of net profits is made to the partners, ad- justments are often necessary in consideration of dif- ferences in capital investment, amount of time de- voted to the business and the skill or ability of the individual partners. 4. Opening entry for partnership books. Follow- ing the suggestion contained in the article of Mr. Greendlinger quoted above, the books of the partner- ship should be opened by an entry which will charge each partner's personal account for the amount which he has agreed to contribute, at the same time crediting his capital account therewith. Thus, if A and B, in forming a partnership, agree to contribute 48 ACCOUNTING PRACTICE respectively, $100,000 and $80,000, the opening entry would be framed in the following manner: A (Personal Account) $100,000 B (Personal Account) 80,000 To A, Capital Account $100,000 B, Capital Account 80,000 To charge each partner for the amount of his agreed con- tribution and to credit the respective partner's capital ac- count therewith. 5. Subsequent entries. Each partner should then be credited with the sum total of the assets which he puts into the business, and the individual asset ac- counts on the books of the partnership debited there- with. If we assume that A contributed sundry as- sets valued at $80,000 and that B paid in $80,000 in cash the following entry would be made : Sundry Assets (itemized) $80,000 To A (Personal Account) $80,000 To credit the latter for the assets turned over by him in part payment of his capital contribution. Cash $80,000 To B (Personal Account) . $80,000 For cash paid in by him, being full payment of his capital contribution. The effect of this procedure would be to place upon the books an account which will reflect the deficiency in the capital contribution of any of the partners. A's personal account reveals the fact that he has failed to put in the agreed amourrt and in justice to his partner he should be charged with interest on the deficit. The assets contributed by the individual PARTNERSHIP ORGANIZATION 49 members become, of course, the property of the firm, and it is therefore important that a definite value be assigned at once to any assets other than cash con- tributed by a partner, and that the agreed value be reflected in the opening entry. The reason for this is, that any increase or decrease in value subsequent to the date of acquirement by the firm, will benefit the partners or be charged to their accounts, in the ratio in which they are sharing profits and losses. Thus, if one of the partners brought in certain se- curities to the firm as a part of his capital contribu- tion which, on the date of the formation of the part- nership had a value of $2,000 and, if the value of the securities should rise subsequently and the firm should sell them for the sum of $4,000, the profit amounting to $2,000 would be distributed among the partners in the ratio in which they had agreed to share profits and losses. 6. Division of profits and share in the partnership distinguished. The purchase of an interest in the profits must be distinguished from the purchase of a share in the business. No confusion will arise if cor- rect principles are followed. To illustrate, X is the owner of a business and sells to Y, a one-half in- terest in the business for $5,000, on the basis of the following balance sheet: BALANCE SHEET OF X Assets $6,000.00 X, Capital $6,000.00 50 ACCOUNTING PRACTICE It is clear that X is disposing of his asset, good- will, in addition to the tangible assets which the busi- ness possesses. If we introduce the value of X's good-will in the balance sheet, the result is expressed in the following statement: BALANCE SHEET or X Assets $6,000.00 Good-will 4,000.00 $10,000.00 X, Capital $10,000.00 $10,000.00 Since Y is buying one-half of X's interest, his pay- ment for that interest will be a private matter be- tween X and Y and will not be reflected in the books of the new firm. The entry to be made on the books of X will be a debit to the capital account of X and a credit to the capital account of Y to the amount of $5,000. The opening balance sheet of the new firm would then be as follows : BALANCE SHEET OF X & Y Assets $6,000.00 Good-will 4,000.00 $10,000.00 X, Capital $5,000.0 ) Y, Capital 5,000.00 $10,000.00 If it was desired to eliminate the asset, good-will, the balance sheet of the new firm would appear as follows : PARTNERSHIP ORGANIZATION BALANCE SHEET OF X & Y 51 Assets $6,000.00 $6,000.00 X, Capital $3,000.00 Y, Capital 3,000.00 $6,000.00 The result would be the same if Y had paid X per- sonally the sum of $5,000 and an adjustment made in the books of X by crediting Y and debiting X with $3,000, the excess of $2,000 representing Y's pay- ment for his share of the good-will of the busi- ness. The case would be different if Y came into the business with a one-half interest on the payment of $10,000. Under these circumstances, the opening balance sheet of the firm of X and Y would appear as follows: BALANCE SHEET OF X & Y Assets $ 6,000.00 Good-will 4,000.00 Cash 10,000.00 $20,000.00 X, Capital $10,000.00 Y, Capital 10,000.00 $20,000.00 If the good-will is written off, the balance sheet would reveal the following condition: BALANCE SHEET OF X & Y Assets $ 6,000.00 Cash 10,000.00 $16,000.00 X, Capital $ 8,000.00 Y, Capital 8,000.00 $16,000.00 52 ACCOUNTING PRACTICE 7. Illustration of purchase of an interest in the profits. Let us assume that the agreement in the first case provided that X would admit Y and give him one-half of the profits, upon the payment of $10,- 000. When Y had made his payment the opening balance sheet would reveal the following condition: BALANCE SHEET OF X & Y Assets $ 6,000.00 Cash 10,000.00 $16,000.00 X, Capital $ 6,000.00 Y, Capital 10,000.00 $16,000.00 It should be noted that in this case the agreement stipulated that the profits and losses are to be shared equally, altho the capital ratios are unequal. This is not an uncommon situation in actual business rela- tions. 8. Other illustrations. Another variation may be illustrated if it is assumed that Y is admitted to a two-thirds interest in the business on the payment of $6,000. Here it is evident that Y is bringing into the business, good-will and business connections in ad- dition to the cash which he contributes, which will make his capital account twice that of X. Under these conditions the balance sheet of the new firm may be represented as follows : PARTNERSHIP ORGANIZATION BALANCE SHEET OF X & Y Assets $6,000.00 Cash (paid in by Y) 6,000.00 Good-will ( brought in by-Y) 6,000.00 $18,000.00 X, Capital $6,000.00 Y, Capital 12,000.00 $18,000.00 The same relation may be expressed by omitting the account for good-will: BALANCE SHEET or X & Y Assets . . $6,000.00 X, Capital . . . . . $-1,000.00 Cash (paid in Y) by . . 6,000.00 Y, Capital . . . . . 8,000.00 $12,000.00 $12,000.00 In all such cases, it is necessary to determine the exact nature of the agreement between the parties; the division of interest between the partners, and what each actually contributes to the new firm. 9. Division of profits. The basis upon which profits and losses are to be distributed to the mem- bers of the firm should invariably be stated. If the copartnership agreement does not definitely provide the method of division, the law assumes that the part- ners intended to divide the profits and losses equally. 54 ACCOUNTING PRACTICE There are a number of different ways in which the profits and losses may be shared. Profits may be di- vided (1) in proportion to the amount of capital contributed by each partner and according to the time such capital has remained in the business ; ( 2 ) in pro- portion to the amount of capital originally contrib- uted by each; (3) on the basis of a ratio agreed be- tween the partners, which may be different from the capital ratio. 10. Illustration of division of profits in proportion to the capital invested and the time such capital has been employed. X and Y are partners under arti- cles of copartnership which provide that the profits at the end of the year shall be divided on the basis of the capital invested and the time it has remained em- ployed. The profits for the period amount to $4,- 120. How much should each partner receive? The capital accounts in the ledger appear as follows : X, CAPITA-L ACCOUNT 19 Mar. 1, Cash $2,000.00 Nov. 1, Cash 3,000.00 Dec. 31, Balance. 7,000.00 $12,000.00 19 Jan. 1, Balance. . $3,000.00 June 1, Cash 4,000.00 Oct. 1, Cash 5,000.00 $12,000.00 191- Jan. 1 . $7,000.00 PARTNERSHIP ORGANIZATION Y, CAPITAL ACCOUNT 55 19 July 1, Cash $2,000.00 Dec. 31, Balance. 9,000.00 $11,000.00 19 Jan. 1, Balance. . $4,000.00 Nov. 1, Cash 7,000.00 $11,000.00 19 Jan. 1, Balance. . $9,000.00 11. Solution of problem. To solve this problem, we must find first, the average investment of each partner, and, second, what portion of the total profits, $4,120, is to be paid to each. The average invest- ment of a firm may be defined as a fund which, if placed at interest for a given unit of time, will pro- duce the same amount of interest as the various amounts invested by the partners for different lengths of time. Inasmuch as the investments and with- drawals in this instance were all made on the first day of the month, we may compute the average investment using the month as the unit of time. If, however, the investments were not made on the same date, it would be necessary for us to use the day as the unit of time. If we inspect the account of X, we will note that he had the sum of $3,000 invested for a period of two months, after which he withdrew $2,000, leaving his net investment $1,000, which remained unchanged for three months. On June 1st, he in- vested $4,000 additional which brought his invest- ment up to $5,000, and which amount remained un- XXI 6 56 ACCOUNTING PRACTICE changed for four months, or until October 1st, on which date he contributed an additional $5,000, bringing his capital up to $10,000, which remained invested for one month. On November 1st, he with- drew $3,000, leaving his net investment $7,000, which remained unchanged until the end of the year. The rule for finding the average investment is as follows : Multiply each amount on the credit side of the account by the number of months or days inter- vening between the date of investment and the end of the unit period. Make a similar calculation of each of the individual amounts withdrawn, from the date of withdrawal to the end of the period. Subtract the sum of the products of the withdrawn amounts from the sum of the products of the contributed amounts. The difference will be the average investment for the unit period whether this be one month or one day. To find the average investment for one year, divide by 12 or 365. It will not be necessary to do this, how- ever, for the purposes of our problem inasmuch as the division by 12 or 365 would not alter the ratio. Two methods of solving this problem are presented, the first of which is to be preferred. The advantage of the first method is, that if the investments have been correctly determined the last amount shown will always be the balance standing at the credit of the capital account. Moreover, the addition of the months or days should always total 12 or 365 respec- tively, thus allowing the calculator to verify his re- sults. The solution is as follows : PARTNERSHIP ORGANIZATION 57 X Jan. 1 $3,000 X 2 $6,000.00 Mar. 1 1,000 X 3 3,000.00 June 1 5,000 X 4 20,000.00 Oct. 1 10,000 X 1 10,000.00 Nov. 1 7,000 X 2 14,000.00 Average Capital for 1 Month $53.000.00 Y Jan. 1 $4,000 X 6 $24,000.00 July 1 2,000 X 4 8,000.00 Nov. 1 9,000 X 2 18,000.00 Average Capital for 1 Month $50,000.00 X is entitled to 53/103 of $4,120.00 or $2,120.00 Y is entitled to 50/103 of 4,120.00 or 2,000.00 Total Profits $4,120.00 SOLUTION BY SECOND METHOD X $3,000 X 12 $36,000 4,000 X 7 28,000 5,000 X 3 15,000 $79,000 2,000 X 10 $20,000 3,000 X 2 6,000 26,000 Average Capital for 1 Month $53,000.00 Y $4,000 X 12 $48,000 7,000 X 2 14,000 $62,000 2,000 X 6 12,000 Average Capital for 1 Month $50,000.00 58 ACCOUNTING PRACTICE 12. Division of profits on the basis of the amount of capital originally contributed by each partner. Under this method of distribution each partner will receive the ratio of the profits that his capital ratio bears to the aggregate capital. Thus, if X contrib- utes $1,000, Y $2,000, and Z $3,000, the aggregate capital will be $6,000; if the total profits amount to $1,200, X will receive one-sixth, or $200, Y will re- ceive two-sixths or $400, and Z will receive one-half or $600. 13. Division of profits on the basis of capital orig- inally contributed and accumulated by each partner. -The agreement between the partners may provide that the profits shall be divided on the basis of the capital originally contributed and accumulated by each partner. In the foregoing illustration, the capi- tal at the end of the first year of business would be $1,200, $2,400, $3,600 for X, Y and Z, respectively. Let us assume that after the profits were stated each partner withdrew $200. The capital account would then be as follows: X, $1,000; Y, $2,200; Z, $3,400. In the following year, if profits of $3,300 had been made, the distribution between X, Y and Z would be in the ratio of 10, 22 and 34, instead of 10, 20 and 30 as in the preceding year. Thus, out of the total profits of $3,300, X would receive $500; Y would re- ceive $1,100; Z would receive $1,700. 14. Distribution of profits on a ratio different from that of the capital ratio. Profits may be divided with- out difficulty upon a basis other than the individual PARTNERSHIP ORGANIZATION 59 capital accounts. After the net profits have been stated, they will be divided among the partners on a ratio previously decided by the partners. It will usually be found that this method has been employed to adjust inequalities between the partners. For ex- ample, two men may engage in business, one with more capital than the other. The partner having the lesser capital may, however, be possessed of more skill or ability in the particular business engaged in. The skill and ability of this partner may more than out- weight his disadvantage on the score of capital. Skill and ability are known as non-ledger assets because we do not keep accounts with them in the ledger, but nevertheless they are often the most valuable assets which a business firm possesses. In such a case, the inequalities between the partners may be adjusted by allowing the partner who possessed the greater skill a larger share of the profits. One man may devote more time to the business than his partner. Inequali- ties between the partners on this score are frequently adjusted by allowing the partner who spends his en- tire time in the business a larger salary than that al- lowed to the partner who devotes only a portion of his time to the business of the firm. REVIEW What are the accounting clauses that should be incorporated in every well-drawn partnership agreement? What difference is there between the accounts of a sole trader and a partnership? How should partnership books be opened? In what ways may profits be divided ? What is the difference between the purchase of an interest in the profits and the purchase of a share in the business? CHAPTER IV 1. The importance of the partnership contract, When men enter into partnership they, are vitally in- terested in the partnership agreement. In fact one of the greatest "bones of contention" is a vague, badly worded contract and probably nothing in their busi- ness life will cause the partners more concern. 2. Interest allowed on capital, first illustration. The attention of the reader has been called in a pre- vious chapter to the importance of clearly providing in the partnership agreement for interest on partners' capital. This point may be further emphasized in the following illustration : Let us assume that the capital of a firm of three partners aggregated on January 1st, 19 $6,000, of which amount X was credited with $1,000; Y, $2,- 000 ; Z, $3,000. The partners share profits and losses in the same ratio as the capital ratio. The articles provide that interest shall be allowed on the capital at the rate of six per cent per annum. Let us as- sume, in addition, that the profit-and-loss account, prior to the time when interest was charged on cap- ital, disclosed the fact that the firm had neither made a profit nor sustained a loss, i.e., the expenses exactly equalled the income. Following the instructions in 60 PARTNERSHIP OPERATIONS 61 the partnership agreement, profit-and-loss account would be charged with $360 and the partners indi- vidually would be credited with interest on their cap- ital at six per cent. The disposition of the debit bal- ance in the profit-and-loss account caused by the charge of interest would be on the basis of the capital ratio, viz., 1, 2 and 3, or $60 to X; $120 to Y; and $180 to Z. The following tabulation will more clearly set forth the status : Total X Y Z Capital at Jan 1, 19. . $6,000 $1,000 $2,000 $3,000 Add interest at 6%., 360 60 120 180 $6,360 $1,060 $2,120 $3,180 Distribution of interest charge on basis of profit-and-loss -sharing ratio, viz.: 1, 2, 3 360 60 120 180 Capital at Dec. 31, $6,000 $1,000 $2,000 $3,000 From the foregoing it is evident that where the capital ratio and the profit-and-loss-sharing ratio are the same, no change results in the status of the indi- vidual partner's accounts, inasmuch as each partner's capital account will be charged in the distribution of the profit-and-loss account with exactly the same amount with which it was previously credited in re- spect of interest. 3. Interest allowed on capital, second illustration. The result would be different if the profit-and-loss- 62 ACCOUNTING PRACTICE sharing ratio differed from that of the capital ratio. Let us assume again that at January 1st, 191-, the total aggregate capital of the firm was $6,000, of which $1,000 was standing to the credit of X, and $2,000 and $3,000 to the credit of Y and Z, respec- tively. The partnership agreement provides for the allowance of interest on the capital account at the rate of six per cent per annum. The agreement also provides that the profits and losses shall be shared equally. Assuming the same condition with respect to the profit-and-loss account as was assumed above, the following tabulation will clearly reveal the status of the partners at the end of the period : Total X Y Z Capital at Jan. 1,19 ..,$6,000 $1,000 $2,000 $3,000 Add interest at 6% . 