UNIVERSITY OF CALIFORNIA AT LOS ANGELES GIFT OF MRS. GEORGE II. U M CES 29 Library Graduate Sch~ol of Business Administration Uni -^rsity of California Los Angeles 24, California NET WORTH AND THE BALANCE SHEET Net Worth and the Balance Sheet By HERBERT G. STOCKWELL, C.P.A. New York The Ronald Press Company 1912 Copyright, 1911 By THE RONALD PRESS CO. Bus. Admin. Library EXPLANATION OF THE BOOK C HREWD business men take pains to learn enough about the accounts on their books ;* to know where they stand at any time and * whether the business is going forward or backward, and why. To such men the knowledge of the vital facts of the business, as shown in their books, provides means by which complete mastery of the business may be obtained. But these shrewd men are few in number compared with the many who do not take ^ the trouble to solve the meaning of the ac- counts in which the history of the business N^ is being recorded. Such men, finding the study of facts ex- | pressed in figures unattractive, too often R leave the matter of bookkeeping entirely to j>J:heir clerks, easily yielding to the difficulty of obtaining the correct interpretation of their accounts. 5 6 Net Worth and the Balance Sheet In many other cases the proprietors, with little or no bookkeeping knowledge, yet dimly seeing the advantages to be gained by greater knowledge, continually struggle in unavailing efforts to comprehend the figures presented to them by their bookkeepers. Whether the failure to grasp the impor- tant facts of a business results from insuffi- cient attempts on the part of the proprietor or follows earnest efforts, ignorance of the true financial conditions has been the cause of many bankruptcies which might have been avoided had impending danger been known in time. If there is one business law of more im- portance than any other, it surely rests in the common-sense principle that a business man should know at all times where his busi- ness stands in relation to his creditors, and to his partners or shareholders. Within reasonable approximation he should know his "net worth." In order fully to comprehend all that is involved in his net worth, he must acquire at least sufficient knowledge of the expres- Explanation of the Book 7 sion of business facts in figures to enable him to read and understand the meaning of his balance sheet, or statement of assets and liabilities. In obtaining this knowledge he will find that, as his stock of accounting information increases, along with each new comprehen- sion will come a growing strength and ability to grasp each business condition as it arises. Besides the additional control over his own business, obtained in the study of his ac- counts, he will gain the power of analyzing the balance sheets of other concerns in whose financial condition he may, for one or more of many reasons, be interested. Few indeed are the concerns engaged in banking, manufacturing, or trading to whom credit for money or merchandise is not granted, or who do not grant credit to others upon signed statements or mercantile reports. Moreover, the investor in the bonds or stocks of corporations would be less depen- dent upon quotations, rumors, or advice of friends if he could himself understand the balance sheets of the corporations whose 8 Net Worth and the Balance Sheet stocks and bonds are offered to him for in- vestment. Thus it appears that all men of indepen- dent means as well as those in business would find advantages in the possession of a moderate amount of bookkeeping knowledge, sufficient, at least, to enable them to under- stand the accounts representing assets and liabilities on a balance sheet, and the net worth produced by the proper assembling of those accounts. The present work is intended to be of as- sistance to all those whose duty or interest compels either the preparation or inspection of balance sheets of merchants or manu- facturers. It endeavors to explain the na- ture of the items involved, to point out what the balance sheet does or should show; and to furnish such information as will enable those seeking further knowledge of the con- dition of any concern than is shown by its balance sheet to frame intelligent inquiries of the management, tending to bring out the information desired. The present volume, as intimated, is con- Explanation of the Book 9 fined almost entirely to the ordinary balance sheet of the merchant and manufacturer. To interpret the business conditions shown by the balance sheets of steam and electric rail- road corporations, electric light and power corporations, water and gas companies, and, last but not by any means least, national, state, and municipal governments, would re- quire much more elaboration than can be brought within the limits of the present work. The wide and interesting field of accounting methods involved when business and finan- cial facts of these balance sheets are ex- pressed in figures, will well repay investiga- tion and may be the subject of a second volume. The definitions appearing in italics have been framed in an effort to simplify some of the terms commonly used by business men, bookkeepers, and accountants. H. G. S. CONTENTS CHAPTER PAGE I. Net Worth 13 II. Balance Sheets 17 III. Cash 23 IV. Notes Receivable 31 V. Notes Receivable (continued) . . 39 VI. Accounts Receivable 48 VII. Accounts Receivable (continued) . 56 VIII. Merchandise 62 IX. Finished Product 72 X. Partly Finished Product .... 78 XL Raw Materials and Supplies ... 83 XII. Real Estate 87 XIII. Machinery Fixtures 9l XIV. Furniture and Fixtures .... 96 XV. Other Assets 98 XVI. Other Assets (continued) . . .107 XVII. Notes Payable 116 XVIII. Accounts Payable 120 XIX. Deposits 124 XX. Bonded Debt 127 XXI. Mortgages 130 11 12 Contents CHAPTER PAGE XXII. Other Liabilities 134 XXIII. Capital and Capital Stock . . . .138 XXIV. Surplus Profits 147 XXV. Reserves 157 XXVI. Reserves (continued) . . . . .163 XXVII. Contingent Liabilities . . . .172 XXVIII. Analysis of Balance Sheet . . .178 XXIX. Comparison of Successive Balance Sheets , 182 Net Worth and the Balance Sheet CHAPTER I NET WORTH jpHE net worth of any business enterprise consists of the excess of the amount of its assets over its liabilities. For example: Total Assets $500,000.00 Total Liabilities 250,000.00 Net Worth $250,000.00 In a statement of assets and liabilities the resulting balance is called net worth on the theory that if all of the assets of the business were sold for cash, and all of the debts were paid out of that cash, the amount remaining would constitute the real capital of the own- ers of the liquidated business. 13 14 Net Worth and the Balance Sheet In other words, while a business man owns numerous assets in various forms, many of those assets may, and generally do, consist of articles of commerce which he has pur- chased, but for which at the time the state- ment is prepared he has not yet paid. There- fore, in order to ascertain how much of the cash and other assets in various forms really belong to him, he prepares a statement show- ing all assets in his possession and all lia- bilities for unpaid obligations. The balance, produced by subtracting the sum total of all of the liabilities from the assets, represents what he may call the amount of his own wealth or worth. Since all assets constitute wealth, or worth, we might, from one point of view, say that a man is worth as much as the total value of all of the lawfully acquired assets in his pos- session, and this without regard to his lia- bility to pay for such portion of those assets as were purchased on credit. But this aspect of wealth or worth does not take into consideration the business man's relation to those from whom he has Net Worth 15 purchased or borrowed wealth, so in business statements we do not rest satisfied with in- formation concerning the gross wealth or worth. We deduct from the amount thereof the total of his debts and thus ascertain his net worth. This process is referred to as producing theoretical results, because as a matter of practice no business is, or can be, liquidated and wound up with a resulting cash balance in hand exactly equalling the amount of the net worth shown in a balance sheet prepared prior thereto. Valuation of Assets With even the greatest amount of care and expert appraisement of assets, it is impos- sible to fix absolutely in advance of an actual sale the cash value of such assets as mer- chandise, machinery, or buildings. Until the exchange of such assets for cash has actually taken place, all calculations of value are but expressions of opinion, more or less accurate, according to the ability of the appraiser and his experience with what has happened in the 16 Net Worth and the Balance Sheet past, on which he bases his judgment as to future happenings. It will thus be seen how important it is that very careful estimates be made of all assets in the balance sheet. Unless the esti- mates are approximately correct, being neither very much too high nor too low, the business man may be deceived as to his real financial position. Moreover, a record of his progress and in- crease in business is clearly indicated by the increase in the amount of the net worth shown on his balance sheet at the end of any given period, as compared with the amount shown on a similar statement prepared at the beginning of that period, due considera- tion being given to cash withdrawn from the business between closing periods in the form of profits. Thus the calculations of values become the more important to the extent that errors in under- or over-estimating his assets at the beginning or ending of a given period may create notions of his prosperity or pov- erty not existing in fact. CHAPTER II BALANCE SHEETS V\7"HILE a balance sheet of a merchant or manufacturer should represent his true financial condition, some of the accounts contained in the ledger from which the bal- ance sheet has been prepared may undergo considerable change and adjustment before the assets represented by the accounts are transformed into cash or its equivalent. A clear example is furnished in the aggre- gate of customers' debit balances, ordinarily styled "Accounts Receivable." Some of these debit balances may have been created by charges for merchandise ordered, shipped, and billed in the regular course of business, and yet the goods may not be accepted at billed value. Claims for errors or for dam- aged or under-graded goods may be set up before the account has been rendered to and accepted by the customer. Furthermore, the customer may fail to settle the account. 17 18 Net Worth and the Balance Sheet For these and other reasons, it is clear that such accounts do not represent assets in the same way as do accounts representing the merchandise itself before it is sold. Un- less sold for actual cash, the merchandise asset is first exchanged for a claim against the purchaser, to be again converted into a cash asset, when he finally pays for the mer- chandise. If we keep fixed in our minds the fact that some ledger accounts represent claims in various stages of liquidation, as well as actual assets, it should be possible to so dis- tinguish these that an understanding of the various items in a balance sheet will present fewer difficulties. Form of Balance Sheet The following is an ordinary form of bal- ance sheet, such as is recommended by the American Bankers' Association to its mem- bers for use in obtaining statements of the financial condition of those applying for loans at their banks. In this statement form the assets and lia- Balance Sheets 19 bilities are shown in two columns the assets in the column to the left and the liabilities in the column to the right the total of the items in the asset column and in the liability column being equal each to the other. This form is used largely by bookkeepers and ac- countants in preparing written balance sheets on regular ledger paper. It frequently hap- pens, however, that when the balance sheet is to be shown on the printed page there is not sufficient room for this form, and what is known as the report form is adopted. In this the assets appear in one group or set of figures, over the second grouping or set of figures which represent the liabilities. This, of course, is a mere matter of form ; the par- ticular way in which a balance sheet is stated being immaterial so long as all of the facts are truthfully represented. Among English accountants it is the prac- tice to reverse the form usually found in this country, the liabilities appearing in the col- umn to the left and the assets in the column to the right. This arrangement is based upon the idea that the management charges 20 Net Worth and the Balance Sheet itself with all of its liabilities and credits itself with its assets, while in this country the balance sheet is thought of as a list of debit and credit balances just as they are found on the ledger, and as the debit balances are shown on the ledger in a column to the left, and the credit balances in a column to the right, the same order is preserved in the preparation of the balance sheet. SCARBOROUGH MANU Balance Sheet, Assets Cash $26,843 .90 Bills Receivable (net) 7,752.84 Accounts Receivable (net). 111,172.08 Merchandise 224,323.82 Land 50,000 . oo Buildings 189,934.93 Machinery Fixtures 134,266.25 Reserve Fund Investments. 22,626.79 Other Investments 17,428.72 Miscellaneous ... $900.00 120.85 1,020.85 Total Assets $785,370. 18 Balance Sheets 21 In order that the balance sheet recom- mended by the American Bankers' Associa- tion may be used by many different classes of concerns, it is necessarily very general and condensed. Only such accounts appear as constitute the main or chief accounts of the average concern, although many other ac- counts with different names may also be found on its books. The filled-in figures are FACTORING COMPANY December 31, 1911 Liabilities Notes Payable $70,000.00 Accounts Payable 15,312.92 Deposits 3,026.67 Bonded Debt 100,000.00 Mortgages 5,000.00 Accrued Liabilities 1,177.09 Total Liabilities... $194,516.68 Capital 400,000 . oo Surplus Profits 82,436. 50 Reserves 108,417.00 Total $785,370.18 22 Net Worth and the Balance Sheet taken from a typical case, the name at the head of the balance sheet, of course, being fictitious. In the blank official form the names of the accounts are printed down the asset side to and including "Machinery and Fixtures." Below that are several blank lines in which for the purposes of the pres- ent consideration the accounts "Reserve Fund," etc., have been inserted. The liability side is given here as printed in the official form. The statement as presented is in the form of a corporate balance sheet. The few differ- ences between a statement of the net worth of a partnership and that of a corporation will be explained in later chapters. In the chapters which follow, each item shown on the statement of the Scarborough Manufacturing Company is taken up in order, and the nature of the debits and cred- its which produce the balances set out against the named accounts is considered. CHAPTER III CASH TV/T OST of us are fairly well informed as to the paper currency and the gold, silver, and copper coins received and paid in the ordinary course of small tradings. The balance of cash in one's pockets is the result, so far as the handling of actual cash is con- cerned, of all one's previous cash transac- tions. Many of our personal instalments of income are received in the form of checks and coupons, as well as actual cash. The sur- plus over and above the amount needed for pocket expenditures is deposited in a bank- ing institution of some kind. So it is with a business concern. The cash balance, as shown on the Cash Book, is the difference between the receipts from all sources on the one, or debit, side of the book and the payments on the other, or credit, side. The balance between the receipts and pay- ments is the exact amount by which the re- 23 24 Net Worth and the Balance Sheet ceipts have exceeded the payments, and cash should be found in the possession of the con- cern to an amount equal thereto. As a rule, a business man keeps little actual currency and coin in his office or store. Checks, money orders, and every other form of bank- able funds received during the course of the business day, and all actual cash, excepting such as is needed for current expenses, are deposited in his bank. In the example given, the cash of the Scarborough Manufacturing Company was divided as follows : Cash in Bank (deposits) $23,098.73 Cash on Hand (petty cash fund) .... 500.00 Cash in Hands of Branch Managers 3,245.17 Total $26,843.90 Cash in Bank Cash in Bank means undrawn deposits in solvent banks, trust companies, with bankers, or in other depositories, payable by check upon demand. It is difficult to frame a concise definition completely describing this asset. It would Cash 25 appear unnecessary to insist that the amount said to be in bank must consist of the amount deposited, less all checks issued against it. With few exceptions, business men, book- keepers, and cashiers understand and adhere to this principle, but in some few cases busi- ness men, in order to present favorable state- ments, affect to think that the actual amount standing to their credit on the books of the bank is the amount which they may consider as in bank, disregarding those checks which have been drawn and issued and sent to such distant points that in the ordinary course of events several days must intervene before they can return and be presented to the bank. In one recent case of bankruptcy the treas- urer of the corporation concerned had habit- ually drawn and issued checks to an amount greater than the balance to the credit of the company in his bank, depending upon his ability to collect funds and deposit them be- fore the outstanding checks could be pre- sented to the bank for payment. In other words, his bank account, according to his own check book, was continuously over- 26 Net Worth and the Balance Sheet drawn, while on the bank's books the com- pany apparently always had a balance to its credit. At least, it always had such an ap- parent balance until one day the treasurer was unable to provide the funds necessary to meet the incoming checks, and a bank- ruptcy was brought on which might have been avoided by stricter accounting and more businesslike methods. It is much safer, and more honest, for a business man to consider that his bank bal- ance has immediately been reduced by the amount of the checks issued, regardless of the time which may elapse before the checks are actually presented at his bank and de- ducted from his credit balance. "Cash in Bank" usually includes deposits payable upon check or "order only after prior notice" of such intention, according to con- ditions under which the deposits were made, but if the amount is large and not available upon reasonably short notice, it would be better to set out the amount of such funds separately from the current checking ac- counts. Cash 27 For instance, a manufacturer may have $100,000 cash balance on which he is draw- ing no interest ; he may find that $50,000 is all that he needs for current working capital. In such case he may have the remaining $50,000 transferred temporarily to another account in the bank on which interest may be paid to him, and the amount of this deposit be shown in a demand or time certificate of deposit. As a general rule, certificates of deposit, whether demand or time, are payable on demand. The time element merely defines the period during which the money must be left in order to draw interest. There may, of course, be other deposits the withdrawal of which must be preceded by notice, as, for example, in savings banks, where with- drawals may be made only upon order with a previous notice of such intention declared a week, two weeks, or thirty days in advance. Frequently checks, drafts, and other nego- tiable instruments payable at distant places are received by the banks as deposits and credited at once to depositors, if in good standing with the bank, it being understood 28 Net Worth and the Balance Sheet that these depositors will not draw against the uncollected credits. Strict banking prac- tice calls for the withholding of credits for such instruments until collection is effected. In a financial statement, if the amount of such uncollected instruments is large, it should not be included in "Cash in Bank," but should be described as "Checks, Drafts, etc., for Collection," and entered on the state- ment as a separate item. Cash on Hand Cash on Hand means ready money in drawer or safe, in office or store, in branches or agencies; currency, coin, legal tender, or bank notes; also checks cashable on demand, money orders, or other instruments received as money, which in the ordinary course of business will be received by the bank as a cash deposit. It does not include promises to pay money in the future, due bills, past due checks or checks dated ahead, promissory notes or memoranda of money loaned or advanced for any purpose. Such items, if of value, Cash 29 should be stated under "Other Assets," and listed separately, if important: but if insig- nificant, included under the heading "Mis- cellaneous." Actual cash in