360 60 120 180 Capital as adjusted. . $6,360 $1,060 $2,120 $3,180 Distribution of interest charge on basis of profit-and-loss - sharing ratio, viz.: 1, 1, 1 360 120 120 120 Capital at Dec. 31, $6,000 $940 $2,000 $3,060 An inspection of this form will reveal the fact that this method of procedure results unfavorably for the partner having the smallest capital and benefits the partners having the greater capital. 4. Interest allowed on capital, third illustration. Still another difference in result will be obtained if PARTNERSHIP OPERATIONS 63 the capital ratio of all the partners is the same but the profit-and-loss-sharing ratio is different. If we assume the same aggregate capital of $6,000, and the same state of facts with reference to interest and the net result of the profit-and-loss account before the adjustment for interest, the following tabulation will disclose the effect of this method of procedure : Capital at Jan. 1, 19 . . Add interest at 6% . . . . Capital as adjusted. . Distribution of interest charge on basis of profit-and-loss - sharing ratio, viz. : 1, 2, and 3. Capital at Dec. 31, Total $6,000 360 X $2,000 120 Y $2,000 120 Z $2,000 120 $6,360 360 $2,120 60 $2,120 120 $2,120 180 $6,000 $2,060 $2,000 $1,940 As will be seen, this method operates to the detri- ment of the partner whose share of the profits is the greatest and benefits the partner whose share is the least, because the latter will bear a smaller charge in respect to the interest than his fellow-partners. 5. Advantages of a fixed rate of interest on capital. It is advisable to charge a fixed rate of inter- est per annum in respect of capital employed in the business. This opinion is based on the assumption that the money if employed in safe investments would earn a fair rate of interest. Thus, profits from busi- ness operations are distinguished from a fair rate of 64 ACCOUNTING PRACTICE return on capital. Where the capital ratios are un- equal it gives to those holding the larger proportion of capital an advantage prior to the division of the profits. The effect of an omission to charge interest on capital is as follows: (1) If the capital contributed by partners is equal, and if the shares in the profits are unequal, the partner entitled to the smaller share will lose. (2) If profits are shared equally by partners, but if their capital contribution is unequal, the partner with the larger amount invested will lose. 6. When interest on capital should not be charged to profit-and-loss account. When interest is allowed on all of the capital accounts, it should not be charged to the profit-and-loss account as an expense of the business unless the articles so provide. The reason is that the charge for interest provided for under this agreement is not a charge for borrowed money. It is a method of equalizing the share of the respective partners in the profits by allowing to invested capi- tal a fair rate of return and considering that the re- mainder of the profits, after provision has been made for the earnings of capital as an investment, will be the profit for risk taking. Therefore, this provision really constitutes a method of distributing a portion of the profits. The charge for interest should be disposed of in the same man- ner as the remainder of the profits are distributed. The profits from operation, exclusive of the interest charge, will first be determined, then distributed, part PARTNERSHIP OPERATIONS 65 in the form of an interest allowance and the remainder upon the agreed ratio. The case is different if in- terest is allowed upon excess capital, which a partner has allowed to remain in the business as a loan. The case is also different when interest is charged on a deficiency of capital contribution. In the first place, interest allowed to a partner on excess capital is really interest on borrowed money, and therefore con- stitutes a proper charge against the income account of the business in the same manner as interest on a bank loan. In the second case, where a partner has failed to contribute the amount he agreed upon, or has allowed his capital account to fall below the agreed amount, the firm would probably be compelled to borrow money at interest for the purposes of the busi- ness, and, therefore, the interest charge made against this partner would be credited to the regular interest account of the business. When an agreement provides that interest shall be allowed on the capital account of all the partners, the entry must nevertheless be made, even tho in doing so the profit-and-loss account would show a debit balance. Thus, in a case where the profits to be distributed were not equal to the aggregate charge for interest allowed on all the capital, the difference between the net profits and the allowance for inter- est would be charged against the capital account of the respective partners in the ratio in which they were to share profits and losses. 7. Adjusting interest on capital thru the part- 66 ACCOUNTING PRACTICE ners' accounts direct. Another method might have been employed in handling the interest on capital as shown on pages 62 and 63. This method consists of an adjustment between the partners' accounts direct, eliminating any entries either thru the interest or profit-and-loss accounts. In the example on page 62 the profit-and-loss-sharing ratio was equal and the capital ratio unequal. The total capital invested was $6,000. The average capital was $2,000. Z, in his capital account would receive a credit of $60 for in- terest on his excess of $1,000 over the average capital, and X would be charged with $60 for interest on $1,- 000, representing the difference between his and the average capital. The entry to accomplish this is : X $60.00 To Z $60.00 In the form on page 63, the profit-and-loss-sharing ratio was 1:2:3. The total capital was $6,000. X, who contributed one-third of the capital, received one- sixth of the profits. Or, expressed in another way, X, who contributed one-third of the capital, would be charged with one-sixth of the losses. His capital ac- count, therefore, is credited with interest on $1,000, the excess of his capital over the average of $1,000 (one-sixth of $6,000). Y's capital was one-third of the total and he re- ceived one-third of the profits or would be charged with one-third of the losses. Hence no adjustment would be necessary in his case. Z, whose capital was one-third of the total, but who was entitled to receive PARTNERSHIP OPERATIONS 67 one-half of the profits, or be charged with one-half of the losses, would be charged with interest on the excess of his capital of $1,000 over the average of one- sixth, or with an amount of $60. The adjustment between the partners, expressed in the form of an entry, is as follows: Z $60.00 To X $60.00 8. Comparison of the two methods. The differ- ence between the two methods may be briefly stated as follows: the first method not only attempts to ad- just the differences between the partners in respect to capital but also attempts to apportion profits as between the part that is representative of a fair rate of return on capital and the profit from business op- eration. The second method serves merely to adjust the differences between the partners in respect to cap- ital contribution. 9. Interest on excess or deficit of capital contribu- tion. When the agreement provides that interest shall be allowed on the excess capital contribution of any partner, and charged on the deficit in capital con- tribution, the interest charges and credits are passed thru the regular interest account as a part of the ex- pense or revenue from business operation. Thus, if X, Y and Z agree to form a partnership, the first agreeing to contribute $60,000, the second $80,000 and the third $10,000, but instead have actually con- tributed $50,000, $.50,000 and $20,000 respectively, it 68 ACCOUNTING PRACTICE is very evident that X has paid in $10,000 less than he should, Y $30,000 less than he should, while Z has exceeded his contribution agreed to by $10,000. Assuming that interest is charged and allowed at the rate of six per cent, and that the partners share profits and losses equally, the capital accounts as adjusted would appear as follows: X, CAPITAL ACCOUNT Interest on Deficit $10,000 Balance Down of $ 600 50,000 Paid In % of Interest Acct. Balance Down L ACCOUNT $50,000 600 $50,600 $50,600 Y, CAPITA $50,000 Interest on Deficit $30,000 Balance Down of $ 1,800 48,800 Paid In i& of Interest Acct. Balance Down L ACCOUNT $50,000 600 $50,600 $50,600 Z, CAPITA 48,800 Balance Down $21,200 Paid In Interest on Excess of 10,000 % of Interest Acct. $20,000 600 600 $21,200 $21,200 ' $21,200 INTEREST ACCOUNT Z, Interest on Excess X, Interest on Deficit $10,000 $ 600 $10,000 $ 600 X, % of Balance $600 Y, Interest on Deficit Y, % of Balance 600 $30,000 1,800 Z, % of Balance 600 1,800 $2,400 $2,400 PARTNERSHIP OPERATIONS 69 If in this case, the profits were distributed in the ratio of 3, 2 and 1 for X, Y and Z respectively, the capital accounts would be stated thus : X, CAPITAL ACCOUNT Interest on Deficit $10,000 Balance Down of $ 600 50,300 Paid In % of Interest Acct. Balance Down L ACCOUNT $50,000 900 $50,900 $50,900 Y, CAPITA $50,300 Interest on Deficit $30,000 Balance Down of $ 1,800 48,800 Paid In y s of Interest , Acct. Balance Down L, ACCOUNT $50,000 600 $50,600 $50,600 Z, CAPITA $48,800 Balance Down $JO,900 Paid In Interest on Excess of $10,000 YQ of Interest Acct. Balance Down ' ACCOUNT $.20,000 $ 600 300 $20,900 $20,900 INTERES1 $20,900 Z, Interest on Excess of $10,000 $ 600 X, % of Balance $900 Y, % of Balance 600 Z, % of Balance 300 1,800 X, Interest on Deficit of $10,000 Y, Interest on Deficit of $30,000 $ 600 1,800 $2,400 $2,400 10. Treatment of good-will in partnership ac- counts. Reference has been made to the subject of good-will. It is not the intention to discuss good-will exhaustively at this point, except in so far as it con- 70 ACCOUNTING PRACTICE cerns partnership accounts. With the sale of a busi- ness, the good-will passes to the buyer ; the contract of sale may not specify this, but it is implied. The valuation of the good-will is an important mat- ter at the time of the death or retirement of a partner. In a recent English case (Smith vs. Nelson) it was decided that the out-going partner was not entitled to anything for good-will. This decision was the re- sult of a poorly constructed clause in the partner- ship agreement. The estate of a deceased partner is entitled to its share of the proceeds derived from the sale of the good-will of a business in which the de- cedent was a partner. The occasion for valuing good-will will arise upon the admission of a new member to the firm, or when a going business is bought outright, or upon the dissolu- tion of a firm or the retirement of a member. Even tho a firm has a valuable good-will, as evidenced by its prosperity, it would be incorrect to place this good- will upon the books. Some merchants make the mis- take of valuing their good-will yearly and placing it in the business statements of the partnership. An interesting case on this subject, which is fre- quently cited, is the case of Stewart vs. Gladstone, de- cided in England in 1897. A clause in this firm's ar- ticles of copartnership provided that the annual accounts should comprise "all particulars that might be susceptible of valuation." One of the partners contended that it included good-will also. Upon this point the court made the following decision: PARTNERSHIP OPERATIONS 71 Then is it a fair construction of these articles to assume that in taking the annual account of the profits of the con- cern, the partners were going to put a value upon the good- will, so as to allow each partner to take, year by year, out of the partnership the amount of his share of the increase in the value of the good-will? That is really what it comes to. Now, one cannot help feeling that no mercantile man ever dreamt of such a thing. The good-will is not an avail- able asset in the sense that you can draw upon it, or that you can turn it into money, or pay it out to the partners, and I should say with some confidence, not only relying upon my own experience, but having appealed to the Bar in this case, that no one ever saw such a thing in a merchant's accounts. This conclusion is both good law and plain com- mon-sense. It is evident that nothing can possibly be gained by writing up a good-will account, for as- suredly no benefit is gained by padding the asset side of a firm's balance sheet, and at the same time in- creasing the capital account of the partners. ( When one of the partners withdraws, it is neces- sary to settle with him for his share of the good-will. Thus, if X, Y and Z form a partnership in which the members are to share profits and losses equally, and afterward they disagree, and X is to retire, he is entitled to payment for his share of the good-will. If it be assumed that the good-will of the firm is valued at $15,000, it is evident that X's share is to be valued at $5,000. The better method to employ in adjusting the account upon retirement of X would be to debit the good-will account for $5,000, or the amount which X's share represents. The amount thereof would be credited to X's capital account. The XXI 7 72 ACCOUNTING PRACTICE reason why it is proper to place the good-will upon the books in this instance is that the surviving mem- bers of the firm, Y and Z, have purchased the good- will of their partner X and have paid him for it. Such good-will, then, is to become the property of Y and Z, and if it is so desired, may be closed out by charging both Y and Z, $2,500 and crediting the good-will account to close it. 11. Retirement of a partner from the firm. It is not uncommon for one of the members of a firm to retire, and the remaining partners continue the busi- ness under the old firm name. The retiring partner will either be paid off in cash or perhaps may take cash and notes for his interest. The remaining part- ners buy his share in accordance with whatever agree- ment they may have made among themselves. 12. Problem. The capital account of a partner- ship showed the following credits: W, $2,115; X, $1,692; Y, $1,269; Z, $846. On the retirement from business of W the remaining partners bought his share in proportion to their capital. What amounts would have to be provided respectively by the remain- ing partners, and what would then be their respective proportions of the total capital? Solution to Problem X's capital $1,692 Y's capital 1,269 Z's capital PARTNERSHIP OPERATIONS 73 X's share of W's capital, 1692/3807 = 4/9 $940.00 Y's share of W's capital, 1269/3807 = 3/9 705.00 Z's share of W's capital, 846/3807 = 2/9.... 470.00 $2,115.00 X's new capital $2,632 = 4/9 of the whole Y's new capital 1,974 = 1/3 of the whole Z's new capital 1,316 = 2/9 of the whole $5,922 13. Interest on drawings. If it is the intention of the partners to charge interest on the drawing ac- counts of the members of the firm, the partnership agreement must provide for it. We cannot imply that it is the intention to charge interest on drawings when the agreement provides that interest is to be credited on the partners' capital accounts. Partners' drawings may be considered from two points of view. The amount withdrawn may be looked upon as a with- drawal of the capital, as stated at the beginning of the fiscal period ; or drawings may be considered sums properly applied against the profits accruing from day to day, altho not as yet ascertained because a balance sheet has not yet been prepared. The second view is the more logical one, and for that reason a partner should not be compelled to pay interest on the profits which have been earned, and which are, theoretically at least, due to him, altho they have not as yet been stated. Moreover, the amount which a partner may withdraw is commonly specified 74 ACCOUNTING PRACTICE in the articles of copartnership, or if the articles make no provision in regard to withdrawals, the partners may agree among themselves as to the amount to be withdrawn. They are in a position effectually to prevent any one of their number from overdrawing his account. It is not uncommon, however, to permit a partner to draw more than the sum mutually agreed upon, and in this event the partner who has made the over- draft will undoubtedly be compelled to pay interest for the privilege. But if the partners have permitted the overdraft, and no agreement was made and no conditions were laid down previously by the partners themselves, they cannot force the partner who over- draws to pay interest on the overdraft. 14. Loans of partners. A partner may loan money to his firm. The loan may be in the form of excess capital, either contributed or represented by an ac- cumulation of profits it may or may not be se- cured by a note of the firm; or the amount loaned may appear in a special-loan account of the partner. The partner who loans the money has clearly risked more in the venture than his fellow-partners, and therefore for his additional risk he is entitled to com- pensation, in the form either of increased profits or of interest. The latter method of compensating the partner is the more usual. If the loan takes the form of excess capital it would be better to reduce the capital account to the agreed amount and transfer PARTNERSHIP OPERATIONS 75 the excess to a special-loan account, because the books of the firm ought to reflect actual facts. 15. Interest on partners' loans. It is sometimes held, in litigation, that when a partner voluntarily allows money in excess of his capital contribution to remain in the business, he is not entitled to claim in- terest on the excess. The theory is that if it was in- tended that interest was to be allowed on excess capi- tal, the partnership agreement would have provided for it. This view has apparently been modified in New York State by a recent decision of the Court of Appeals, to the effect that the law will presume interest in such cases, and if no rate of interest is specified the court will allow the legal rate. When interest is charged on a partner's loan it should be charged to the regular interest account of the busi- ness, inasmuch as it is the same as interest on money borrowed from a bank or from an outsider. REVIEW Under what circumstances should interest on capital be al- lowed? What is the effect of an omission to charge interest on capital? Why should interest on capital be charged to the profit-and- loss account? What is the essential difference between the method of ad- justing interest directly thru the partners' capital account and the other method mentioned in the Text? Why should interest on the excess or deficit of capital con- tributions be charged against the profit-and-loss account? How should good-will be treated in the books of a partner- ship ? CHAPTER V PARTNERSHIP DISSOLUTION 1. Types of dissolution* The dissolution, or liqui- dation, of a partnership may be voluntary or involun- tary. In the first case, liquidation is brought about by agreement among the partners, and in the second case by the action of outsiders, who are generally cred- itors of the firm. It is important to note that the ac- tion taken in liquidation depends very largely upon whether the partnership is solvent or insolvent. When the liquidation is voluntary and the partnership solvent, one of the partners usually acts as agent for the firm in the proceedings. Where the partnership is dissolved because of insolvency, the affairs of the firm are usually wound up by the assignee or by a receiver. 