the possession of branch offices or stores may be included, but un- settled accounts of cash in the hands of agents or representatives to be accounted for when expended should not be included as "Cash on Hand." Petty Cash and Imprest Fund Ordinarily in a manufacturing business very little actual cash is required. Such as is needed for petty expenses which cannot con- veniently be settled by checks is provided for by means of the Petty Cash fund kept in a desk drawer or safe. Some concerns are accustomed to withhold from the deposits of the day, for petty cash purposes, a part or the whole of the currency and coin received a practice not to be com- mended while other concerns deposit in bank all cash in whatever form it is received. Those who deposit every penny of cash in 30 Net Worth and the Balance Sheet bank provide for petty cash needs by means of checks drawn on their bank accounts, and cashed. In such cases it is quite a common practice to charge on the ledger, through the cash book, the cash from the first check to Petty Cash account under a system known as an Imprest Fund, where the amount re- mains as a fixed fund. The amount of this fund is maintained thereafter by means of subsequent checks to equal the total of the depletions of the fund for expenses; the amounts expended being periodically charged to the proper accounts through the cash book. At any given time the amount on the ledger will be represented by actual cash and petty cash vouchers. CHAPTER IV NOTES RECEIVABLE 'HE term "Notes Receivable" means ne- gotiable promissory notes or accepted drafts received from customers in settlement for goods sold, not discounted, transferred or assigned. Many people use the term "Bills Receiv- able," meaning the same thing as "Notes Re- ceivable," but as some of these confuse "Bills" meaning promissory notes received with bills for merchandise purchased, the distinction is better preserved in the use of "Notes Receivable." When a merchant or manufacturer sells goods to his customers, as a rule he expects to be paid within a certain time, fixed accord- ing to the terms of the particular sales or the general custom prevailing in his line of business. Sometimes promissory notes are offered by the customer, either before or after payment 31 32 Net Worth and the Balance Sheet is due by him for the goods purchased. If the promissory notes are accepted by the mer- chant or manufacturer the amount of these notes is usually credited to the customer in his ledger account and at the same time the "Notes Receivable" account is charged. Discounting Notes Receivable If the concern receiving such notes is pro- vided at the time with sufficient working capital, it will retain these notes in its safe until shortly before they become due, when they are sent for presentation and collection to the place where, by their terms, they are made payable. In case it becomes convenient to obtain funds before the maturity of the notes, they are sent to the bank for discount ; the bank discounting the notes by deducting from their face the amount of interest from the day of discount until the date set as the time for payment by the maker. The notes thus disposed of are credited to the Notes Receivable account, the amount of the discount is charged to Interest and Dis- count account, and the difference between Notes Receivable 33 the interest deducted by the bank and the whole amount of the notes, called the "pro- ceeds," is charged to Cash. There are other methods by which the dis- counting of notes is placed on the books, but this one answers the purpose of showing that, under the ordinary procedure, the bal- ance of the Notes Receivable account always shows the amount of the notes on hand. Notes received and subsequently dis- counted at bank should not be stated as an asset. The amount of such discounted notes remaining unpaid by the maker at the time the statement is prepared should be stated as a contingent liability in a footnote to the balance sheet. In some methods of bookkeeping the notes which have been discounted are not credited to the Notes Receivable account according to the method already described, until actually paid by the makers. The general rule that such notes should not be stated as an asset must then be varied. It is correct as to prin- ciple, but under the method of accounting just referred to does not apply, as such notes 34 Net Worth and the Balance Sheet are carried as assets with an offsetting lia- bility. When a promissory note is received from a customer the usual practice, as stated, calls for a debit to Notes Receivable and a credit to the customer of a like amount. Then when the note is discounted at bank, it calls for a credit to Notes Receivable of the full amount of the note and a debit to Cash of the proceeds received from the bank, and another debit to Interest and Discount of the amount of interest deducted from the face of the note by the bank. For example : Method A: Cash, Dr $940.00 Interest and Discount, Dr. . . 60.00 Notes Receivable, Cr $1,000.00 Under the other method referred to, the course is similar until the note is discounted, when another account is opened called "Notes Receivable Discounted" and the discounted note is credited to that account instead of to the Notes Receivable account. Notes Receivable 35 For example : Method B : Cash, Dr $940.00 Interest and Discount, Dr. . . 60.00 Notes Receivable Discounted, Cr. .$1,000.00 Assuming that the Scarborough Manufac- turing Company, whose Notes Receivable on the balance sheet amounted to $7,752.84, had received other notes to the amount of $20,000 not then due, but which it had discounted at bank, under method B the balance sheet would show as follows : Under Assets : Notes Receivable $27,752.84 Under Liabilities: Notes Receivable Discounted 20,000.00 This condition would be just as intelligible to the man who understands this method as the other method in which the amount of con- tingent liabilities is stated as a footnote on the balance sheet. Following the process a little further, when the maturity date of the note dis- counted arrives, and the note is found to have 36 Net Worth and the Balance Sheet been paid by the customer, a journal entry is made as follows: Notes Receivable Discounted. . .$1,000 To Notes Receivable $1,000 The object of this method is to have the ledger show at any given time the amount of customers' notes which have been dis- counted, but which have not yet been paid by the makers. The only objection to be urged against this method is found in the fact that it places on the ledger a liability that is not, strictly speaking, the kind of liability that should ap- pear there. This liability is that of the in- dorser of a note, and when such a note has been received for goods purchased by the maker of the note, the indorser is not liable unless the maker fails to pay it himself. It is a contingency which arises every time a note is discounted by the indorser to the extent that he may be compelled to pay back to the bank the money advanced by the bank on the note. In a well-managed business, where the general business standing of the customers Notes Receivable 37 is good, and their financial responsibility is established, it is but seldom that the merchant or manufacturer is compelled to pay the notes he has discounted, and, except in un- usual cases, it is not necessary to maintain the Notes Receivable Discounted account, or to make the extra double entry in the books called for by this method. "Good" Notes Notes described as "good" should include only such negotiable instruments as are not due when the statement is prepared and which the merchant or manufacturer actually believes, after diligent inquiry, will be paid by the maker at maturity. Overdue notes should be stated in a separate amount under the description "overdue notes." It is sometimes very hard to look upon the real value of notes in hand as being less than the face value. But in order that the state- ment of net worth may not contain any un- certain elements it is necessary to scrutinize this class of assets with care. We very often hear the expression regarding; promissory 288458 38 Net Worth and the Balance Sheet notes, "They are as good as wheat," when a further inquiry reveals some doubt of the ability of the maker to settle his obligations promptly. Unless fully secured either by col- lateral or indorsement, or unless warranted by absolute knowledge of the financial re- sponsibility of the makers or indorsers, Notes Receivable should not be appraised as "good" for the full amount. This applies especially to "Notes Receiv- able" continuously renewed by the customers. Such notes should not be stated at face value unless amply secured by collateral or by indorsements. It is easy to see that if a debtor does not reduce the amount of his indebtedness within a reasonable time, he is not making good progress, and unless some turn in his affairs should improve his con- dition, his ability to meet his obligations may fade away. CHAPTER V NOTES RECEIVABLE (continued) T/f/^RITTEN contracts or engagements not negotiable, to pay money, or for services or property, should not be included in Notes Receivable. Nothing should be called Notes Receivable save legal negotiable promissory notes given to the merchant or manufacturer who is pre- paring the statement. All other contracts, rights, patents, processes, and evidences of property of more or less value to the concern, should be shown in the statement, but not under Notes Receivable. Accommodation Notes Notes Receivable given to the merchant or manufacturer for his accommodation should be stated separately and not as a part of the total of Notes Receivable-from customers for goods sold. Such notes are the same in effect as if 39 made by the party accommodated and in- dorsed by the party issuing the paper, it being expected that the merchant or manu- facturer for whose accommodation the note has been made will pay it at maturity regard- less of his nominal position on the paper. Any notes received in settlement or part settlement of previous charges on open ac- count should be deducted from such accounts and stated as Notes Receivable. This is be- cause the acceptance of the note changes the legal form of the claim against the customer from that of goods sold to that of note un- paid. Some bookkeepers charge back to the cus- tomer's account a note received from him but not paid at maturity. For the same reason that a note is deducted from the open account, it should not be charged back when not paid. The mere failure in payment does not again transform the note into a claim for goods sold. Sometimes when accounts due for mer- chandise sold are difficult to collect, promis- sory notes are accepted in lieu of the old Notes Receivable 41 account. This further extends the time of payment, and in such cases the promissory notes may not be worth face value as an asset. Notes Not in the Ordinary Course of Business Notes received from officers, directors, partners, clerks, or stockholders should not be included in Notes Receivable, but should be stated in a separate amount. Sometimes loans are made to those directly connected with the business, and memoranda, due bills, or promissory notes are taken as evidence of the loans, which are then carried in Notes Receivable account. While these may form legitimate assets, they should not be included in the account Notes Receivable, for the reason that such transactions are only incidental to and not part of the main pur- pose of the business. It may further be said generally that all facts not forming a neces- sary part of the business should be stated separately from those facts which are di- rectly connected with and form part of the business itself. If this is not done the bal- 42 Net Worth an'd the Balance Sheet ance sheet may lose much of its meaning and value. Thus the fact that the Scarborough Man- ufacturing Company has on hand a small amount of notes received from its customers is one having some significance. If the actual amount of these customers' notes is obscured with miscellaneous obligations, it is more difficult to picture the business in its own entirety. Notes Receivable given by subsidiary, con- trolled, or allied interests for merchandise should be stated separately from those re- ceived from outside customers. Where one corporation owns or controls a number of other smaller corporations whose business forms part of the whole, the main company is sometimes referred to as the "parent" company and the other smaller companies as "subsidiaries." Materials and finished manufactured articles may be transported from one to an- other of these subsidiary concerns, or from the "parent" to one or more, or from the sub- sidiaries to the parent corporation. Again, Notes Receivable 43 advances of money are frequently obtained from the parent company by the subsidiary concerns. On the books of the parent com- pany such debts of the subsidiary companies are sometimes clearly shown to be just what they are, but more often the notes given to the parent company are included as part of the Notes Receivable balance. In some cases these notes represent cash advanced for construction purposes; in others, cash for current operating expenses ; in others, the notes may represent goods or materials shipped which are either still on hand or which have been sold. There are as many different things for which these notes may have been given as there are ways of spending money. This uncertainty in itself renders the statement more difficult of understanding than it would be if all notes given by one allied or controlled concern to another operating under the same ownership were stated separately from its ordinary Notes Receivable. So much for the clearness of understand- ing. There is another reason for separating 44 Net Worth and the Balance Sheet these notes, of more importance in any con- sideration of the real net worth of a business. It may happen that many of these notes rep- resent investments in enterprises which have turned out to be unsuccessful, and while the notes are being carried at full value, they are not represented by full value in the assets of the subsidiary concern. In one concern whose statement was re- cently examined it was found that the Notes Receivable of one of the manufactur- ing plants were held and carried among the other ordinary promissory notes by the main organization to the extent of $1,000,000, while the total capital stock of the subsidiary concern, all owned by the parent company, amounted to only $100,000. The capital needed by the small concern, not only for con- struction purposes, but also for materials and labor, had been supplied by the parent company. Since the subsidiary company, at the time, was doing very badly, it was a grave question whether the assets of the parent company represented by these notes were of any material value. Notes Receivable 45 There was no doubt whatever that the statement of Notes Receivable was mislead- ing, containing as it did this large amount of notes representing anything but ordinary Notes Receivable from customers. It was misleading to the extent that without inquiry it would have appeared that the parent cor- poration possessed a much larger amount of what is known as "quick" assets than was actually the case. Notes Assigned or Pledged Any notes assigned or pledged as collateral for loans should be stated and the liability for the borrowed money shown as a liability. Ordinarily business concerns having a credit standing are able to borrow such funds as are needed for temporary purposes upon their own promissory notes, which they dis- count at bank. But when they are compelled to offer security additional to that of their own established credit standing, they may take to the bank or banks, as collateral for these loans, such promissory notes as they have received from their customers. 46 Net Worth and the Balance Sheet If such promissory notes have been re- ceived in the ordinary course of business from responsible concerns, and the date of maturity and places of payment are not far distant, it is quite within the ordinary for the holders to discount them at the bank, although it is generally regarded as better financing for business houses, wherever pos- sible, to hold such notes until maturity, in the meantime borrowing for their requirements on their own notes. But in many lines of business custom re- quires that settlements be accepted for goods sold, in long-term notes. In other lines the business is such that the sellers have to take many very small notes. In such cases the notes received from customers do not in themselves constitute very desirable loans from a banker's standpoint, and, as already suggested, money needed is obtained of the bank upon the concern's own notes, with these long-term or numerous small notes as collateral. When so taken, it is usual for the bank or banker to collect these collateral notes when due and credit the amount col- Notes Receivable 47 lected to the Bills Payable of the concern borrowing the money. For the sake of clearness, as has been said, the Notes Receivable taken from customers and pledged as collateral should remain as Notes Receivable on the books of the concern owning them, the amounts of payment being credited as reported by the bank. For example: Notes Payable $1,000 To Notes Receivable $1,000 Note J. Watkins, due December 3ist, paid and applied to our loan at First National Bank. In the balance sheet the amount of the Notes Receivable pledged should be set out in a separate item and designated as pledged, and the amount borrowed should appear as Bills Payable in the liabilities. In the case of the Scarborough Manufac- turing Company no such expedient was necessary. The aggregate of the Notes Re- ceivable is small and the working capital owned and borrowed sufficiently large for its needs. CHAPTER VI ACCOUNTS RECEIVABLE ACCOUNTS RECEIVABLE means the sum total of unsettled charges against debtors, usually for merchandise sold and de- livered. When used in a general sense, this term may include any legal demand or claim aris- ing out of verbal or written contract not evi- denced by draft, promissory note, judgment, or mortgage of record. In other words, an open book debit against any person may consist in part or in whole of claims against him which do not represent charges for delivery of the goods forming the main object or purpose of the business. Examples may be given, such as the sale by a dry goods merchant of his horses and wagons, or by a manufacturer, of cutlery, of old machinery, etc., which, though proper enough charges, are not charges for goods manufactured or traded in. 48 Accounts Receivable 49 When used in a more restricted sense, the term "Accounts Receivable" is usually un- derstood to include only unsettled charges to customers for merchandise or manufactured product sold on ordinary trade terms, the right to collect which has not been trans- ferred or assigned. This restricted sense is that which is given to the usual customers' debit balances. In some retail lines the open book accounts are styled "Charge Accounts" as distinguished from cash sales. In gas, water, and electric light and power company accounting the unpaid charges are usually styled "Consumers' Accounts" or "Due from Consumers." Referring to the suggestion that Accounts Receivable should not include those accounts which have been transferred or assigned, perhaps it will be well to explain that some- times merchants and manufacturers, finding it difficult to obtain sufficient accommodation for their financial needs at their banks, arrange with trust companies or bankers for loans on their bills for goods sold, 50 Net Worth and the Balance Sheet When this is done the bills, instead of being at once mailed to the customers, are first taken in lots to the trust company or to the banker, and about 75, or even 80, per cent, of the amount of such bills is advanced to the merchant or manufacturer. The trust company or banker then takes possession of the bills and forwards them to the customers, first stamping them with a direction to the customer to remit, not to the merchant or manufacturer from whom the goods were purchased, but instead to the trust company or banker whose name appears in the stamped direction. The business man obtaining money in this way should keep a careful record of the bills upon which his loans are obtained. The money received as an advance should of course be entered in his cash book as a charge to cash, with the necessary interest and com- mission adjustment, and the liability be cred- ited in the proper book of record to "Loans on Assigned Accounts." In preparing his statement of net worth when such loans are made, the amount of un- Accounts Receivable 51 assigned Accounts Receivable should be stated first, followed by the total face value of the "Accounts Receivable Assigned," each and all of which should be plainly designated on the ledger as assigned. As the accounts are paid to the trust company or banker and reported to the merchant or manufacturer, he should enter in his journal credits to his customers for the amounts collected, and at the same time enter debits or charges of corresponding