2. Application of assets at dissolution in a solvent firm. The assets of a solvent firm are applied as follows: (1) In the payment of firm debts to credi- tors, exclusive of loans from partners; (2) In the re- payment of loans made to the firm by the partners themselves; (3) In the repayment of the capital ac- count of the partners; (4) In the distribution as profits of the residue, if any, to the partners, in the i Before reading this chapter it would be advisable for the reader to review the legal phases of partnership dissolution in the Modern Business Text on "Business Organization." 76 PARTNERSHIP DISSOLUTION 77 proportion specified in the partnership agreement ; or equally, if the agreement does not provide for any definite proportion. 3. Application of partnership assets of an insolvent firm. Losses from operation, as well as losses on realization and liquidation, are charged against the capital account in the proportion in which profits and losses are to he shared. If any of the partners have contributed money to the firm in the form of loans, the loans are to be repaid next, unless the partners who loaned money to the firm are in debt to the firm on account of capital. Finally, partners must con- tribute individually to the deficit, according to their respective shares. 4. Status of a partner's loan in liquidation. The loan that a partner has made to his firm cannot be paid until the outside creditors receive what is due them. The reason for this is that it might be neces- sary to use a part of the money which a partner con- tributed as a loan for the payment of the partner- ship debts. Inasmuch as the partners are jointly and severally liable for firm debts, a partner who loans money to the business cannot expect his loan to be repaid until it is definitely known that the assets of the firm will realize a sufficient amount to pay off all the firm's creditors. In this connection, how- ever, it must be noted that if losses on operation, or losses on realization and liquidation, are so great as to wipe out the capital account of a partner who has loaned money to the firm, so much of his loan as 78 ACCOUNTING PRACTICE would be necessary to cancel the debit balance in his capital account would be deducted from the amount to be paid to him. 5. Expenses of liquidation. One or more of the partners may be intrusted with the task of liquidating the affairs of the firm. Since this work is not a part of the partnership duties, special compensation is given. When the partnership is insolvent, the liqui- dation is usually placed in charge of a trustee ap- pointed by a court. The services of the liquidating agent are paid for on such a basis as the statute per- mits, or upon such a basis as the court to whom he ac- counts, may deem proper. When one partner liquidates the affairs of a firm as agent for his fellow-partners, the compensation that he receives should not be charged as .an expense of the business, because if it is so charged the liquidating partner will be debited with his share of the expense in the final settlement. The commission or payment that he receives is a private matter between himself and his fellow-partners, who will compensate him. But if an outsider liquidates the affairs of a partner- ship, the compensation for his services will be charged to an appropriate expense account, and that expense will be borne by all the partners in the proportion in which they share profits and losses. 6. Treatment of partners' loans illustrated. Sup- pose that M and N are partners who share profits and losses equally; M's capital is $8,000 and N's capital is $10,000. The former has loaned the busi- PARTNERSHIP DISSOLUTION 79 ness $10,000, and the latter has loaned $3,000. They dissolve partnership, and the net assets after the creditors have been paid, realize $14,000. To whom shall distribution of this amount be made? Solution of Problem M's CAPITAT, ACCOUNT To V* Loss of $17,- 000 $8,500 $8,500 By Balance . .... $8,000 Transfer to Loan Account . 500 $8,500 M's LOAN ACCOUNT To Transfer from Capital Account $500 Cash 9,500 $10,000 By Balance $10,000 $10,000 N's CAPITAL, ACCOUNT To y Loss of $17,- 000 $8,500 Cash 1,500 $10,000 By Balance $10,000 $10,000 N's LOAN ACCOUNT To Cash $3,000 By Balance $3,000 80 ACCOUNTING PRACTICE CASH ACCOUNT To Proceeds of As- $14,000 By M, Loan % . . . N, Loan % . . . N, Capital % . . $9,500 . 3,000 . 1,500 $14,000 $14,000 7. Comments on the solution of the problem. The total aggregate capital and loans of the members of the firm are $31,000, and the assets realized $14,000 in cash. Therefore the loss of $17,000 will be charged against the capital accounts of the respec- tive members of the firm in the proportion in which they share profits and losses, i.e., equally, M is debited with $8,500, and N is debited with the same amount. It will be noticed that this settlement creates a debit balance in M's capital account of $500, which is trans- ferred to his loan account ; the net amount, then, that is still due him out of the assets is $9,500. N's ac- count presents no difficulties. It should be noted that partners' loans in liquida- tion stand on an equal status and rank equally in payment. 8. Repayment of partners' capital. After the out- side creditors have been paid, and the balance due to partners on their loans has been liquidated, the as- sets should be applied in repayment of the partners' capital accounts. The distribution of assets in liqui- dation is always made with the capital accounts as a basis at the time the dividend is distributed. It is PARTNERSHIP DISSOLUTION 81 often necessary for the liquidating agent to require considerable time for the realization of the assets, and in the meantime the partners may desire to receive a portion of the amount that he has collected. If the capital ratio is the same as the profit-and-loss-sharing ratio, the liquidator may do this without any further trouble. Difficulty is liable to arise, however, if the capital ratio is different from the profit-and-loss-sharing ratio. It is evident that if there is a great difference between the capital accounts of the partners, and if the partner who has made the smallest capital contribution should be the one who either is entitled to receive the largest share of the profits or is to be charged with the greatest part of the losses, a situation may arise in which the liquidator must be especially careful in paying off the capital accounts of the partners. 9. Adjustment of capital ratio to profit-and-loss- sharing ratio in liquidation. For the sake of illus- trating the danger that the liquidator will encounter if he does not bring the capital ratio into agreement with the profit-and-loss-sharing ratio when he pays liquidation dividends, let it be assumed that X, Y and Z are partners, each with a capital account of $30,- 000. After the payment of creditors and partners' loans, the loss which is to be charged against the re- spective partners, who share in the ratio of five, three and two, amounts to $24,000. The liquidator has for distribution $33,000 in cash, and he proceeds to dis- tribute it among the partners on the basis of the cap- 82 ACCOUNTING PRACTICE ital ratios, after the loss of $24,000 has been charged against them. But additional losses develop, amount- ing to $24,000, which are charged against the capital accounts of the partners in the ratio in which they share losses. The following tabulation will show the results that will be brought about by the neglect to reduce the capital ratio to the profit-and-loss-shar- ing ratio. Total X Y Z Capital at dissolution $90,000 $30,000 $30,000 $30,000 Losses 24,000 12,000 7,200 4,800 Capital as adjusted $66,000 $18,000 $22,800 $25,200 First dividend 33,000 9,000 11,400 12,600 Capital as adjusted $33,000 $9,000 $11,400 $12,600 Losses $24,000 12,000 7,200 4,800 Capital as adjusted $ 9,000 g 3,000 $ 4,200 $ 7,800 It will be noticed that in the payment of the divi- dends, one partner X, has been overpaid by the amount of $3,000. The liquidator is personally liable to Y and Z for the amount of this overpayment. If, however, the liquidator had reduced the capital ratio to the profit-and-loss-sharing ratio, this diffi- culty would have been avoided, as the following state- ment will show : Total X Y Z Capital at dissolution $90,000 $30,000 $30,000 $30,000 Losses 24,000 12,000 7,200 4,800 Capital as adjusted $66,000 $18,000 $22,800 $25,200 First dividend 33,000 1,500 12,900 18,600 Capital as adjusted $33,000 $16,500 $9,900 $6,600 Losses 24,000 12,000 7,200 4,800 Capital as adjusted $9,000 $ 4,500 $ 2,700 $ 1,800 PARTNERSHIP DISSOLUTION 83 On the distribution of the first dividend, amount- ing to $33,000, the liquidator has applied the cash used in the payment of partners in such a manner as to reduce the capital ratios of the partners to the profit-and-loss-sharing ratio. Instead of $9,000, X will receive only $1,500; Y will receive $12,900, in- stead of $11,400; while partner Z will be paid $18,600, instead of $12,600. The adjusted capital, after the dividend of $33,000 has been paid, will be $16,500 for X, $9,900 for Y and $6,600 for Z. After this ad- justment has been made, all future losses, payments and charges for expense of liquidation, will be dis- tributed on the same ratio that is, five, three and two. Altho the distribution is made on the profit-and- loss-sharing ratio, this method has been adopted not because it is proper to distribute liquidating divi- dends on the profit-and-loss-sharing ratio, but be- cause the capital ratio has been reduced to the profit- and-loss-sharing ratio. 10. Method by which the liquidator can easily de- termine the amount to be distributed. In the total column the capital remaining after the first dividend is paid amounts to $33,000. To find how much of the dividend of $33,000 is to be paid to X, Y and Z respectively, the liquidator should divide the capital remaining after the payment of the dividend, on the basis of five, three and two. If this were done it would be seen that X's capital would be $16,500; Y's $9,900; and Z's, $6,600. 84 ACCOUNTING PRACTICE The amount standing at the credit of X's capital, prior to the distribution of the dividend, was $18,000. If his new capital is to be $16,500, assigned on the basis of the profit-and-loss-sharing ratio, it would mean that out of $33,000 to be distributed, he is to receive $1,500. Then Y's capital, according to the new arrangement, will be $9,900, whereas his present capital is $22,800, and the difference between these two sums, or $12,900, will be the proportion of the $33,000 to be given to Y. By the same method it is easy to show that Z is to receive $18,600 of the $33,000. It may happen, in such cases, that the first dividend will not be sufficient to permit the reduction of all the capital accounts of the partners to the profit-and-loss- sharing ratio, and that one of the partners will re- ceive nothing from the first dividend. For example, if the first dividend distributed amounted to $30,000, the amount of the aggregate capital after the distri- bution would be $36,000. Of the $30,000, Y's share would be $12,000, Z's would be $18,000 and X would receive nothing. The remaining capital accounts would then be as follows : X $18,000 ; Y $10,800 ; Z $7,200. The ratio is five, three and two. The following tabulation states this in summary form : Total X Y Z Capital as adjusted $66,000 $18,000 $2,800 $25,200 First dividend 30,000 12,000 18,000 Capital as adjusted $36,000 $18,000 $10,800 $ 7.300 Of course, according to this arrangement X would receive nothing from the first dividend. If he should PARTNERSHIP DISSOLUTION 85 object to this method of distribution the liquidator could withhold all cash and not distribute any of it until he could be certain that he would not be per- sonally liable in case he paid too much to any of the partners. 11. Oilier examples of partnership adjustment. When a receiver has been appointed to wind up the affairs of a partnership, it is customary to prepare a statement of affairs setting forth the status of the business, on the basis of enforced liquidation. The proceedings are under the direction of a court of com- petent jurisdiction. Discussion of this kind of state- ment and of the principles involved in the sale and transfer of the assets of a partnership to a corpora- tion, is postponed until a later chapter. REVIEW The same subject is continued in the following chapter and review questions on the two chapters together are found on page 102. CHAPTER VI PARTNERSHIP DISSOLUTION ILLUSTRATED 1. Adjustment of affairs upon retirement of a partner. The adjustments necessary upon the re- tirement of a partner are well illustrated in a case stated by Mr. Leo Greendlinger, C. P. A. A, B, C and D were partners, having a partner- ship agreement in writing which contained the follow- ing special provisions: (1) The capital $100,000 is to be contributed by: A one- half, B one-fourth, C one-fifth and D one-twentieth. (2) Interest at 6 per cent per annum is allowed on any amount contributed by a member in excess of the required investment and charged on any deficiencies. (3) Withdrawals are not to be made beyond the salary allowances. (4) Each partner is allowed a yearly salary, to be drawn monthly or otherwise : namely, A $3,500, B $2,500, C $2,000 and D $1,000. Such salary allowance is to be credited at the end of the year to the drawing account of each partner an offset against his monthly withdrawals of such salary. (5) All adjustments among the partners for interest on capital, drawings, etc., are to be made at the end of each year after the trial balance of the ledger accounts has been taken. (6) On the retirement of a member of the firm, he is to be entitled, in addition to the amount appearing on the credit side of his ledger account, to good-will. The valuation of the good-will is to be one-half the sum of the last two years" net profits of the business for each retiring member. 86 PARTNERSHIP DISSOLUTION 87 (7) Profits and losses are to be divided as follows : A, 50 per cent ; B, 25 per cent ; C, 15 per cent ; D, 10 per cent. 2. Preparation of necessary statements for adjust- ments. On December 31, after the partnership has existed for four years, A wishes to retire. A list of the ledger accounts as well as all the facts and no- tations necessary for the adjustment in accordance with the partnership agreement is prepared and gives the following information: Plant and machinery $ 50,000.00 Purchases of raw materials : 200,000.00 Land and buildings 49,600.00 Advertising 1,800.00 Wages (productive) 240,000.00 Accounts receivable 20,000.00 Supplies for factory 2,450.00 Light, heat and power ( factory) 20,000.00 Superintendence (unproductive labor) 10,000.00 Light, heat and power (office) 1,000.00 Cash 87,500.00 Packing materials 1,300.00 Salesmen's traveling expenses 6,000.00 Accounts payable 161,000.00 Insurance on buildings and plant 1,200.00 Interest lost 1,200.00 Reserve for bad debts 5,400.00 A, capital account 52,500.00 B, capital account 28,275.00 C, capital account 13,400.00 D, capital account 4,125.00 Notes receivable 76,000.00 Raw material inventory Jan. 1, 192- 13,500.00 Finished goods inventory Jan 1, 192- 19,000.00 Supplies inventory Jan. 1, 192- 16,000.00 Sundry factory expense 7,200.00 Commissions 1,500.00 Notes payable 21,000.00 Taxes on land and buildings 500.00 Trade discounts gained 4,000.00 Reserve for depreciation on plant and machinery 5,000.00 Reserve for depreciation on buildings 2,000.00 Reserve for depreciation on furniture and fixtures 1,000.00 Mortgage on buildings (5 per cent interest) 15,000.00 Allowances on sales 1,500.00 Insurance on stock and fixtures 1,000.00 Freight, outward 1,600.00 XXI 8 88 ACCOUNTING PRACTICE Freight, inward $ 900.00 Cash discount gained 2,800.00 Interest on mortgage 730.00 Finished goods sales 550,000.00 Salaries (including partners) 20,000.00 Furniture and fixtures 7,000.00 A, drawing account 500.00 B, drawing account 500.00 C, drawing account . 500.00 D, drawing account 500.00 The net profits for the previous three years were $8,500, $9,300, $6,700 respectively. The semi-annual interest on the mortgage is pay- able in January and July. Of the premium paid on insurance of buildings and plant, and stock and fixtures there is unexpired in- surance amounting to $200 and $100 respectively. The inventories are as follows: Raw material $16,750.00 Factory supplies 930.00 Goods in process of manufacture ,. 5,450.00 Packing materials 150.00 Finished goods 20,300.00 It is agreed that the depreciation of various assets at the present should be at the following percentages, on the net balance shown on the respective ledger ac- counts, after deducting the depreciation of former years as shown by the various depreciation accounts: On plant and machinery 5 per cent Land and buildings 2 per cent Furniture and fixtures 10 per cent It is also agreed that a reserve of 5 per cent is to be provided for bad and doubtful accounts on the notes and accounts receivable outstanding. In the first year of the enterprise the partners con- PARTNERSHIP DISSOLUTION 89 tributed capital as follows: A, $60,000; B, $20,- 000; C, $14,000; D, $6,000. As no interest adjust- ments were made at the time, the partners agree that such an adjustment is to be made now. The items shown as drawings to B's and C's accounts are not all to be considered as overdrafts on salary. On the contrary, an abstract shows that B and C have not taken out all their salaries, and that there is due to each, after deducting the withdrawals of $500, another $500 on account of salary not withdrawn, while A and D have each overdrawn $500. After completing the foregoing transaction, the partners decide in accordance with the partnership agreement (clauses 5 and 6) that A is to get in cash one-half of the sum due him and the other half in four notes of equal amounts, payable within two years' time; one note every six months. The problem, then, is (a) to determine the re- sult of the year's operations; (b) make the proper adjustment entries consistent with the intentions of the partners; (c) prepare a final balance sheet, and (d) show the partners' respective capital accounts. 3. Trial balance and profit-and-loss account. The first step is to find out if the books are in equilibrium and in order to do this we prepare the trial balance given on page 95. In accordance with the best practice the accounts are grouped so as to facilitate the preparation of financial statements. A profit-and-loss account for the firm for the year ending December 31, 192- shows in the first section 90 ACCOUNTING PRACTICE of the debit side the cost of the material used dur- ing the year's operation, e.g., the raw material, in- ventory and the purchases. From this is deducted the raw material inventory as well as the trade dis- count allowed on purchases. Other charges follow. The inventory of raw material on hand at the end of the period is shown as a deduction from the pur- chases, tho it could be entered on the credit side of the same section. The result would be the same, but if the percentage of the cost against proceeds is to be obtained, or a comparison of percentages of differ- ent periods is to be found, the deduction of these in- ventories is preferable to entering them on the credit side. Goods in process of manufacture are entered on the credit side, because correct results would not be obtained if the expenditure on these goods were charged to the current period, when they are not utilized nor even completed during such period. The balance is carried down as a first charge against the trading section of the profit-and-loss account. The second section, known as the trading section, contains on the debit side; first, the balance brought down from the manufacturing section, followed by the inventory of finished goods on hand at the be- ginning of the period, as well as by all the other items pertaining to the trade. The credit side shows gross sales from which proper deductions are made for the allowances, leav- ing net sales of $548,500. There is shown also the PARTNERSHIP DISSOLUTION 91 amount of finished goods on hand at the end of the period, giving a gross profit of $50,128 on trading. This balance is carried forward to the credit side of the third section of the profit-and-loss account. Against this is charged all general items of expendi- ture, such as salaries (including the unpaid salaries due to B and C), general insurance, etc., showing the ordinary business profit to be $25,628. This is carried to the credit side of the final section of the profit-and-loss account, and by adding the cash dis- count gained, a total of $28,428 is made. Against this amount is charged the interest on the mortgage and general interest, thus leaving a net profit, exclu- sive of interest on investment and reserve for bad debts, amounting to $26,478. The reason for dividing the profit-and-loss account into various sections is to present to the best ad- vantage the result of each section. 4. Preparing a profit-and-loss appropriation ac- count. The profit-and-loss account having been completed the profit-and-loss appropriation account is prepared. This account shows the net profit to be distributed among the partners, after provision has been made for reserve for bad debts. The credit side shows the net profits from the profit-and-loss account, amounting to $26,478. It shows also interest charged to B, C and D on account of their deficient investment as well as withdrawals, making a total of $27,000. The debit side shows the five per cent re- serve for bad debts on notes and accounts receivable, 92 ACCOUNTING PRACTICE amounting to $4,800; also the interest accrued on A's excess investment, after deducting withdrawals, amounting to $120, leaving a balance of $22,080 for allocation among partners. This net profit is al- located according to the provision for dividing profits and losses, namely: to A, 50 per cent, or $11,040; to B, 25 per cent, or $5,520; to C, 15 per cent, or $3,312, and to D 10 per cent, or $2,208. 5. Verifying the profit-and-loss account and ex- amining financial conditions. Next the results shown by the profit-and-loss account must be verified and the financial condition of the concern disclosed as well. The balance sheet on page 99 shows this con- dition. It will be noticed that the assets are divided into current, fixed and deferred. By deferred as- sets is meant outlays made under one period for the benefit of a future period. The item here is the unexpired insurance premium amounting to $300. The total assets are $325,378. The total liabilities (divided into current and fixed) amount to $197,000. The last division of the balance sheet shows the proprietorship and reserves. The reserves deducted for the current period are taken off from each asset, while the general reserves created in previous periods are entered on the liability side. The capital left in the business, after adding the profits made during the period, as well as the accrued salaries of B and C, and deducting the excess withdrawals of the other part- ners, amounts to $114,978. The problem now re- quired is to show the partners' individual capital ac- PARTNERSHIP DISSOLUTION 93 counts, and these are shown on pages 100-101 respec- tively. B, C and D's capital accounts are self-explan- atory. They show the credit balances to each partner at the beginning of the period, January 1, 192-, to which is added the share of profit made during the pe- riod, including in B's and C's accounts the unpaid sal- ary, and against which is charged interest. The inter- est is debited, if there is a deficiency, or credited if there is an excess of capital. At the end appears the balance of capital in each partner's account. 6. Analysis of transactions in the problem. An analysis of the problem shows that it has been neces- sary to make adjustments among the partners for in- terest on capital, drawings, etc., which is here shown: Adjustment account $660.00 To A, capital account $600.00 To D, capital account 60.00 Adjustment of interest on first year's investments as per unanimous agreement. B, capital account $300.00 C, capital account 360.00 To adjustment account $660.00 Adjustments of interest on first year's invest- ments as per unanimous agreement. The entry shows a debit of $660 to the adjust- ment account, and a credit to A for $600 and to D for $60. It also shows a debit to B for $300, and one to C for $360, and a credit to the adjust- ment account for the $660. These entries repre- sent the adjustment of interest on the first year's investments. This is not carried thru the profit-and- loss account because it has nothing to do with the profits. In this case, if B and C are debited, and A and D credited for the respective amounts mentioned 94 ACCOUNTING PRACTICE in the adjustment entry, the result is the same as if the adjustment account was debited and credited for the same amounts. Nevertheless, if the figures dis- closed a balance in the adjustment account, if it were debited for only $600 instead of $660, and credited for $660, that balance of $60 would have to be apportioned among the partners in accordance with the provision for sharing profits and losses. In such case the partner or partners who are charged with interest would share in the apportionment, and rightly so. It makes no difference to the business whether the interest is earned by reason of a partner's deficiency of investment, or because the money has been loaned at interest to an outsider. 7. Debiting or crediting partners' accounts for ad- justments. After having made the adjustment en- tries each partner's respective account is debited or credited in accordance with the adjustments. The value of the good-will to which A is entitled, as set forth in Clause 6, is then found. The clause reads, that in case of the retirement of a member of the firm he is to receive for good-will one-half the sum of the last two years' net profits of the business. On page 88 it is seen that the net profit for the previous year was $6,700, to which is added the net profit of this year, $22,080, making a total of $28,780. Therefore, A is entitled to one-half of this, $14,390, and this sum is credited to his account. As four notes total- ing $39,075 are issued to A and a like amount paid him in cash, his account is debited for such notes and cash, thus making it balance. PARTNERSHIP DISSOLUTION TRIAL BALANCE, DECEMBER 31, 192- Cash $ 87,500.00 Notes receivable 76,000.00 Accounts receivable 20,000.00 Raw material inventory (January 1) 13,500.00 Finished goods inventory (January 1) 19,000.00 Supplies inventory (January 1) 16,000.00 Plant and machinery 50,000.00 Land and buildings , 49,600.00 Furniture and fixtures 7,000.00 Notes payable $ 21,000.00 Accounts * payable 161,000.00 Mortgage on 'buildings (5 per cent interest) 15,000.00 Purchases of raw materials 200,000.00 Wages (productive) 240,000.00 Light, heat and power (factory) 20,000.00 Supplies for factory 2,450.00 Superintendence (unproductive labor) 10,000.00 Packing materials 1,300.00 Salesmen's traveling expenses 6,000.00 Advertising 1,800.00 Insurance on buildings and plant 1,200.00 Sundry factory expense 7,200.00 Commissions 1,500.00 Taxes on land and buildings 500.00 Trade discounts gained 4,000.00 Allowance on sales 1,500.00 Insurance on stock and fixtures 1,000.00 Freight outward 1,600.00 Freight inward 900.00 Cash discount gained v 2,800.00 Interest on mortgage '. 750.00 Finished goods sales 550,000.00 Salaries (including partners') 20,000.00 Light, heat and power (office) 1,000.00 Interest lost 1,200.00 Reserve for bad debts 5,400.00 Reserve for depreciation on plant aJid machinery 5,000.00 Reserve for depreciation on buildings 2,000.00 Reserve for depreciation on furniture and fixtures 1,000.00 A, capital account 52,500.00 B, capital account 23,275.00 C, capital account is',400.00 D, capital account 4,125.00 A, drawing account 500.00 B, drawing account 500.00 C, drawing account 500.00 D, drawing account 500.00 $860,500.00 $860,500.00 ooooo oooo o o 00 o oo o o o oo o CO O oo o oooooo o o o o ci o o o o o o oo O O O O M oo IM oo oo mo t- O ^.^^1-^ 00 o o o coco i t t-w ^ CO" l- 1 1-1 tH o" 00 ef'H in" o i-f co" in <0 N w ea in < ee- > -00 oo ; ' i i ! oo oo : : I !"a loo om ioo .00 -d ' ' ::| .coin .Or-l fl . .- ' OQ . ^ a . . b? ee- 09- : : ; w |^ -,^- *n -, n OD M S i|lg U4M|. ^07 O O O o c "5 O <3D CO CO <: C l~ C t- ac o ^f O CO o co" g t-' *l .S . ^ CM 'O CO O /fc\ @ O O O O O O O < 500 o o o o < r o o r o o c *r> o *o o o o * D < O O O O O 3 o 2 *o *"v u5 *^J> ^"^ *"i* C C C 1 ^ cc i-* 1 1-1 c o ss. -o 6 ^^ S "3 ^ 'to ' * e ' * en H 55 D =2 a'e S2 eg rj w ^J C3 4J r CJ ^ ? ^, H ^j fc-< ^ ^ ^^ t O cd i '^ rv * *fe /) T3 u > > > 5 o -S 0* * .S 0* 3 'S ^ ^ r g s i n M ^* ** W W ^ y jH --i ^j ^ "^ s*l o I-H ? 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CD" i'T I-H se- M> CO ! c O *J "S CO tU ^s ^ C CO ^ Oi O to pr H S-< fr * u: 2^ O p S c CS ^^Q 05 CS cq c c OS CS 03 -n-s 1 -* M H q q 8 o o H O *c *o O q o' M s CO -* S^ i PH O CD 'O CO &" g CJ <& , .* e CO* CO c cn to O "** to U Q > 4i> "w ^C .s 'o 4) 4-> cC "fl "fi -0 '".Si . co "3 C =*- < .S w O qj *fe <-> 4* cS tn M p CO ro 4> S"- p *J ^3 03 CS CO C3 ^ co V i i 3 >> ^ CO "cfl ^ '*"'-' .S "c a cy 03 >H flj A c-2 >" o ^ S O ^s, ^ CS H H E" 1 co fQ CO CO 1 1 i-H I-H CO CO CO t~ *-* S-i v to ,1 1 b CU CU 4^ .0 .0 f^ III SQ Q 2! 2QQ Q 101 102 ACCOUNTING PRACTICE REVIEW What are the reasons for the dissolution of a partnership? How should the assets be distributed in the case of a solvent partnership? In the case of an insolvent partnership? What is the status of partners' loans in liquidation? How should liquidating dividends be distributed on the capital ratio, or on the profit-and-loss-sharing ratio? Why? CHAPTER VII CONSIGNMENTS AND JOINT VENTURES 1. Legal relation between consignors and con- signees. The relation that exists between a consignor and a consignee is that of principal and agent. While the rights and duties of both parties are usually regu- lated by a contract, their relations are governed also, to a large extent, by what is known as "the customs of the trade." A consignment may be defined as a ship- ment of merchandise, made by the owner or con- signor, to another party, called the consignee, who acts as agent for the consignor in disposing of the goods. There are two kinds of agents general agents, who represent the principal in all his business, and special agents, whose authority extends to the per- formance of certain acts only. The important ques- tion, in any individual case, is to find out just what the agent's duties are. This authority may be di- rectly conferred by the consignor; or it may be inci- dental that is, necessary to certain powers expressly conferred ; or it may be implied from the fact that the principal has held the agent out to the world as pos- sessing that authority. In any event it is only when the agent acts within his authority that he can bind his principal. XXI 9 103 101 ACCOUNTING PRACTICE 2. The factor; his general rights and liabilities. The factor, or commission merchant, is an agent to whom goods are sent to be sold. He is a bailee with the right to sell goods in his own name for cash or on the usual terms of credit, at any price ; he has also the right to receive the money and to execute and deliver to the buyer a binding discharge. He may also war- rant the goods, if they are of the kind usually sold with a warranty. He may take negotiable instru- ments on a sale on credit. He has a lien on the goods for the balance of the account in his favor, but a 1 voluntary relinquishment of possession destroys the validity of the lien. A factor cannot barter the goods but under the Factor's Acts an innocent pledgee is protected. The statutes known as the Factor's Acts modify the common-law rights and liabilities of the factor; they were passed principally to protect inno- cent purchasers, who of course cannot know whose goods the factor is selling, or what instructions, with reference to their sale, the owner may have given. 3. Factor's responsibility for his goods. All the rights and duties of both parties may be gov- erned by a contract; when there is no contract the customs of the trade shall govern. The principal is bound by these customs. The factor is obliged to protect the property of the consignor while it is in his possession; he must take such care as a reasonably prudent man would take of his own property. He is not called upon to insure the goods against loss by fire or theft. CONSIGNMENTS AND JOINT VENTURES 105 4. Factor's responsibility to his principal; credit. If the factor receives specific instructions from his principal, he must follow them absolutely. For ex- ample, if he has been advised as to the price at which the goods are to be sold, he would violate instruc- tions at his peril. The factor is also bound to sell the goods at the highest prices obtainable, if no specific instructions as to selling price have been given; and if he sells merchandise on credit for his principal, he is expected to use reasonable prudence and discre- tion in extending credit. In other words, he must use the same diligence in ascertaining the responsibility of the purchaser, that the average merchant would use. If the factor can prove that he has fulfilled this requirement, he will not be held responsible for .the loss caused by a purchaser's failure to pay for goods received. 5. Factor and secret profit; books of account. As an agent, the factor is not entitled to secret profits; he must account for all moneys received in the trans- action of his principal's business. Even in the case of illegal transactions, he is required to keep and render accounts. Moreover, an agent who mixes the prop- erty or moneys of his principal with his own is liable for any loss that may result. Inasmuch as his relation to the principal is one of trust, he must act for his principal alone. Thus it has been held that even after an agent has left a prin- cipal's employ, the latter may enjoin him from using trade figures that he learned while he was working 106 ACCOUNTING PRACTICE for that principal. The factor is bound to give his principal due notice of all information he has gained that may affect the latter's interests. An agent may not buy what he is delegated to sell; therefore factors should not purchase, on their own account, goods which have been intrusted to them for sale by their shippers. Unfortunately some factors are not always honest in this respect. After the merchandise is sold, the factor must ac- count for it to his principal. In order to be able to do this he must keep proper books of account. While it is generally held that if there is no agreement to the contrary the books of a factor are subject to his principal's inspection, a definite provision to the con- trary is sometimes included in the contract, for the reason that information obtained from an inspection of the accounts of a factor would reveal to his princi- pal the merchants to whom the goods were sold. If the factor makes any secret profits, he is of course under the law accountable to his principal for them. 6. Expenses for which the principal is accountable. If the agent has made advances to his principal, it is usually held that he has a lien upon the goods in his possession for the amount of his advances, and that he also has a lien for expenses incurred in the scope of the agency, such as marine and fire insurance carried under instructions, and freight or customs duties paid, as well as allowances made to customers and claims made upon him, in order to protect the validity of his sales to them. CONSIGNMENTS AND JOINT VENTURES 107 7. Del credere agency. That kind of agency in which the agent guarantees the accounts of the cus- tomers who become debtors to the principal thru his solicitation, is known as a del credere agency. In the majority of the states of the Union, contrary to the usual rule governing contracts of guaranty, the con- tracts between the principal and the del credere agent do not need to be in writing. In other words, the factor agrees to pay to his principal the price of the goods that have been sold by the time the term of credit extended to the purchaser has expired. Or, if the purchasers fail to pay, the agent must give the principal the price of any goods for which credit has been allowed; thus the principal is relieved of all risk of loss in such cases. Inasmuch as this involves an additional undertaking on the part of the factor, he receives an additional commission, sometimes called a "guaranty," if his agency if of this kind. Of course the factor is not entitled to claim a guaranty on cash sales, since he has assumed no risk in making them. Any transaction under del credere agency practically amounts to a sale to the agent and a resale to the customer, altho actually the title to the goods passes directly from the principal to the third party. 