amounts to the account called "Loans on Assigned Accounts." Thus at any given time the balance of the account will show the actual amount of the money owed to the bank, and the total of the "Ac- counts Receivable Assigned" will show the face value of those accounts assigned and not paid by the customers. As used in the restricted sense, Accounts Receivable should not include money loaned or advanced to any person for any purpose. In order that a business man may intelli- gently inspect his true financial position in business, he should not fall into the habit of carrying records of outside transactions upon 52 Net Worth and the Balance Sheet his business books of account. Investments, loans, contributions to syndicates, or ac- counts with individuals for any one or more of a multitude of transactions which may give rise to charges on open book accounts, ought not to be mixed in with the accounts relating solely to the business of which the books purport to constitute a record. If such outside transactions are recorded on his books he should set out such accounts separately from those representing the main business. Good Accounts Receivable When Accounts Receivable are described or appraised as "good," it is understood that the amounts included in the total so desig- nated are (a) not yet due according to the terms of the sale and no information has been received creating doubt of the customers' re- sponsibility and readiness to pay when due, or (b) are overdue, but experience with such customers in the past has been such as to warrant the reasonable belief that they will pay within a reasonable time. Merchandise 53 The total of overdue accounts, especially after request or demand for payment, should not, as a rule, be considered worth face value in a carefully prepared statement of financial condition, but a deduction should be made for possible losses on collection. In a conscientious effort to prepare an ac- curate statement of net worth, the debit bal- ances or open book accounts with customers should be carefully analyzed. Of course no one can forecast the future action of any cus- tomer with absolute accuracy. Furthermore, customers who in ordinary times pay their bills regularly may be entirely upset in periods of business depression. Under such conditions, men believed to be absolutely re- liable do such strange things that their prob- able course in any given transaction cannot be foreseen. At the same time, a thorough analysis of the open balances will throw much light upon accounts the value of which, considered as an aggregate without analysis, may be difficult to estimate. Overdue Accounts Taking the general terms of the trade, as 54 Net Worth and the Balance Sheet well as any specific terms to certain custom- ers into consideration, an analysis should be made of each account and the average date of the charges for unpaid merchandise ascer- tained. These accounts should then be classified according to age, as follows: Analysis of Overdue Accounts Under 30 days overdue Over 30 days, but less than 60 days Over 60 days, but less than 90 days Over 90 days, but less than 6 months Over 6 months, but less than 9 months Over 9 months, but less than I year Over i year overdue Careful examination should be made of those accounts appearing under the "over- due" headings, taking the terms of sale into consideration. No matter how much confi- dence a merchant or manufacturer may have in his customers, he cannot consistently claim as absolutely good, assets accounts found in the "over 90 days" column, which, by the terms, were due in 30 days from date of sale. While in many individual cases he may be very sure that the customers will pay in time, yet on the whole the chances are unfavorable Accounts Receivable 55 that all of those falling within the delinquent 90-day class will pay the full amount of their debts. And so on, until he finds accounts over a year old, though due in 60 days from date of sale. He could not reasonably count on realizing the full value of all of such ac- counts unless he holds some security or pos- sesses some special information regarding all the individuals in this excessively delinquent class, which would take them out of the gen- eral rule. Many credit men are very suspicious of all accounts not paid for after 60 days from the promised day of payment. To throw out of asset valuation each and every such ac- count would be just as unreasonable as to include all old accounts at their face value. Careful inquiry of his clerks regarding the steps taken to collect overdue accounts will often lead the merchant or manufacturer to a definite conclusion, not perhaps that any account apparently good is absolutely worth- less, but that, considered as an asset, he ought not to take it in his statement at full value. A CHAPTER VII ACCOUNTS RECEIVABLE (continued) CCOUNTS subject to discount, allow- ance, rebate, claims for damaged or imperfect goods, or known to be doubtful for any reason, should be deducted to the extent of the known or estimated shrinkage to occur in final settlement. Of course, all known bad debts should be closed out and charged to the Profit and Loss account. Those accounts not known to be bad or even doubtful, which on their face are delinquent, and thus, according to general credit knowledge, not worth face value, should be partially offset by means of a re- serve set aside from the profits for bad or 'doubtful debts. It is customary to charge off bad debts, and close the accounts of those from whom it appears impossible to collect the amounts due. It sometimes happens, however, that changes in circumstances make it possible to 56 Accounts Receivable 57 collect accounts subsequently which appeared worthless at the time they were charged off. A separate book or ledger should be kept con- taining records of all bad debts. This book should be frequently scrutinized that known changes for the better in any of the old debtors may not be overlooked. Unsettled Charges No unsettled charges against any individ- ual connected zvith the business, either as a proprietor, stockholder, officer, or clerk, whether for overdrawn salary accounts, ex- pense accounts, unpaid stock subscriptions, or for any other reason, should be included in Accounts Receivable, but should be stated separately. It is frequently observed that overdrawn salary accounts are carried in the Accounts Receivable as balances due from the officers or clerks who have overdrawn ; and in some cases partners maintain open drawing ac- counts indefinitely, including the debit bal- ances in the same class as balances due from customers. 58 Net Worth and the Balance Sheet Again, large advances of cash are some- times made to agents or salesmen either on account of salaries or commission, or for expense funds. It would seem needless to say that such accounts are not Accounts Re- ceivable in the understood sense of the term, if it were not for the fact that some business men and bookkeepers include all open debit balances against individuals in this one class. Collecting Accounts Receivable The elimination from Accounts Receivable of every kind of debit charge other than for goods sold, is useful in more than one way. Besides the assistance rendered in determin- ing the net worth of a business, the amount of outstanding debit accounts for merchan- dise sold, taken into connection with the vol- ume of sales, throws light on the financial ability of the management a light which should be of help to the management in cor- recting the weaknesses disclosed. After learning the terms of credit on which goods have been sold, a simple compu- tation based on the terms of credit, volume Accounts Receivable 59 of sales, and the amount of Accounts Receiv- able, will show whether or not the collections have been made promptly. For example, the Scarborough Manufacturing Company sold during the year 1911 an aggregate of $680,000 on various terms of credit, the aver- age of which would be about 45 days. The amount outstanding was approximately the same at the beginning as at the end of the year, i.e., $111,172.08; whereas the Accounts Receivable, if collected according to the terms of credit, would amount at any one time to not over, approximately, one-eighth of the total sales, or about $85,000. The actual amount of the Accounts Re- ceivable is therefore about $25,000 greater than the average term of credit would indi- cate as necessary. Of course this rule must not be taken as a basis for final judgment without further in- quiry, but on its face the Scarborough Manu- facturing Company's collection department has been too easy with its customers for its own good. Not long since, the annual sales of each of 60 Net Worth and the Balance Sheet two concerns in the same line of business aggregated about $1,000,000. One con- cern carried $400,000 of Accounts Receiv- able, while the other succeeded in keeping its customers' accounts down to only $200,000, or 100 per cent, less than the more easy-going concern. As a result the first was obliged to borrow heavily and pay interest on the amount borrowed a tax on the business which would not have been needed if it had collected the accounts due to it. Besides this, the danger of loss through accounts grows with the length of time the accounts are al- lowed to remain uncollected. Accounts Receivable from Allied Interests Accounts Receivable representing un- settled charges against subsidiary, controll- ing, or allied interests should be stated separately. Many interconnected companies buy of and sell to each other, piling up large Ac- counts Receivable and Payable, which are not of such character as to be properly in- cluded in the same class as accounts due from Accounts Receivable 61 outside parties. In some cases, of course, the concerns, though controlled, are sufficiently distinct to permit transactions between them to be regarded as similar to those of entirely separate concerns. But in many instances the charges for goods delivered by one of the subsidiary concerns of a large corpora- tion to another of the concerns amounts to nothing more than a transfer of materials or merchandise from one plant to another. Where commission merchants having mer- chandise in their possession owned by manu- facturers, advance funds to the owners of the merchandise in anticipation of sales, the amount advanced should not be included in Accounts Receivable. Such advances should be separately stated and described as "Ad- vances of Cash Against Merchandise in Our Possession for Sale on Commission." CHAPTER VIII MERCHANDISE HP HIS account in a balance sheet is in- tended to mean unsold marketable