8. Why goods are shipped on consignment. There are a number of reasons why goods are shipped on consignment. In the first place, a merchant who dis- poses of his product thru the agency of a factor is relieved of the burden of developing a market for his goods and of training a sales force. In other words, 108 ACCOUNTING PRACTICE he can devote his entire attention to the manufactur- ing, or producing end of his business. Factors are often called upon to sell a surplus which the busi- ness cannot conveniently dispose of thru its regular channels of business. Or sometimes goods will be shipped on consignment to a business house to be sold at a specific price, because the shipper has riot suffi- cient faith in the credit-standing of the consignee to be willing to sell him goods on credit. 9. Goods on consignment; the consignee's liability. When goods are sold outright, the title to the goods passes at once to the buyer; but when merchandise is shipped on consignment, as long as the goods are un- sold they remain the property of the consignor. In the latter case, it is the consignee's duty to keep them separate and distinct from his own merchandise, so that they may be readily identified at any time. If the consignee appropriates to his own use either the money he has received for goods sold, or the goods that he still has on hand, he is liable under the crim- inal law. Since there is also civil liability, the shipper is protected by a double safeguard. 10. Goods on consignment; live stock and farm /;/*o- duce. Live stock and farm produce are frequently shipped to commission merchants to be sold on con- signment, because the shipper cannot know at the time he sends them to market what the market price will be when they arrive, and since the goods are perish- able it is necessary that they be disposed of as soon as they reach the market. Generally in cases of this CONSIGNMENTS AND JOINT VENTURES 109 kind the shipper specifies no selling price for the goods, hecause if the factor should be unable to realize a fixed price the goods would have to be Carried, and the shipper would have to bear the carrying charges and whatever loss there might be from deterioration. 11. Consignment and the retail merchant. The re- tail merchant should be careful not to overbuy. And yet, too great conservatism may mean that he will not have stock on hand when customers are ready and willing to purchase ; this would, of course, mean a heavy loss. He may avoid both of these extremes if he can arrange with a wholesaler or a manufacturer to ship him certain goods on consignment. If this arrangement is made, the consignee is protected in the event of his not being able to find a market for the goods. The consignment method enables even the merchant who does not possess the capital necessary to purchase the goods outright, to enjoy all the trad- ing advantages of a complete stock of goods. 12. Brokers distinguished from factors. A broker is an agent who, altho intrusted with the duty of dis- posing of goods or property, does not actually hold possession of them. For this reason he has less ap- parent authority than a factor. In dealing with a merchandise broker, the purchaser should be on his guard, for the former has no apparent authority to receive payment for goods, and usually has no right to make a sale on credit or to take negotiable instru- ments in payment for goods sold. Moreover, he may not warrant the goods. 110 ACCOUNTING PRACTICE 13. Mill agents. The so-called mill agent is not an agent at all; he is, in reality, an independent con- tractor who agrees to take and sell the entire output of a certain mill or factory. He actually has posses- sion of the goods, and title to them as well, since the mill actually sells the goods to the mill agent. In other words, a mill agent is a principal, not an agent. 14. Joint ventures. Transactions in which con- signments are made for a merchant's own account are sometimes called ventures, or single adventures. Similarly, transactions in which the merchant is a co- partner with others, are termed joint ventures, or joint accounts. The members of a venture are part- ners, but the partnership relation exists only for the carrying out of one or more specified transactions, and terminates as soon as the business has been completed. Thus, a merchant may ship goods to an- other merchant at another point, to be sold for the joint account of both parties; the second party either furnishes the necessary cash to finance the venture, or perhaps he may ship to the first party a consignment of goods to be sold by the latter, the proceeds to be shared by both parties. Not infrequently three or more individuals are interested in a transaction of this character. This relationship gives rise to a num- ber of complications for several reasons: the contri- butions of the different members of the venture may be unequal; the goods exchanged between the parties to the transaction may not all be of the same value; CONSIGNMENTS AND JOINT VENTURES 111 or the cash capital contributions of the members may be unequal. 15. Accounting procedure in the commission busi- ness; general. The great variety of conditions in the commission business makes it difficult to discuss its accounting procedure except in a general way. In every case, the records of both the consignor and the consignee should reflect exactly the terms of the con- tract that binds them both. Sales made on approval, and the shipment of goods on consignment, must not be entered in the sales account until the factor has disposed of the goods ; nor can the factor treat the receipt of merchandise sent him on consignment as ordinary purchases would be treated in books of account. Each party must there- fore provide the bookkeeping machinery necessary to record such shipments properly. It is common prac- tice for business undertakings that are in the habit of consigning merchandise to dealers "on sale or re- turn," to treat such transactions in their accounts as if they were actual sales that is, to charge the ac- count of the customer and credit the sales account. When the balance sheet is prepared at the end of the fiscal period the amounts charged to customers are frequently given an arbitrary valuation ; for instance, 66 2/3 per cent of the amount of the face value of such approval sales. The sales account is adjusted accordingly. 16. Sales on approval, and allowance for deteriora- 112 ACCOUNTING PRACTICE tion. Even if the valuations were correct it would not be proper to include sales on approval as valid sales in the income account. It would be as incorrect to state under accounts receivable the amount that ap- pears in the customers' accounts, since no sale has taken place. Moreover, the facts set forth in the bal- ance sheet would be misleading. As long as the goods remain unsold, they should appear as part of the inventory, and should not be carried in the balance sheet under accounts receivable. It is also evident that if the goods consigned consist of clothing or furs, which are subject to radical changes in style, a further adjustment may be neces- sary, owing to the fact that changes in style are likely to affect the price which may subsequently be realized on merchandise as yet unsold. Very often a manu- facturer is compelled to make expensive alterations in garments returned to him from the consignees in order to make them fashionable. The consignor should remember that goods sometimes become shop- worn while in the hands of consignees, and that their value is affected accordingly. Evidently, the record of the goods still unsold, in the hands of consignees, should be included in the inventory of finished goods. The valuation will depend upon ( 1 ) the present mar- ket price; (2) whether or not the goods are subject to changes in style or fashion; (3) whether or not they have deteriorated while in the hands of the con- signees. 17. Freight and storage; consignments occasional CONSIGNMENTS AND JOINT VENTURES 113 and frequent. If freight has been paid on the con- signed merchandise, or storage charges have accrued, the question will always arise, whether or not prepay- ments of this character, with respect to goods as yet unsold, should be treated, at the close of a period, as deferred charges to future operations, or written away directly to profit-and-loss. While the amounts of these items are usually not large, and while it may not make much difference whether or not they are in- cluded in the balance sheet, it is necessary, neverthe- less, to dispose of items of this character. It would seem that the final disposition of the items would de- pend upon whether or not there were any reasonable prospect of the consignee's disposing of the goods at a price that would enable the consignor to realize the amount of their cost and the accrued charges. The accounting procedure will depend also upon whether or not consignments are occasional or fre- quent; it is clear that the records of a business in which only occasional shipments are made, will differ greatly from those of a business that disposes of most of its products thru the agency of factors. Another question that will have to be considered is, whether con- signments should be entered in the financial records at the time they are received, or not until the goods are sold; that is, whether or not memorandum entries should be made in the general books of either party to record the values of goods shipped or received. It is the opinion of the author that, except in the case of occasional consignments, no entries should be ACCOUNTING PRACTICE made in the general financial records of the value of consignments shipped or received, because when this practice is followed the sale of the goods at a later date will necessitate making numerous adjustment entries a rather crude and time-consuming pro- cedure. 18. Minimum prices on goods shipped. The fact that goods are shipped on consignment does not al- ways mean that a commission is to be paid. Oc- casionally a business house will consign to one of its customers goods that are billed out at a fixed minimum selling price. The consignee, under these circum- stances, has the privilege of selling the goods at any price that he can obtain. If the price that he secures is higher than that which the consignor set, the con- signee may keep the difference. This differs from an ordinary sale only in that the consignee does not have title to the goods and that he does not have to pay for them until he has sold them. The more usual case, however, is that in which the goods are consigned, either at a fixed price or at an open price, and the factor who sells the goods receives a commission at an agreed percentage on the amount realized. It is evi- dent that in these cases the factor is doing a strictly commission business, and consequently his profit is derived from commission and not from trading. 19. Accounts to be kept on the books of the con- signee. As soon as the factor receives a lot of goods on consignment, he will make an entry in an appro- priate memorandum book, fully describing the lot, CONSIGNMENTS AND JOINT VENTURES 115 and he will enter the numbers, or marks, by which it is customary to identify consignment shipments. Any expenses which the consignee has incurred in handling goods such as freight, cartage, insurance and duties is chargeable to the consignor, and when the consignee pays these charges he will open an ac- count with the consignor charging these items to his account. If the consignments are at all numerous, the factor will probably provide for a consignment ledger to be controlled by a controlling account, "consign- ments," in the general ledger. If he has made any advances to his shippers, the factor will, of course, charge the account of the shipper with the amounts and credit his cash account, making a notation also on the memorandum record, so as to offset these amounts against the amount of the sales at the time he renders his account sales to the shipper. 20. Del credere agency and its effect upon the bal- ance sheets of both parties. It is evident that when the factor is operating under a del credere agency he may regard the charges made to his customers at the time of sale as valid assets. If so, he should treat the balance in the consignment sales account as a liability, because he has guaranteed to his shipper thai the amount will be paid at the due date, and has received an additional compensation because of that guaran- tee. The charge for guaranteeing the account, will be made against the account of the shipper, and will be credited to a guaranty account on the books of the factor. When the proceeds of the sales are guaran- 116 ACCOUNTING PRACTICE teed, the shipper will credit the account of the factor with the amount due to him for guaranty, charging an appropriate expense account therefor. 21. Consignment accounts of live stock and pro- duce commission merchants. It is evident that an elaborate system of this kind will not be required by commission merchants who deal in live stock or in farm produce, because of the fact that the goods are usually sold immediately upon receipt and an appropriate ab- stract sales journal can be devised which will greatly simplify the work of bookkeeping. At the time each lot is received, it will be given a distinguishing number or mark which the salesman will enter upon all sales tickets. An abstract sum- mary of the daily sales will be made, and at the end of the day these will be itemized by lot numbers and an entry for the total proceeds of the lot will be made in the abstract sales journal. The entries of the day in the abstract sales journal must, of course, agree in the aggregate with the summary of that day's sales. The check for the proceeds is usually mailed to the shipper on the day on which the goods are sold, and the account of the commission merchant with his ship- per is then closed. If this method is followed, it is not necessary to open any general ledger account for the consignees in the books of the factor. In some instances, as mentioned above, the factor will make advances against goods which have been shipped to him; in this event the advances will be charged to the account of the consignor. As soon as CONSIGNMENTS AND JOINT VENTURES 117 any expenses in connection with the goods have been paid, or any advances have been made, a proper record of the details will be entered in the memorandum con- signment record. As any consigned goods are sold, the factor will render an account sales to his principal, unless there is a special agreement between them regu- lating the time at which accountings are to be made. The details of all sales are noted in the memorandum consignment record, under the headings of the lots affected, and when the account sales is made up, or a detailed record of the sales is prepared, it will be entered in an abstract sales journal. 22. Abstract sales journal. The abstract sales journal, a form for which is shown on page 118, will provide for the following columns: date of sale; ac- count sales number; lot number; marks; number of packages received; name of shipper; net proceeds; ad- vances ; a special column for each kind of charges paid by the factor for the account of the shipper such as freight, insurance, duty and commission; gross pro- ceeds of the sales; folio; name of the party to whom the factor sold the goods ; the due date ; and a remarks column, in which will usually be entered the date on which the customer of the factor made remittance for the sale this will ordinarily be the date upon which the proceeds are due to be remitted by the factor to his shipper. 23. Posting abstract sales journal. The gross pro- ceeds of the sales will be charged to the account of the customer of the factor from the abstract sales journal; > D a: ET PROCEEC z 5 U. O h 2 " O O 4 . rs ( ' 1 Q 1- ft s CRATES s ^ s CO 888 ooo * r ' ,-T ? O - 1 ^ 2 8 S o ** " '* Is * 8 fl y 5J CJ w W m" * C/5 t_ =s s 2 & a ^ +* .^|2 mm IMH ^ si s! nr pw nr h i tl i^ SSg >9S 3 S O(^i CO O 00 106 o q c g o" d d Oi i- o" T b^ ~* Ct I-l a &f oo O SO 00 00 o o o o o o o o o o o -^ 0^ ,"t c^'t-" *o~ 3J i-l C2'CD I ..II i ~^> J-J > d> OBINSON .2 | > V Sfc.3 tC S In I | 1 II l-g * ^ ' .5 s i il ^^ ~*' *T3 H r^ . et C '- G T3^5 2-T3 - 8 en M ~" n 5 ^ 2 w V5 ^ fc a; 5 O "* 11 |1| ^ ( . W J ^ -5 rt H O yj ' ~ en - -2 = 00 ^ >^V2 H 1-3 OQ 2 Q ^> W H O CJ g 8 ? 6 o ^ l "V to" CD* -* ^ 88 ^ fc o' o 5 o o'cs' 1 1 6- s [g aT "c o S .a.s 1 ;n tn 3. i ^ r ^ U G K 5 S O -w 1 "3 g S 51 3 1 * a _ 's, " 3 C s CS M O S *i W * co j S 'S, >>.t so c - ~ 3 8 .. . s 1 *S o >-5 W O H 167 168 ACCOUNTING PRACTICE JONES & ROBINSON STATEMENT OF AFFAIRS December 15, 192- Second Method ASSETS Nominal Expected Value to Realize Deficiency Cash on hand $ 5,500.00 $ 5,500.00 Sundry debtors: 2,600.00 1,200.00 $ 1,400.00 Good $ 1,000.00 Doubtful 600.00 Bad 1,000.00 Notes receivable 4,250.00 4,250.00 Other securities in the hands of creditors: 28,000.00 Partly secured 3,000.00 Fully secured 25,000.00 Deducted per contra $28,000.00 Surplus from securities in the hands of creditors, fully secured, per con- tra 8,000.00 20,000.00 Property 14,000.00 9,000.00 5,000.00 $27,950.00 Deduct preferential creditors for wages, salaries taxes, etc., per contra 700.00 Net free assets, available for settlements of claims of unsecured creditors being 59.36% of their claims... 27,250.00 Deficiency 18,650.00 Impairment of partners' capi- tal 12,250.00 $66,600.00 $45,900.00 $26,400.60 Nominal Expected LIABILITIES Value to Rank Creditors unsecured $25,000.00 $25,000.00 Creditors, partly secured $23,900.00 23,900.00 Securities at estimated value per contra 3,000.00 20,900.00 INSOLVENCY ACCOUNTS 169 LIABILITIES Nominal Expected Value io Rank Creditors fully secured $17,000.00 $17,000.00 Securities at estimated value per contra 25,000.00 Surplus to contra $ 8,000.00 Preferential creditors for wages, salaries, taxes, etc Deducted, per contra 700.00 $66,600.00 $45,900.00 To losses on trading, viz : Sundry Losses Trade ex- $13,500.00 7 400,00 DEFICIENCY ACCOUNT By capital brought into the business at eomrnence- $20,900.00 ment, and Losses and shrinkage in values, as ex- since, viz. ; Jones, capital $10,000.00 Robinson, cap- ital 16 050.00 $26,050.00 statement of affairs, viz. : Property .... $ 5,000.00 Deficiency a s shown by statement o f 18,650.00 f ul 400.00 Debtors, bad . 1,000.00 6,400.00 Drawings from business, viz.: Jones $ 9.000.00 Robinson .... 8,400.00 17,400.00 $44,700.00 $44,700.00 date of December 15. The left-hand side of the state- ment shows in one column the nominal or book value of the assets. The second column shows the amount that we expect these assets to realize. Creditors are not much interested in the book value of the assets, but they are interested to know how much they may expect to realize from these assets. The total of this column after deducting preferential claims is $27,250. On the right-hand side of the statement are shown the 170 ACCOUNTING PRACTICE liabilities. We have there also two columns, one showing the total or book liabilities and the other the amount the liabilities are expected to rank. It will be noticed that the secured creditors are omitted en- tirely, since they are not expected to rank to any amount as they are fully secured. The partially secured creditors are shown in the total liabilities column for the full amount, while in the column "expected to rank" only $20,900 as the securities in their possession as part pledge are esti- mated at $3,000. Preferential claims are entered only in the total liability column because they have been deducted from the total assets. The total of the column "expected to rank" amounts to $45,900. As the assets available for distribution amount to only $27,250, we have a deficiency of $18,650, which is ac- counted for and explained in the deficiency account shown on page 167. This account begins on the debit side with the capital brought into the business at commencement, amounting to $26,050. On the credit side are entered the losses on trading, as well as the trading expenses, making the total $20,900. The second part on the same side deals with the losses and shrinkages in values which amount to $6,400. Finally are entered the withdrawals amounting to $17,400, thus showing a total on the credit side amounting to $44,700. Against this is the capital only, amounting to $26,050, hence there is a deficiency amounting to $18,650, which is the exact sum shown on the statement of affairs. INSOLVENCY ACCOUNTS 171 12. Realization and liquidation account. The statement of affairs sets forth what the receiver may expect to accomplish on the basis of forced liquida- tion. If, after the receiver's report has been sub- mitted, the creditors decide to wind up the affairs of the insolvent business, the receiver realizes on the assets and pays out the claims against the insolvent estate in the order of their rank. He disposes of the assets, debiting his cash account for the amount re- ceived on realization and crediting the individual asset accounts. As claims are paid off, the appropriate lia- bility accounts are debited and cash account is cred- ited. After all the assets have been sold and the proceeds applied in the liquidation of the liabilities, the accounts remaining open on the ledger will be the balances in the asset accounts, representing the excess or deficit of book value on realization, and the unliquidated liabilities and the capital accounts of the proprietor or partners, or the capital stock and sur- plus accounts of a corporation. The losses on winding up should be charged to the capital account of a sole proprietor or to the capi- tal accounts of partners in a partnership ; in corpora- tions, the losses will be charged against surplus. The stockholders in a corporation will surrender their shares of capital stock, which will be debited to capi- tal account and credited to surplus. If the realiza- tion is conducted at a loss, the amount of unliquidated liabilities will of course equal the debit balance in the capital account of a sole trader or the debit balances 172 ACCOUNTING PRACTICE in the accounts of partners ; in a corporation, the debit balance in the surplus account will be equal to the amount of the unliquidated liabilities. Should the receiver be fortunate enough to con- duct the realization so as to obtain a surplus over the book value of the assets at the time of sale, such excess will be credited to the surplus or individual capital accounts. Very often the receiver will open up a "winding-up" account thru which the closing opera- tions will be entered. 13. Form of realization and liquidation account. The form of realization and liquidation account used by teachers of accounting and employed in C. P. A. examinations is not a practical statement. It is made up in either account or statement form. If the ac- count form is used, the realization and liquidation ac- count is debited with the assets to be realized and credited with the liabilities to be liquidated. Cash on hand is not included in the assets to be realized because cash is already realized. The statement is then credited with the assets realized and debited with the liabilities liquidated. Any expenses of the re- ceiver in connection with realization and liquidation are debited to the account under the caption "supple- mentary debits"; any income collected by the receiver after he takes charge is credited to the account under the caption "supplementary credits." At the date of the accounting, the assets not realized are credited to the account and the liabilities not liquidated are deb- ited to the account. The difference between the debit INSOLVENCY ACCOUNTS 173 and credit sides of the account will then represent the profit or loss to date on realization and liquidation. This account will not, however, show the details of the profit or loss on realization and it is customary to supply a realization profit-and-loss account show- ing the details ; this statement may of course be recon- ciled with the profit or loss shown in the realization and liquidation account. The cash transactions of the receiver are shown in a separate cash account because he is usually paid on the basis of the cash received and paid out. The re- ceiver's cash account will start with the balance on hand at the time he took charge ; it will be debited with the proceeds of the assets realized arid with any in- come received by him during realization; it will be credited with the liabilities liquidated and with any expenses paid during realization. The balance of the two sides of the account may be reconciled with the cash in the hands of the receiver. If the liquidation has not been completed at the date of the accounting, it is customary to prepare a receiver's balance sheet which will show the cash and other assets on hand at the date of the accounting; the liabilities unliquidated will be stated and the difference between the two sides will represent the profit or loss on realization and liquidation to the date of the accounting, assuming that the remaining assets will be liquidated at the values shown in the books of the undertaking. For the purpose of illustrating the preparation of the realization and liquidation account, attention 174 ACCOUNTING PRACTICE is called to the following problem and solution: PROBLEM J The affairs of Peter Post, a manufacturer, were in a criti- cal condition, for altho he had an unimpaired investment of $62,50.0, and his books showed a clear increase of $6,022, he owed his trade creditors $25,289 and had only $265 in cash and $4,062 in receivable book accounts on which to rely for funds. The rest of his business estate was tied up in the following chattels which he had acquired in an effort to keep pace with the business growth that had outrun his capital : machinery and tools, $31,497; raw materials, $18,838; partly made goods, $31,562, and finished wares, $7,587. It was also necessary in order to continue operations to have immediate cash for payrolls and incidental expenses. A meeting of his principal creditors was called and as it appeared that the business was well established, profitable and had a sure and growing market, they decided to advance him $6,000 in cash for immediate needs and extend his credit in sufficient amount to permit of the purchase of necessary ma- terials and generally to continue operations till the present stock of materials could be made up and realized on. In order to insure the proper application of the funds and credit so provided, a trustee was appointed to administer the finances till the creditors' claims were satisfied, at which time the control would revert'to the proprietor. The subsequent operations under the trusteeship were as follows: cash paid for labor $15,725; for expenses $5,430; for additional tools $750; purchases on book account, charged to materials $6,300; to expenses $15,000; sales on book account $72,300 ; loss on collection of book debts $380 ; personal drawing of Peter Post $3,500. The unliquidated values at the close of the trusteeship were as follows : inventory of raw materials $5,000 ; finished wares $27,900; accounts receivable outstanding $3,382; accounts payable $89. Prepare with due regard to the grouping, order, and ar- i New York C. P. A. Examination. INSOLVENCY ACCOUNTS 175 rangement of the items, as best calculated clearly to display the facts, (a) realization and liquidation account, (b) trustee's cash account, (c) balance sheet of business as re- stored to Peter Post. BALANCE SHEET OF PETER POST (WHEN TURNED OVER TO TRUSTEES) Assets Cash $ 265 Accts. receivable 4,062 Mchy. & tools 31,497 Raw materials 18,838 Goods in process 31,562 Finished goods 7,587 .$93,811 Liabilities Creditors $25,289 Proprietorship Capital $62,500 Surplus 6,022 68,522 $93,811 REALIZATION AND LIQUIDATION ACCOUNT OF PETER POST Assets to be realized Accts. receiv. Mchy. & tools . . . Raw material Goods in process . Finished goods . . . $ 4,062 3^,497 18,838 31,562 7,587 $93,546 Liabilities liquidated Creditors 31,200 Liabilities not liquidated Creditors 89 Supplementary charges Inventory $13,838 31,562 Purchases 6,300 Labor 15,725 Expenses 5,430 Tools 750 Expenses 15,000 88,605 Profit on operation 3,628 Liabilities to be liquidated Creditors $25,289 Creditors (loan).. 6,000 $31,289 Assets realized Accts. receiv $ 680 Raw material 13,838 Goods in process . . 31,562 Assets not realized Accts. receiv. Raw material . Finished goods Mchy. & tools . $ 3,382 5,000 7,587 31,497 46,080 47,466 Supplementary credits Finished goods . . $20,313 Sales $72,300 Less loss 380 71,920 92,233 $217,068 $217,068 176 ACCOUNTING PRACTICE TRUSTEE'S CASH ACCOUNT Balance $ 265 Loan from creditors 6,000 Sales 71,920 Accts. receivable 680 Labor $15,725 Expenses 5,430 Tools 750 Materials 6,300 Drawings 3,500 Expenses 15,000 Accts. payable 25,200 Creditors' loan 6,000 Balance 960 $78,865 $78,865 Balance $ 960 BALANCE SHEET OF PETER POST (AFTER REALIZATION AND LIQUIDATION) N Assets Cash $ 960 Accts. receivable 3,382 Raw material 5,000 Finished goods 27,900 Mchy. & tools 31,497 Liabilities Creditors Proprietorship Capital at begin- ning $62,500 Surplus at begin- ning 6,022 $ 89 Less drawings Add profit 68,522 3,500 65,022 3,628 68,650 $68,739 $68,739 REVIEW How would you differentiate between voluntary and involun- tary insolvency? How would you define the term, "statement of affairs"? What information will a statement of affairs disclose that would not be disclosed by an ordinary balance sheet? What is the relation between the deficiency account and the statement of affairs? Can you trace the analogy between the balance sheet and statement of affairs and between the profit-and- loss account and the deficiency account? How should reserves for depreciation be treated in the prepara- tion of a statement of affairs ? CHAPTER XI CORPORATIONS 1. The varied aspect of corporations. In different volumes of the Modern Business Text, corporations are treated from different standpoints. In "Busi- ness Organization," the legal phases of corporations are considered. In "Corporation Finance" the topic is the procedure followed in securing the capital for the enterprise. Here it is the purpose to deal par- ticularly with the accounting of corporations, tho it is in practice sometimes difficult to draw distinct lines of demarcation between law, finance and accounting in the discussion of corporate problems. 2. Difference between accounting practice of cor- porations and that of partnerships. There is no dif- ference in the general scheme of accounts in a cor- poration from that employed in a partnership, except as to the opening and closing entries, the booking of the proprietorship and the distribution of profits. A corporation is required to keep certain incidental books which differ from the records of partnerships. 3. Books incidental to a corporation. Most if not all of the following auxiliary books are necessary if proper records are to be kept of transactions of a corporation : 177 178 ACCOUNTING PRACTICE (a) Minute book, (b) Subscription book, (c) Instalment book, (d) Instalment-scrip book, (e) Stock-certificate book, (f) Stock ledger, (g) Stock- transfer book, (h) Dividend book. 4. Minute book. The minute book contains a rec- ord of all the meetings of the stockholders, and* gen- erally of all the meetings of the board of directors, altho in some cases it is advisable to have a separate minute book for the meetings of the directors. In certain corporations where some of the duties of the directors are delegated to an executive committee, there will be a separate minute book for the meetings of the executive committee. 5. Subscription book. The subscription book is used for the purpose of recording the subscriptions of stockholders. It should contain the date of each sub- scription, the name and the address of the subscriber and the number of shares which he agrees to take. This book records the contract existing with the sub- scribers, whereby each binds himself to take the amount of stock for which he has subscribed. If the corporation is small, or if it is a close corporation, the account of subscriptions is commonly kept in the gen- eral ledger. UJ \ Ul > z 1 < < . a{ c u. E O o o 03 3 S Z I O C P h- cr S z u u S 1 5 3* II li LEDGER ADDRESS.-. DATE OF OF SHARES O cc O 5 z * EH g CO CO D t- < u! C feS u LEDGER o jES u z < 2 O < c \ ij u " " UJ Ul pe z >. es ^s^'.a CL, 5- c 18 .c O J O *^ CO U u. II (i, o = w 5 OC '^ *^ co O ^5 K X Ul 5 OT ^3 ?! g -Is" H fa S x5 o> 3 ul S to 5 O UJ co 1 1 ,. I^M %J LL "^ H>T *- flJ CO . a- I- CO UJ . O ** o M 5 S-o j K !i! : o rf z Is Ul S |-sl Q E UJ *c _1_> cc I 0= II* > UJ > u. Jjl 1 o: 2. t^j S M '*> ls^ C I- co to Q S OQ ^, CM Ul UJ ^ O i> 5 uj i 05 _C 03 M+3 4U O Q UJ W ro Si i- gggg z g K!2 S o "v l ~i ^i. ^1. s ^ S5 ?5 J.N3W -1VJ.SNI ^ (M lilt g 8 rS I o- O a C H 0) IS O t CM "O a 3 rt CO 1 O C g c-5 H u! UJ ^aa Q 3 II14 1- gggg O S O Ift to 10 K K ^ e eo < T-< 8 p ofe| S5 *f 10 10 ! i r* a 1 a , ^ cc ^ fl n -O O 3 I O hogs * t/j &4 ( K 9 -( " UI H S"" O Sssa ggggg \- S z 25 ,o s S CO ^ S ul ? p z ,-1 S t- t- cc Ul O UJ cr 5 O S 5 o = ~ 2 1 1 X 55 all O h5fq EH CO Ul B < ggggg X CO Ul R-rijaa g 5; Q .d j= a a O ~ g S S H II Z - > O O S g . s.s E UJ o UJ CO o Q_ CO Q 11 Sfl 4) X ! a 3 " CO CO UJ ce g g X S M CO UJ 83 1- S .Q "Sa 180 CORPORATIONS 181 6. Instalment book. The instalment book is made up from the records of the subscription book and con- tains the name of each subscriber and the amount of each instalment paid. A separate record should be kept for each instalment. It is hardly necessary to state that the use of the instalment book and of the instalment-scrip book is limited to cases where the stock is to be paid for by instalment. 7. Instalment-scrip book. The instalment-scrip book is the receipt book for instalments paid by stock- holders. It contains blank receipts to be filled out and signed by the secretary and the treasurer as the instalments are paid; the receipts are given to the subscriber by the secretary. In some cases the by- laws of a corporation provide that the president and the secretary, instead of the treasurer and the secre- tary, shall sign these receipts. Upon the payment of the last instalment, the scrip should be taken up and a certificate of stock should be issued in its place. 8. Stock- certificate book. The "stock-certificate" book, or simply the "certificate" book, contains blank certificates to be filled out and signed, in accordance with the provisions of the by-laws of the corporation, either by the secretary, the president and treasurer, or by the secretary and the treasurer. For con- venience, these certificates are numbered consecu- tively. A transfer form is usually printed on the back of the certificate, in order to facilitate the trans- fer or sale of the stock. 9. Stock ledger. The stock ledger contains an ac- 182 ACCOUNTING PRACTICE count entitled "capital stock," which is debited with the par value of all the stock issued. It also contains an account for each stockholder, which is credited with the par value of the stock issued to him. When stock is transferred, for any reason, from one owner to another, the transferer is debited, and the trans- feree is credited, with the par value of the stock trans- ferred. Thus this ledger is always self-balancing, and the account for capital stock is exactly the reverse of the capital-stock account in the general ledger, which is credited with the par value of the stock issued, to record the liability of the corporation thereon. Furthermore, this ledger shows the detail of the capi- tal-stock account in the general ledger. In those cases in which it is customary to place upon the gen- eral books of the corporation the total amount of the authorized issue of stock, as a ledger account, off- setting it by the total amount unissued, the differ- ence at any time between the capital-stock-authorized account and the balance remaining in the capital- stock-unissued account will be the amount of the capital-stock issued. This latter amount, of course, should equal the amount shown in the capital-stock account in the stock ledger, and should agree with the data that is given on detailed list of stockholders, as shown by the stock ledger. The laws of the State of New York call for the keeping of a stock book or a stock ledger which shall contain the following information: (1) the names of stockholders, arranged alphabetically; (2) the resi- CORPORATIONS 183 dence of each stockholder; (3) the number of shares held by each ; ( 4 ) the time when stock was acquired ; (5) the amount paid thereon; (6) a record of all transfers, showing from whom the stock was received and to whom it was transferred. 