goods and wares owned by a merchant and bought for sale, these goods being of any kind falling within the general purpose of his business. Reference is made here to the merchan- dise of a merchant or trader. The finished product of a manufacturer is described in a later chapter. Valuation of Merchandise With certain exceptions, the inventory value of merchandise should be based upon purchase price plus freight charges, and, in some cases, expenses incident to carrying the stock. Some merchants and manufacturers cal- culate the inventory at full selling price, or at selling price less certain discounts, but ex- 62 Merchandise 63 cept in a few particular cases this method is not in accordance with the best business principles. According to the views of such merchants and manufacturers, the moment goods are bought or manufactured and ready for sale, a value attaches to them corresponding to the demand of the consumers. The price which the purchaser is willing to pay for the goods constitutes that value, they argue, and that price is the amount at which the merchant should be allowed to appraise his goods in stock. On the other hand, until the goods are ac- tually sold and accepted by the purchaser, the goods actually belong to the merchant or manufacturer, although it is true that cases exist in which the legal phases of the con- tract between the vendor and vendee produce conditions whereby it would be perfectly justifiable for the merchant or manufacturer to value his goods at full price. Again, there are lines of business in which the articles dealt in are constantly fluctuating in price, due more or less to the speculative 64 Net Worth and the Balance Sheet value of the article, as, for example, flour and cotton. Such cases may form exceptions to the general rule and must be considered carefully, but if a valuation on merchandise is fixed above cost, the result, according to the ordi- nary methods of bookkeeping, will be a show- ing on the books of a profit not yet earned. By "not yet earned" is meant that the goods have not yet been actually sold and accepted. Up to that point the goods belong to the merchant. When the goods have been sold and accepted, the asset is changed from the asset "Stock on Hand" to an asset con- sisting of a claim against a supposedly re- sponsible party. That change in the legal status seems to form the most appropriate marking point for the taking on the books of a profit. In some lines goods are ordered by the purchaser six months in advance of delivery. In such cases it would seem that at inven- tory time such goods as are on hand, having been manufactured on order, should be val- ued at selling price less expenses of carrying Merchandise 65 in stock and delivery to the point agreed upon. This method seems to be correct on the principle that the goods actually belong to the purchaser, and since he is bound to take and pay for them, the profit to the man- ufacturer has already been earned. In the exceptional cases referred to, such would be the fact, and such a method of treatment would be correct, but the cases are comparatively rare in which the goods, though still in the manufacturer's actual possession, have in law been delivered to the customer and are simply held, subject to his order and at his own risk. A fairly accurate test of the matter in each case may be applied in the form of this question: ''In the event of destruction of the goods by fire, on whom would fall the loss?" If the answer is clear to the effect that the customer would be the loser, the manufac- turer is justified in considering the goods as sold. If, on the other hand, under the terms of the contract of sale, the goods, though ordered and manufactured, are still the prop- erty of the manufacturer to the extent that 66 Net Worth and the Balance Sheet their loss or damage by fire would fall on him, he is not justified in considering them sold. Cancellations may come in before de- livery and after delivery the goods may not be accepted. By whatever means effected, delivery, either actual or constructive in law, must be made to the customer and the goods be ac- cepted by him as to price, quantity, and qual- ity before their ownership passes. When, however, the cost of the merchan- dise at inventory time for any reason exceeds the market value, the latter should form the basis of the valuation ; the reason being that the inventory at cost compared with market value shows a known loss, which should be deducted from the value of the merchandise at once. A frequent instance of overvaluation is found in merchandise which was once sal- able, but which has become worn, or out of style. Such articles are sometimes carried in stock under the heading of "discontinued numbers." Whatever the reason for their depreciation in value, articles of merchandise Merchandise 67 not worth what they cost should not be car- ried at more than their real value. The exceptional cases in which the general rule as to valuation does not hold are those wherein the nature of the business is such that the market or selling price furnishes the most practical basis for the true ascer- tainment of the financial position of the mer- chant. Manufacturers of paint and linoleum seem to furnish instances of this kind. The con- trolling ingredient in the manufacturing of these articles is linseed oil, the price of which varies considerably, according to numerous factors which affect the market price. At the end of the year 1911 the price of this oil was about seventy-one cents per gallon, while during the year the average cost was eighty- five cents per gallon. This condition in the linseed oil market during the year produced a cost above market price at the end of the year for such articles manufactured from the higher priced oil as were then on hand. In many cases at the end of the year paint and linoleum concerns reduced the inventory 68 Net Worth and the Balance Sheet valuation of finished goods to a basis of the price of oil at the time the inventory was taken. But suppose the price of linseed oil was considerably higher at the close of the year than it had been during the year. Would the manufacturers be justified in increasing the inventory valuation of finished stock to agree with the higher priced oil ? The justi- fying argument advanced by some in support of this course is that if the sales for the next year are based upon the actual cost price of oil during the preceding year, a loss would occur which would not be incurred if the in- ventory of manufactured goods at the close of the year was based upon the cost of oil at the end of the year. This argument is used by those who think of the cost of an article as having a necessary relation to the selling price, and that the cost once found may be used for a year in ad- vance. This idea confuses the actual cost of manufacturing in the past with estimates on which prices are fixed in advance for future sales. Merchandise 69 While actual cost records should be con- sulted very carefully in making up schedules of present or future prices, it must be remem- bered that the cost figures are obtained from past happenings and may not be safely relied upon as the sole guide for future costs or prices. When the price of an article is made and the cost price must enter into the considera- tion, each item of the latest cost record of that article should be examined in the light of later knowledge of market and labor con- ditions and probable future conditions, so that the future cost may be estimated as nearly as possible in accordance with antici- pated future happenings. Looking at costs and prices from this point of view, it will be seen that the inventoried cost of an article at the end of the year may be taken at actual cost, or market price if that is lower than cost, and the estimates on which prices for the following year are based may, without inconsistency, be taken at en- tirely different or even purely supposititious figures. 70 Net Worth and the Balance Sheet Therefore, even in the case of oil, higher priced at the end of the year than the aver- age price during the year, the rule of taking actual cost when lower than market value would not only be sound, but would at the same time be in accordance with conserva- tive management, and, as has been seen, it need not conflict with subsequent price- making. Merchandise on Hand Merchandise on Hand should include all merchandise actually in the merchant's store or warehouse, or out on approval, and all merchandise purchased by him, not yet de- livered, but which he must receive and pay for; but it should not include merchandise ordered but not received or accepted, which by the terms of the purchase he may cancel before delivery, or refuse to accept upon de- livery. Any merchandise pledged for loans should be stated separately from the amount of mer- chandise unpledged, and the liability for the borrowed money should be shown as a lia- Merchandise 71 bility. Frequently concerns handling mer- chandise of considerable value are able to obtain loans upon the pledge of that material as collateral. Sometimes the merchandise is placed in the actual possession of the bank loaning the money, but more often the evi- dence of its existence is in the form of ware- house certificates or bills of lading. Any merchandise held for sale on consign- ment, or in trust for any purpose, not abso- lutely owned by the merchant, should not be included in the inventory, which is intended to show only such materials or merchandise as is owned. CHAPTER ix FINISHED PRODUCT IN I SHED PRODUCT means unsold completely manufactured marketable articles made and owned by a manufacturer and in his possession at his factory or mill, or at warehouses or branches or agencies. In other words, this means the ordinary goods produced by the manufacturer and ready for sale. It will be noted that a distinction is made between the merchandise of a merchant and the product of a manufacturer. This is a distinction which indicates that merchandise is bought and sold by merchants, while the finished product represents materials bought and labor expended in producing the articles manufactured. The finished product of a factory may consist of merchandise ready for the final consumer, who purchases it from the manufacturer direct or from mer- chants. 