10. Stock-transfer book. The stock-transfer book is used for the purpose of recording the transfers of stock, and contains the original entries which are posted to the stock ledger. In some cases the stock ledger and the stock- transfer book are combined. But both books, separate or combined, are required by the laws of a number of states. In New York state there is a tax on the transfer of capital stock, and the law requires a special form of book to be kept by transfer agents and brokers. There is no transfer tax on the original issue of capital stock, but all transfers of a beneficial interest are taxable. 11. Dividend book. The dividend book, or more properly, the dividend-receipt book, is used for the purpose of recording each dividend declared and paid. It contains a record of each dividend, of the number of shares held by each stockholder, and of the amount of the dividend paid thereon, with the signature of the stockholder as a receipt for the dividend paid to him. 12. Illustration of stock-transfer book. The form given on page 179 is an illustration of a stock-transfer book. The left side of the page records the transfer of the stock, and the right side attests its validity. The number of shares surrendered and the number XXI 14 184. ACCOUNTING PRACTICE of shares each certificate represents, are entered; the name of the person from whom they have been trans- ferred and, for convenience, the folio of his account in the stock ledger, are also shown. The number of the new certificate, the number of shares it represents, the name of the person to whom it is transferred, i.e., the transferee; the address of the transferee; and for convenience, the folio of his account in the stock ledger, are given, and to close the page, the signa- ture of the stockholder's attorney, authorized to make the transfer, who is the secretary of the corporation. 13. Illustration of stock ledger. The form given on page 179 illustrates a stock ledger. It shows the name and address of a stockholder, the date when any transfer or surrender of stock was made, the number of the transfer and the person to whom the transfer was made. It also shows the number of the certifi- cate surrendered and the number of shares it rep- resents'. On the right-hand side of the account are the date of acquisition of stock and the information whether it is an original issue or a transfer from a prior holder. If the latter, the name of that prior holder is recorded. Columns are provided for the number of the new certificate issued and the number of shares it represents. The balance of shares held at any time is shown in the last column. As stated on page 181, the stock is often sold with the under- standing that it is to be paid for in instalments; the instalment book and the instalment-scrip book are used in such a case. It is sometimes advisable to use CORPORATIONS 185 an instalment ledger also, in order to keep track of the various payments. On page 180 an illustration of an instalment ledger is given. In this example, it will be noted that the original subscription was made on January 15th. On that date James Smith sub- scribed to 100 shares at $100 each, a total of $10,000 on which he paid nothing. On February 1st, he paid the first instalment of 25 per cent; his account in the instalment ledger was credited for that payment, and instalment scrip for that amount was issued to him. On March 1st, F. Brown transferred to Smith his subscription to 50 shares of stock, on which the first instalment had already been paid. Smith's account is therefore charged for that transfer, and shows the unpaid amount of $3,750. On March 15th, Smith transferred 25 shares to A. Peters. In order to com- plete that transfer, Smith surrendered the instalment scrip for 50 shares issued to him on Brown's transfer, and was given two new scrips, each for 25 shares, in order that he might be able to give to Peters the scrip that he than transferred. On April 15th, Smith paid the second instalment on his subscriptions, and this was credited to his account. If the shares debited on the left side of the account are added, and the shares credited on the right side subtracted from them, the number of shares on which there remains an unpaid balance will be found. Smith's subscriptions at present are 125 shares, on which two instalments have already been paid. A comparison of the total debits with the total credits 186 ACCOUNTING PRACTICE in the monetary columns shows a debit balance of $6,250, which Smith still owes. That balance repre- sents the two instalments that he owes on the 125 shares which he at present owns. 14. More than one form of stock ledger possible. The reader has already been given on page 179 an illustration of a stock ledger. This is not by any means the only form of stock ledger commonly used. Special forms are adopted for use in particular cases. Sometimes a combination of the stock-transfer book and the stock ledger is used, and sometimes a com- bination of the instalment ledger and the stock- holders' ledger. On page 180 there is an illustration of a common form of stockholders' ledger. The credit or right side of each account shows the total amount of stock issued to the stockholders that they have received. This credit may represent original issues or subsequent acquisitions of stock. The debit side shows any surrender to the corporation or trans- fer to others of the stock which he owns. The differ- ence between the total of the credit-column "shares" and the total of the debit-column "shares," represents the number of shares owned by the stockholder; and the difference between the corresponding money col- umns is the par value of those shares. If the latter figures cannot be obtained by multiplying the par of the stock by the number of shares shown by the former figure, there has been an error in the keeping of the books. Sometimes stock without any par value is issued, CORPORATIONS 187 but no new complications are involved in such a case. It is evident, of course, that the records should show the value of the property received in exchange for the specified number of shares. In all cases the rec- ord should show just what the stock was issued for. In a close corporation, stockholders' accounts are sometimes carried on the general ledger, but this is rather unusual. 15. Opening entries for corporate books; first illus- tration. There are a number of different ways in which corporate books may be opened. For the pur- pose of illustration, let it be assumed that The Pros- perous Company was incorporated on January 1, 1920, with an authorized capital of $1,000,000, of which $500,000 was preferred stock and $500,000 was common stock, par value $100 a share. The incor- porators subscribed and paid for $50,000 of the com- mon stock, and $100,000 of preferred stock was sold to the public. The first method starts with a statement of the incorporation and the capitalization of the company; in addition, it provides a record of the contractual agreement entered into between the subscribers and the corporation, whereby the former agreed to take a certain amount of the stock. THE PROSPEROUS COMPANY Incorporated under the laws of the State of New York with an AUTHORIZED CAPITAL of $1,000,000 188 ACCOUNTING PRACTICE Divided into 5,000 shares of preferred stock and 5,000 shares of common stock Par value $100 each Subscribers $50,000 To Subscription $50,000 for the subscriptions of the incor- porators who have agreed to take 500 shares of the common stock. Cash 50,000 To Subscribers 50,000 payment of the subscriptions by the incorporators. Subscriptions 50,000 To Common capital stock 50,000 for 500 shares of common stock is- sued to incorporators. Cash 100,000 To Preferred capital stock 100,000 for the sale of 1,000 shares of pre- ferred stock to sundry purchasers. 16. Opening entries for corporate books; second illustration. According to the second method of opening corporate books, the total authorized issue of stock is placed on the books in the form of a ledger account; it will be noted that this method differs from the method illustrated above in this particular re- spect. The full authorized stock is offset by an ac- count with the unissued stock. Under this method, the amount of stock issued and outstanding at any time will be the difference between the amount stand- ing at the credit of the authorized-stock account, minus the amount standing at the debit of the unis- sued account. The unissued stock, while it is a debit on the ledger, is not an asset; in the preparation of CORPORATIONS 189 the balance sheet of the organization, the amount of stock unissued should be deducted from the authorized amount on the liability side of the balance sheet. Common capital stock unissued $500,000 Preferred capital stock unissued 500,000 To Common capital stock, authorized $500,000 Preferred capital stock, authorized. 500,000 To record the incorporation of the Pros- perous Company organized under the laws of the State of New York, with an authorized issue of 5,000 shares of com- mon and 5,000 shares of preferred stock, par value $100 each. Subscribers to common capital stock. . . . $50,000 To subscriptions to common capital stock 50,000 To record the subscriptions of the incorporators for 500 shares of common stock. Cash 50,000 To Subscribers to common capital stock 50,000 For the payment by the latter of their subscriptions to the common stock. Subscriptions to common capital stock. . 50,000 To Common capital stock unissued . 50,000 For the issue of 500 shares of common stock to the above- mentioned subscribers. Cash 100,000 To Preferred capital stock unis- sued . 100,000 To record the sale of 1,000 shares of the preferred stock for cash. 190 ACCOUNTING PRACTICE 17. Third illustration. Instead of either of the above two methods, the following method of opening entry might have been used: Unsubscribed common stock $450,000 Subscribed common stock 50,000 To Common capital stock author- ized $500,000 Unsubscribed preferred stock 500,000 To Preferred capital stock au- thorized 500,000 Cash 100,000 To Unsubscribed preferred stock., 100,000 To record the sale of 1,000 shares of preferred stock for sale. REVIEW The same subject is continued in the following chapter. Re- view questions covering both chapters will be found on page 207. CHAPTER XII CORPORATIONS (Concluded) 1. Other illustrations of opening entries. The fol- lowing problems illustrate a number of phases of corporate opening entries, as well as the procedure to be followed in converting a partnership to the cor- porate form of organization. PROBLEM John Smith, Alfred Brown, Peter Marks and Adam Freund decide to incorporate under the laws of the State of Illinois as The Brown Manufacturing Company. They agree that the capital stock of the company is to be $25,000, divided into 1,000 shares at the par value of $25 each. The subscription to such stock is as follows: J. Smith, 200 shares; Alfred Brown, 300; Peter Marks, 250, and Adam Freund, 250. They duly sign a subscription agreement and, after the articles of incorporation are approved by the sec- retary of state, each pays one-half of his subscrip- tion in cash and gives a note payable in sixty days for the balance. 1 The organization expenses in con- i The payment of stock subscriptions by notes is a frequent practise tho not to be commended. See Corporation Finance, p. 51. 191 192 ACCOUNTING PRACTICE nection with the formation of the corporation amount to $350. Required: (a) the entries in the various corpora- tion books; (b) the initial balance sheet. SOLUTION The initial entry should be a memorandum to show the organization of the corporation, in form such as this: THE BROWN MANUFACTURING COMPANY Incorporated under the Laws of the State of New York, with an Authorized Capital of $25,000 divided into One Thousand Shares of $25 each. This entry would, of course, be made in the journal of the corporation. The subscriptions to the stock should appear in the subscription book. The following entry is then made : Subscription Account $25,000 To Capital stock $25,000 Representing the subscriptions to the Capital stock of the company, viz: J. Smith 200 shares A. Brown 300 " P. Marks 250 " A. Freund 250 " As one-half of the subscription is paid in cash an entry should be made in the cash book, on the debit side, shown on page 193. CORPORATIONS 193 Attention is called to the fact that, while in this form of cash book only one monetary column is shown, recording only this particular transaction, the usual form of cash book contains more than one monetary column. Dr. CASH BOOK.. . 191.. (Date) (Date) (Date) (Date) To subscription account J, Smith 50% on stock subscribed To subscription account A. Brown 50% on stock subscribed To subscription account P. Marks 50% on stock subscribed To subscription account A. Freund 50% on stock subscribed | $2.500.00 | 3,750.00 | 3,125.00 | 3,125.00 As the subscribers pay the other 50 per cent of their subscriptions by notes the following entry in the journal is made: Notes receivable $12,500 To Subscription account $12,500 Representing four 60-day notes, given by Smith, Brown, Marks and Freund respec- tively, in payment for 50 /o of their subscriptions. The organization expenses in connection with the formation of the company, amounting to $350, are shown on the credit side of the cash book, as follows : CASH BOOK Cr. Date Organization expenses Expenses incurred in connection with the organization of the company. .$350.00 In the entries in the books of the company, those pertaining to the issue of the stock are omitted, be- cause in a former chapter the method of entering the issue of stock in the stock ledger has been given. 194 ACCOUNTING PRACTICE The initial balance sheet of the corporation is as follows : Balance Sheet of the Brown Manufacturing Company as on .192- Assets: Capital Stock. Cash $12,150.00 Capital stock.$25,000.00 Notes re- ceivable 12,500.00 $24,650.00 Organization expenses 350.00 $25,000.00 $25,000.00 This balance sheet shows the cash on hand to be $12,150. It will be recalled that $12,500 in cash was received from the subscribers, from which organiza- tion expenses of $350 were paid, leaving the bal- ance as shown above. The notes receivable are the notes given by the subscribers in payment for the second half of their subscriptions. These two items represent the available assets of the company, and accordingly they are grouped together. The item for organization expenses is treated for the present as an asset for the reason that it will be met out of the profits that the company expects to earn during the year. As it is not an asset that can be converted into cash at present, it is entered separately from the other assets. The credit side of the balance sheet does not contain any liabilities because none have been in- curred. 2. Procedure when a partnership is converted into CORPORATIONS 195 a corporation. The following problem will illustrate the conversion of an existing partnership into a cor- poration : PROBLEM A, B and C constitute a firm engaged in a manu- facturing business which they have decided to incor- porate with a capital stock of $100,000, equally di- vided into common and preferred stock, the par value of each share to be $100. The agreement among the partners is that each partner is to take 75 per cent preferred and 25 per cent common stock to the amount of his net invest- ment in the business. The remaining shares author- ized are to be offered for sale. The partnership books show the following balances in the ledger accounts: Real estate $25,000.00 Accounts payable 5,000.00 Accounts receivable 9,000.00 Cash 5,000.00 Machinery and tools 10,000.00 Merchandise 15,000.00 Notes receivable 3,000.00 Notes payable 10,000.00 Materials and supplies 8,000.00 The capital of the partners consists of $60,000 divided as follows: A, five-twelfths; B, four- twelfths; C, three-twelfths. Required: (a) closing entries for the partnership books; (b) opening entries for the corporation books. 8 8 5 o" i ee- (0 88 000 8 8 o o o oS" S*o"S" en ee- JC J^0> I-H W en H O j H JQ S O 2 PH =8 - 1 o ^^^ Pi ccc pa V 333 " O O O G C 9 n t) 1 * O O K t** 61 * :c cd 05 fa W w 3 ii S 'cL'EL'cl, C5 OS co 000 SB o o * /J3 JM EH ?;< o.. K ffi O *O o o o So o o O 1 1 II II Pi rH ^ 88 2^ 9* Ho o en o o en gf oT If : .-2 Cash Notes receivable . Accounts receivabl Merchandise inver Materials and sup Real estate Machinery and to< 8!! 196 CORPORATIONS 197 SOLUTION Before we can proceed to make any entries we must arrange the facts given in the problem in some systematic order. As there are no nominal accounts, we can prepare the balance sheet shown on the pre- ceding page. As far as the partners are concerned there is no material change, since they will share in the dividends of the firm on the same basis that they have shared in the profits of the partnership, each partner re- ceiving stock to the amount of his capital in the part- nership. In law, however, the ABC Manufactur- ing Co. is entirely different from the former firm of A, B & C, altho owned and controlled by the same persons. It is assumed that the old firm, A, B & C, sells to the ABC Manufacturing Co. all its assets, and that the company assumes to pay all the liabili- ties of the old firm. The consideration to be paid by the company for this purchase would be the value of the assets less the liabilities, or the amount of the proprietorship in the partnership. This will be done by the issue of stock. The first entry, then, in the books of the firm A, B & C will be in the journal as follows : The ABC Manufacturing Co. $75,000.00 To Cash $5,000.00 Notes receivable 3,000.00 Accounts receivable 9,000.00 Merchandise 15,000.00 Materials and supplies . . 8,000.00 Machinery and tools 10,000.00 198 ACCOUNTING PRACTICE Real estate $25,000.00 For the sale of all the assets enumerated above. This entry records the sale of the assets which creates a debit or charge against the ABC Manu- facturing Co. and a credit to respective asset accounts. It is obvious that when this entry is posted the various asset accounts will be closed out in the partnership books. The next entry, also made in the journal, will show the assumption of the liabilities of the old firm by the corporation, and will be as follows : Notes payable $10,000.00 Accounts payable 5,000.00 To A B C Manufacturing Co. $15,000.00 For the assumption of the above mentioned liabili- ties, by the vendee, the ABC Manufacturing Co. Thus far the ABC Manufacturing Co. has been charged with the assets acquired, amounting to $75,- 000 and credited with the liabilities assumed, amount- ing to $15,000. By this second entry the liability ac- counts have been closed out in the books of A, B & C. The ABC Manufacturing Co.'s account shows a debit balance of $60,000 due to the partnership. In accordance with the agreement the corporation is to issue to the partnership 75 per cent of this amount in preferred stock and 25 per cent of it in common CORPORATIONS 199 stock. When this has been done, the following entry is made in the partnership journal: Preferred capital stock $45,000.00 Common capital stock 15,000.00 To the ABC Manufacturing Co $60,000.00 This represents the issue of stock, it being the balance of the purchase price of all the assents after the as- sumption of the liabilities. As this stock is to be apportioned to the respective members of the firm in accordance with their invest- ment accounts, the following entry in the partnership journal is made: A's capital account $25,000.00 To Preferred capital stock. . $18,750.00 Common capital stock. . . . 6,250.00 For his share in the net capital of the part- nership. B's capital account 20,000.00 To Preferred capital stock. ., 15,000.00 Common capital stock. ... 5,000.00 For his share in the net capital of the part- nership. C's capital account 15,000.00 To Preferred capital stock. . 11,250.00 Common capital stock .... 3,750.00 For his share in the net capital of the part- nership. XXI 15 200 ACCOUNTING PRACTICE This last entry closes all the accounts that have ap- peared on the books of the partnership, because the firm has sold its assets, its liabilities have been assumed by another concern, and the partners have received stock for their investments. This completes the first part of the problem, namely, the closing of the books of the partnership. 3. How entries are opened in books of a corpora- tion. The second part of this problem deals with the opening entries in the corporation books. The first entry will be a memorandum in the journal, showing the organization of the company, as follows: THE ABC MANUFACTURING CO. Incorporated under the laws of the State of with an Authorized Capital of $100,000.00 Divided into $50,000.00 Common and $50,000.00 Preferred stock of One Hundred Dollars par value each. The next entry should also be in the journal to show the subscription to the capital stock as follows : Subscription to preferred capital stock $45,000.00 Unsubscribed preferred capital stock 5,000.00 Subscribed common capital stock. . . 15,000.00 Unsubscribed common capital stock. 35,000.00 To Authorized preferred capital stock $50,000.00 Authorized common capital stocr. 50,000.00 For the capital stock sub- scribed as follows: CORPORATIONS 201 A 250 shares, common and preferred. B 200 shares, common and preferred. C 150 shares, common and preferred. It will be noticed that in the first problem the en- tire amount of authorized capital stock was subscribed to, while in this problem only part of it is so taken. As it is advisable to show in the capital stock account the full amount of capital stock authorized, an ac- count "unsubscribed capital stock" is debited for the amount that is unsubscribed, in order to justify the placing of the full authorized issue of stock on the books. But in preparing a financial statement it is not advisable to list this unsubscribed stock on the debit side, because it is not in any sense an asset. This account should be deducted from the capital stock which should be stated in the balance sheet thus: Authorized preferred capital stock . $50,000.00 Less unsubscribed 5,000.00 $45,000.00 Authorized common capital stock . . . 50,000.00 Less unsubscribed 35,000.00 15,000.00 The next journal entry should show the acquisition of the various assets as follows: Plant and sundry assets $70,000.00 Cash (also entered in the cash book) 5,000.00 To A, B and C $75,000.00 For the transfer to this com- 202 ACCOUNTING PRACTICE pany by the above mentioned vendors of their right, title and interest in all of their assets, including cash, as scheduled in the bill of sale, dated 191 .. As the company has assumed the liabilities of the firm, the following entry is made in the journal: A, B and C $15,000.00 To Notes payable $10,000.00 Accounts payable 5,000.00 For the assumption of their lia- bilities by this company as part consideration of the purchase of their assets. The next step is to issue the stock to the firm, so the following entry is made in the journal: A, B and C $60,000.00 To Subscription to preferred cap- ital stock $45,000.00 Subscription to common stock 15,000.00 For 450 shares of preferred stock and 150 shares of com- mon stock, issued to them as per their subscription, for which they pay in property instead of cash. It will be noticed that the purchase of the assets has been recorded by merely debiting the account entitled "plant and sundry assets." This is the policy generally followed for the reason that the assets may be acquired at one value and placed on the books of the corporation at a different value. To close out 8 8 4 o; o" o 8 8 55- s S O C: o q o o 8' 0* O O 1 5s- S- " | 1 i 11 13 H g 8 ' ' W3 rQ ^j 1/5 O^5 5 CO g 3 i -g : j 13 0. 3 . 'S || ^ O CB J_ w J. ' M O 3 a* *o 'O 3 "tJ " o *, A -2 .a 'S c .Sec p ,5 s * w 19 9 4J ^i t> CO o 3 j; C 1 1 WO " 3 S gg < ft. ^ ^UJ H &< u 5- 8 o t ? o ^ ?~~j o Q ^, o ^ o f *C g i o o o o q q q O o o pa" o o o' o o o o o 88 Scj, < 2 - 02 G i I ffi ^ 88 H pH O O S o w q. O < ^ H * * CO J b^ w ffi W3 *^ C jr^ rtj Co Q> -r > > ^ 1 W O S 'S .S T3 | g | 1 V ^y ri *rj "t^ ^* u- a* T--S C CO . _ U3 3 ^C (-1 s | 4; .2 pa SiJ 8 fc , S ^ * 3 ^ cO 203 204 ACCOUNTING PRACTICE the account "plant and sundry assets," and to place the various assets on the books of the company are the next operations. These are accomplished by means of the following journal entry: Real estate $25,000.00 Machinery and tools 10,000.00 Merchandise inventory 15,000.00 Materials and supplies 8,000.00 Notes receivable 3,000.00 Accounts receivable 9,000.00 To plant and sundry assets $70,000.00 For the purpose of placing the respective assets on the books of the company. It is advisable in all such cases to test the accuracy of the work accomplished and for this purpose a bal- ance sheet should be prepared. It is preferable to prepare a balance sheet rather than a trial balance because there are no nominal accounts. The balance sheet would be as shown on the preceding page. 4. Liquidation of a corporation. The important features of the liquidation of a partnership have al- ready been considered and it has been pointed out that the creditors were paid off first, any losses being charged against the partners' capital accounts in the ratio in which they agreed to share profits or losses. The balance of the assets, if any, were paid out to the partners on the capital ratio. In the event of the liquidation of a corporation the same procedure is followed with reference to the payment of creditors. The profit-and-loss-sharing ratio and the capital ratio CORPORATIONS 205 in a corporation are always the same, because share- holders share profits or losses pro rata, according to the number of shares which they hold. Therefore, the liquidator is not under the necessity of watching the capital account in the case of a corporation, as he would be in a partnership where the profit-and-loss- sharing ratio was different from the capital ratio. In winding up the affairs of a corporation, the capi- tal stock account will be debited for the shares re- turned to the corporation by the stockholders, and surplus, or winding up account, will be credited; the surplus account, or the winding up account, will be debited with the payments which have been made by the liquidator to the stockholders for liquidation divi- dends. The surplus account, or winding up account, will also be debited with any losses sustained on real- ization, and likewise credited with any profits realized. The balance, if any, will then be distributed to stock- holders in the proportion in which they held shares of stock. 5. Reduction of capital stock resulting in the crea- tion of a surplus. The laws of most states impose re- strictions upon a reduction of the capital stock for the purpose of protecting creditors, the general tenor of the laws being that a corporation may not reduce the amount of its capital stock to an amount less than that of its liabilities. In some cases, a corpora- tion may desire to wipe out a deficit by deducing the amount of its capital stock, and this practice is prob- ably correct under the law, provided, that the capital 206 ACCOUNTING PRACTICE stock is not reduced to such an extent that the debts of the corporation exceed it in amount. To illus- trate: If the assets of a corporation amount to $210,- 000, its debts to $100,000, and the capital stock out- standing to $175,000, there is evidently a deficit of $65,000. It is probably legal for the corporation to reduce its capital stock to $100,000, crediting the amount of $75,000 to the deficit account, thereby convert- ing it to a surplus account with a credit balance of $10,000. It would undoubtedly be improper to re- duce the capital stock to an amount less than $100,000 for the reason that the outstanding liabilities of the company equal that amount. 6. Surplus is available for distribution. There is no doubt but that the amount of $10,000, now stand- ing at the credit of the surplus account, will be avail- able for the distribution to stockholders as a dividend, altho it is not a dividend in the usual sense since it arises from the fund originally contributed for capi- tal. In the case of the Continental Securities Com- pany vs. Northern Securities Company (66 N. J. Equity 274) the court in passing upon a similar dis- tribution said: "The proposed distribution is not a dividend in the sense intended by the statute, but a division of the surplus capital rendered useless for the purposes for which it was originally contributed to capital." It also follows that the corporation would not be able to pay more than the amount standing at the CORPORATIONS 207 credit of surplus account, because such distribution would impair the remaining capital stock. The im- portant point to be noted, therefore, is that a return of an original capital contribution is not a dividend l in the sense in which the latter term has been used, because it does not represent surplus profits arising from the business. Furthermore, it has been held that unpaid cumulative preferred stock dividends are not entitled to any portion of a surplus distribution of this kind, but that the amount must be distributed among the stockholders without preference. REVIEW What books of record would be found in a corporation in addi- tion to those found in a partnership, and what is the purpose of each ? Under what different methods may corporate books be opened? What is the object of keeping an account with the subscribers to capital stock ? If you were called upon to close the books of a partnership the members of which had decided to organize in corporate form, what steps would you take to close the books of the old firm and open those of the new firm ? In the problem accompanying this chapter, what is the use and object of the plant and sundry assets account? What dis- position is ultimately made of this account? i See decision in the case of Roberts vs. Roberts-Wick Company t 184 N. Y. 257. CHAPTER XIII BRANCH ACCOUNTS 1. Reasons for the establishment of branches- - When a business undertaking begins to extend the field of its selling operations beyond its immediate vicinity, it may become advisable to establish branches or agencies. Branches must be distinguished from agencies, for the reason that the former are practically departments of the parent concern, and are more or less self -managing. The latter are not departments of the parent concern ; the relation between the under- taking and the agent is governed by a special contract. The advantages to be gained from the establishment of branches may be summarized as follows : (1) It is much easier to keep in close touch with the trade and the activities of competitors by having in the field an organization whose policies are under the control of the home office, and whose salesmen are directly interested in, and concerned solely with, the product of the concern. (2) If a large stock is carried at the branch office, deliveries can be more quickly made, and adjustments with customers can be more satisfactorily settled. (3) Delivery expenses are reduced, because ship- ments can be made to the branch offices in carload lots instead of paying less than carload rates for ship- 208 BRANCH ACCOUNTS 209 ments made directly from the home office to indi- vidual customers. The carload rate can be obtained on shipments from the main depot to the branch office, and if the shipper bears the delivery expense, the saving in freight alone will be considerable in the course of a year. (4) There is nothing to prevent an agent or jobber from ceasing to handle the product of a business con- cern at the expiration of his contract. * The product sold by an agent or jobber is of course sold to the individual customers of the agent, and the shipper does not have that intimate relation with his ulti- mate consumers that he has if the product is handled thru his own branches. Obviously, moreover, a change of agent or jobber may result in a large tem- porary loss, or even in some permanent loss. 2. Types of branches. The methods to be em- ployed in installing a system of accounts for branches will depend upon the degree of authority and con- trol which is to be vested in the local management, upon the nature of the business, and upon whether the sales are to be made entirely for cash or for both cash and credit. Many concerns do not wish the branch managers to know the amount of the profit that the branch makes ; if this is an important consideration, the system of accounts must be devised accordingly. It is clear that if the sales of a branch are made for cash, an elaborate system of accounts at the branch office will not be necessary. But if, as frequently happens, the 210 ACCOUNTING PRACTICE branch makes purchases of merchandise on its own account, it will probably be desirable to allow the branch to keep its own accounts. 3. Simple type; general characteristics. Some of the widely known chain store businesses furnish good illustrations of the simple type of branch. The branch receives all its merchandise from the main office. The important items of expense, such as rent, salaries and delivery charges, are paid by the home office. The branch makes its sales for cash only. Each branch is supplied with a small amount of petty cash with which to meet expenses not paid by the main office. In a branch of this type, a sys- tem of comprehensive daily or weekly reports to be filled out by the local manager and forwarded daily or weekly to the main office, is all that is necessary. All the sales of the branch will be recorded on a cash register, and not infrequently a daily record of sales is sent to the main office. A separate bank ac- count will be provided for each branch manager, in which he must deposit his daily receipts. The bank agrees to allow only the home office to check this ac- count, and also to mail to the home office a signed duplicate of the daily deposit slip. It will also be understood that the bank shall wire the home office immediately if the local branch manager fails any time to make the daily deposit. 4. Method of taking inventory. All merchandise sent to the branch will be billed at sales prices; the branch manager will not, therefore, be aware of the BRANCH ACCOUNTS 211 cost price of the goods, and it follows that he cannot know the amount of the gross profit made by the branch. The inventory of the branch will be taken at irregular intervals by auditors from the home office, who will report to the home office the quantity and kind of merchandise on hand. The home office will then price and extend the inventory, usually on both the cost and the sales price basis. When the home office carries records of the goods shipped to branches at sales prices, a verification of the inventory is an easy matter. For example, it is clear that if branch A had on hand at the last in- ventory a stock valued at $1,000 (sales price basis), and has received from the main office (during the in- terim) deliveries amounting to $10,000 (sales price basis), and has reported sales amounting to $7,000, the present stock on hand at the branch, estimated at sales prices, should amount to $4,000. If the ac- tual physical inventory exceeds this amount, and no errors have been made, there must have been a gain in the inventory. This may be brought about in sev- eral ways for example, in the cigar business, when cigars of a certain brand sell "three-for-a-quarter," and three individual cigars of this particular brand are sold for ten cents each. In practice, this difficulty is frequently overcome by putting out a brand that is worth ten cents at re- tail to be sold to a customer who desires one cigar for ten cents. It may also happen that the inventory will reveal a loss for example, (1) when sales are made 212 ACCOUNTING PRACTICE and not recorded; (2) where thefts have been com- mitted, either by customers or by employes; (3) when breakage or shrinkage has occurred. Any unusual gain or loss in the inventory should be carefully inves- tigated. 5. Accounts kept by branch offices. Under this system each branch will have upon the home office books a merchandise account, an analytical expense account, and possibly a branch profit-and-loss ac- count. The merchandise account will probably be specially devised to provide for the record of the in- ventory on hand at the beginning of the period, and for deliveries to the branch, upon both a cost and a sales price basis. Form A on page 213 shows how the gross profit on sales is determined when a method sim- ilar to that outlined above is employed. An analytical branch expense account, for expenses paid by the home office, as well as for expenses paid out of the petty cash fund of the branch, is shown in Form B. The branch profit-and-loss account illustrated in Form C shows how the net profit from the operation of the branch is ascertained by this method. 6. Relation between the home office and the branch offices. The shipments to the branch are charged to the branch merchandise account at both the cost and the sales price, and are credited to the main office stock account, or purchase account, at cost price only. In the cash book of the main office a current analysis is kept of the cash receipts, by branches; or if it is not convenient to keep this detailed record in the general 1 rn I 1 01 H 1 1 1 1 1 II S "- ^- x " " B ^ CREDIT! 1 o i CO as i Q LU CC. (J 1 1 Z 1 1 i S S z * t- ^ ^S o" LJ V, 3> CJ C c 1 3 J 3 u s 1 \ UJ . I - 1 > - - i ** Q r i* . 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