72 Finished Product 73 Some manufacturers accommodate their customers by supplying articles not man- ufactured by them, but which are traded in or used by customers buying the main articles manufactured. An example is found in a paint company which manufactures nothing besides paints, but which carries a small stock of brushes, sand paper, glass and similar articles for the accommodation of its customers. In such cases the inventory should be classified so as to show the total of the raw material, the partly finished and finished product, and also the merchandise purchased from others for use in supplying customers. Manufacturing Cost The valuation of finished product should be based upon cost, including a proper pro- portion of the expenses of manufacturing and caring for the stock to the time of in- ventorying. Just what expenses may properly be added to the manufactured product of a factory to determine its cost cannot be enumerated 74 Net Worth and the Balance Sheet and described in detail in such manner as to establish an exact rule for the guidance of all manufacturers. In general it may be said that the manufacturing cost of a finished article is intended to include all items enter- ing into the cost of production, such as ma- terials, labor and overhead factory expense. Manufacturing cost does not include any part of the cost of advertising and selling. It should include the cost of that portion of the general administration devoted to pro- ducing, but no portion not strictly chargeable to manufacturing. Perhaps the distinction between what may be included in manufacturing cost and what may not will be clearly marked in the item of Bad Debts, which represents loss due to error in judgment of the salesman or credit man or both, or to unfortunate turns of events which could not have been foreseen at the time the credit was granted. Whatever the cause for the loss on Ac- counts Receivable for goods sold, delivered, and accepted, the manufacturing branch of the business cannot be charged with fault. Finished Product 75 If it cannot be charged to the factory, by the same reasoning such items do not constitute part of the manufacturing cost, and thus cannot be added as a manufacturing expense to the valuation of the inventory. Briefly, the manufacturing cost attaches to the product up to the time the goods are ready for delivery and have been sold. A distinction might be drawn between the actual cost of manufacture and the expense of storage up to the time the goods leave the factory, but while the cost of carrying might seem at first blush to constitute storage cost as distinguished from manufacturing cost, an argument on the other side to the effect that in many lines goods cannot be sold un- less made up and kept ready for sale, would narrow the storage idea to a line too fine for practical purposes. In some lines of business goods are manu- factured upon orders considerably in ad- vance of the time set for delivery. At in- ventory time many business men, consider- ing that the ordered goods have been sold, put the entire selling price on such of these 76 Net Worth an'd the Balance Sheet goods as have not been delivered. Unless the buyer has actually inspected and accepted the goods, they have not really been sold, and until they are really sold the manufacturing cost only should be used as a basis for valu- ation. Consigned Goods Finished Product should include all articles shipped on consignment for sale and account- ing to the owner. Some manufacturers in- clude the charges for such consigned goods in the Accounts Receivable, but these charges do not consist of actual sales, and the state- ment should show what in reality is a fact, that certain articles of product owned by the manufacturer have been shipped to con- signees for sale and accounting for the pro- ceeds of the sale. There are certain contracting enterprises which do not fall under the head of manu- facturing, where deviations may or must be made from this general rule. An explana- tion of the special accounting terms used by such concerns is not included in the present Finished Product 77 consideration, which is restricted almost en- tirely to the terms used by merchants and manufacturers engaged in the ordinary lines of business. CHAPTER X PARTLY FINISHED PRODUCT pARTLY finished product consists of articles in process of manufacture at the time the inventory is taken, which are intended to be completed and become finished and salable stock in the ordinary course of the business. Such partly completed articles should be valued at cost of labor and material, plus a proper proportion of the expenses of the business to the time of inventorying, as ex- plained under the description of finished stock. In some lines of manufacture it is com- paratively easy to estimate the cost of goods partly finished at the time the inventory is taken. In other lines it is exceedingly diffi- cult to estimate the amount of labor, ma- terial, and general manufacturing expenses which have been absorbed in the course of manufacturing the articles not yet fully fin- 78 Partly Finished Product 79 ished. Where the total of such articles would, if correctly inventoried, form an im- portant bearing upon the net worth, manu- facturing plants cannot well do without some form of cost accounting which will show the cost of the manufactured product in every stage of its progress through the fac- tory, from raw material to its finished state. It may be simple to estimate the amount of material and direct labor, and even direct expense, consumed in a partly finished article, but the distribution of indirect or overhead expense i.e., such expenses as cannot be easily identified with any particular object of the many produced presents a much more difficult problem. Some adequate plan must be provided for this, or otherwise the application of such expenses at the time of inventorying is likely to lead to misrepre- sentation in the accounts. The Perpetual Inventory Contrasted with 'the difficulty which every manager who does not have a cost system ex- periences in placing the proper valuation on 80 Net Worth and the Balance Sheet partly finished articles is the comparatively simple problem presented to the manufac- turer whose cost records are carefully planned and can be safely used in obtaining inventory values. In some concerns the amount and cost of every article in stock, whether fully or partly manufactured, can be readily ascertained at any time. Some, indeed, maintain a perpetual inventory of all supplies, materials, goods in process of manufacture, and finished product. In such cases the actual inventory of unfinished product consists merely of the verification of its existence. For this purpose a list of the unfinished articles shown by the records to be in exist- ence in various stages of manufacture in the different departments of the factory is pre- pared, and the actual weighing and counting is undertaken merely as a proof of accuracy, in much the same way that a cashier counts his cash in confirmation of the cash balance shown in his cash book. Ordinarily, when information is wanted as to the amount of cash on hand, it is not Partly Finished Product 81 necessary for the cashier to go to his cash box and by actual count assure himself of the contents. An actual count is undertaken, of course, with sufficient frequency to pre- vent mistakes in his actual cash, but for gen- eral purposes he may safely rely upon the balance supposed to be on hand as shown by his cash book. In the same manner, properly planned and maintained cost accounts should at any time produce the most satisfactory information as to the quantity and cost of not only the raw materials and finished stock, but of the amount and cost of the goods which have not yet reached the completed state. Parts of articles made up in advance of actual assembling into the finished product should be inventoried at cost, plus in some cases a proper proportion of general ex- penses to time of inventorying as explained under Finished Product. In some lines of manufacture the product consists of complicated machinery or other articles, the completion of which calls for the assembling of more or less numerous 82 Net Worth and the Balance Sheet parts, which have previously been manufac- tured and placed in the store-room awaiting an order for the assembling. A proper system of accounts will produce the cost of each one of these parts so that when assembled the total cost of the com- pleted article may be determined, and in the meantime the cost of each and every part may be readily ascertained. CHAPTER XI RAW MATERIALS AND SUPPLIES term Raiv Materials means uncon- sumed materials purchased and owned, to be used in the manufacture of the finished product of the manufacturer. Raw materials in the elementary sense mean nothing more nor less than earth prod- ucts, such as clay, ore of various kinds, and timber. But as used in the ordinary sense all materials are raw materials, whether in the raw state or partly finished, bought for conversion through labor into another state. For example, brass pipe already manufac- tured is raw material for metal bed manu- facturers, and sheet paper is raw material in the manufacture of books. The valuation of raw materials should be based on the cost, plus freight, and a proper portion of expense of carrying in stock until used. Materials not adapted to the present 83 84 Net Worth and the Balance Sheet shapes, styles, or quality of the product should not be included at higher than scrap value, Inevitably in any manufacture, as the shape and style change from year to year, the stock of raw materials will contain more or less out-of-date material, worth no more than scrap value. Careful scrutiny of this stock should be made by the business man who does not wish to deceive himself re- garding his real net worth. Much of this loss on materials may be prevented if current watchful vigilance is exercised by the manager. An unnecessarily large stock should not be carried. Old ma- terial should be used up as far as may safely be done before new is purchased. This rule is not always observed. It not infrequently happens that requisitions are made by fore- men for certain sizes and shapes of material which do not happen to be on hand, and such stock is ordered immediately by those hav- ing charge of the purchasing of material, when the needs of the foremen might be accommodated to the stock in hand, and by Raw Materials and Supplies 85 this means its volume be kept down to actual needs. Supplies on Hand The item Supplies on Hand means uncon- sumed articles in stock, to be used in the operation of a factory or mill, not entering directly into or forming part of the finished product itself; fuel, oils, repair parts or ma- terials, and packing are examples of supplies. Supplies, as the term is ordinarily used, means certain kinds of materials which must be used by every factory in keeping the plant in running order. This sort of material does not become a part of the manufactured goods, and in carefully planned accounting systems, records of such supplies are kept separately from material consumed in the manufacture of the product. The amount should be kept down to the minimum actually needed. The same caution is required to prevent overloading of supplies as is needed to prevent too much stocking-up of raw ma- terials. The valuation of supplies should be made 86 Net Worth and the Balance Sheet on the basis of cost plus freight, unless, of course, the prices of the supplies have dropped below the original cost, when the same rule applies as to merchandise. To the cost may be added a proportion of the expense of handling and storing. Any worn-out or obsolete article should be included in the inventory at no higher than scrap value. CHAPTER XII REAL ESTATE JN general, the term Real Estate includes any interest in lands. A more restricted use excludes all other interest than actual 'ownership in fee of such land and buildings as are used in the operation of the business. Real Estate should be valued at cost, less depreciation. There are cases in which the value of the land increases to an extent suffi- cient to offset the depreciation of the build- ings, and there are certain cases in which the merchant or manufacturer would be warranted in increasing the amount at which the real estate is carried on his books, but in business circles it is a general rule that such increase should not be placed on the books. Logically, there is no reason why the book accounts representing assets should not be "written up" where book values are below actual values. If a manufacturer "writes 87 88 Net Worth and the Balance Sheet down" the book value to provide against possible depreciation, he ought from every consideration of pure reason be allowed to write up his assets when their value exceeds the book value. In other words, if an ad- justment of book values to correspond with facts is to be commended, the rule requiring such adjustment ought to work both ways, up as well as down. As a matter of practice, while many cases of "writing up" are not founded on facts sufficiently established to warrant it, there are cases in which the writing up is not ob- jectionable. If the method of bookkeeping employed calls for adjustments up and down in definitely expressed accounts, the "appre- ciation" of value would not constitute an addition to the asset account itself, but would call for the opening of another asset account, called "Appreciation of Real Estate," with a corresponding surplus account, probably called "Real Estate Appreciation Surplus." This suggestion is in accordance with the opposite principle of depreciation by which all plant accounts should be kept in such a Real Estate 89 way as to show actual cost, with any esti- mated depreciation shown separately as a reserve account. If the merchant or manufacturer occupies his premises as lessee, he should not include the lease in real estate, but should state the amount or value of the lease, if of a long term and valuable, separately. If the building is leased under terms by which the tenant is obliged to pay for all improvements, any large outlay may be stated in the balance sheet under the head- ing "Improvements," care being taken to write off enough annually to reduce the amount to the minimum at the end of the lease. On the balance sheet of the Scarborough Manufacturing Company the real estate is separated into two accounts "Land" and "Buildings." It is of advantage to those who examine statements to have these items shown separately. When this is done, a better idea of the equipment as a whole and as to its separate parts can be obtained and a better estimate of the amount of deprecia- 90 Net Worth and the Balance Sheet tion can be calculated; the depreciation on buildings from a manufacturing standpoint having little relation to the rise and fall in the value of land. If land and building can be stated sepa- rately, the cost of each should be shown, together with the amount of depreciation to the date of making the statement. The amount of depreciation should be shown as a reserve. The assessed value of the real estate and the market value should also be stated in a footnote. CHAPTER XIII MACHINERY FIXTURES 7l/fACHlNERY as applied to a manufac- turing plant means all plant equipment owned, other than buildings and land; engines, boilers, shafting, belting, genera- tors, machine tools, small tools, appliances, and instruments; such machinery or me- chanical devices as are used in the operation of the mill or factory. Many manufacturing concerns do not in- clude in the plant inventory small tools such as hammers, files, saws, chisels, shovels, and wheel-barrows. Such tools, if subject to con- stant use, usually wear out rapidly and fre- quent purchase of other tools is required, the cost of which is charged to the expenses of operation and not to the plant account. There is no objection to this plan, nor, on the other hand, is it objectionable to include in the plant inventory and carry on the books all small tools at a lump sum fairly repre- 91 92 Net Worth and the Balance Sheet senting the value of such tools as are re- quired to be on hand at all times. The amount of the ledger account need not change unless the number and value of the small tools change materially. Under such circumstances all renewals of worn-out tools may properly be charged to maintenance of the plant as an operating expense. Valuation of Machinery The valuation of machinery shotdd be based upon cost, with the proper deductions for depreciation, and, if buildings are not owned, with due regard for the terms of lease. Appraisal companies, when asked to ap- praise machinery, usually attempt to fix a valuation thereon which they describe as the "reproduction" value at the time the ap- praisal is made. For example, if a machine was purchased many years ago at a cost of $1,000, and at the time the appraisal was made could not be duplicated as a new ma- chine for less than $1,200, the latter amount would be used, to which would be added an Machinery Fixtures 93 estimated amount to represent cost of freight and installation. From the "reproduction" value is deducted the estimated amount of depreciation on the old machine as it stands at the time the ap- praisal is made. If carefully estimated, the total of the inventory and appraisement thus produced represents the estimated amount which would be required to reproduce the machinery in the condition found at the time the appraisal was made. If the amount so found is kept in a sep- arate book and used only for fire insurance purposes, the method is, if carefully exe- cuted, reliable enough for that purpose. If, however, the amount so found is placed upon the books, it sometimes causes a "writing up'' of the machinery accounts and produces a surplus not justified, on the mere assump- tion that new machinery would cost more to-day than formerly. Wherever possible, it is safer for the man- agement of any business to maintain the machinery account at cost, providing for de- preciation by proper charges to the operating 94 Net Worth and the Balance Sheet expenses and corresponding credits to a Re- serve for Depreciation account. There can, of course, be no argument against the conservative adjustment of book values according to established facts, but if machinery values are adjusted and read- justed according to the opinion of successive appraisers, an unreliable balance in the ma- chinery account is likely to result. Further- more, such ups and downs of the machinery account may produce deceiving effects upon the surplus account. If, on the other hand, the original cost of machinery is adhered to, with deductions for worn-out machinery and additions for new machinery, the balance of the account always means something definite. It means that every article of machinery in use at any given time is represented in the machinery account at its original cost. The offsetting account where the wear and tear of the ma- chinery is provided for is, of course, the re- serve account, which will be more fully de- scribed in its own chapter. Machinery Inventory should not include Machinery Fixtures 95 obsolete, dismantled, or worn-out tools or appliances at higher than scrap value. Sometimes machinery of special kinds is purchased to be paid for in instalments. If the full value of the machine is stated as an asset, the amount of the unpaid instalments should appear in the liabilities. Where buildings are not owned, a careful inventory of machinery actually owned by the manufacturer should be made, and a defi- nite understanding between the owner and tenant should be reached as to just what may be removed by the tenant as his property at the expiration of the lease. CHAPTER XIV FURNITURE AND FIXTURES pfURNITURE and Fixtures, as usually understood, means articles of ordinary or special use needed by a merchant or manu- facturer to display his stock of goods or samples, afford conveniences to his custom- ers and clerks, and record his business trans- actions. Ordinarily the term includes many articles, such as, for example, show-cases, desks, racks, shelves, chairs, typewriters, and some- times electric lighting systems, sprinkler sys- tems, partitions, and all improvements not forming part of the building as a building. The furniture and fixtures should be val- ued at cost price, less a proper deduction for depreciation. If the building is owned by the merchant or manufacturer, Furniture and Fixtures may include all the various articles usually so designated, whether separate from or at- 96 Furniture and Fixtures 97 tached to the floors, walls or ceilings, such as elevators, and sprinkling, heating and light- ing systems; but if the building is not owned by the merchant, in inventorying and valuing the furniture and fixtures due regard should be given to the terms of the lease. CHAPTER XV OTHER ASSETS r "PHE ordinary statement forms provided by banks for the preparation of state- ments by their customers are usually very much condensed and provide no special spaces for assets, save those which have been described. Where other assets are to be listed, the term "Other Assets" is frequently used with a blank space or two for the sep- arate listing of important items. In a business of ordinary character, the items which cannot be properly placed under any of the more specific accounts will not be numerous or important, but there are excep- tions to this general rule. In such excep- tional cases all the important assets of the business should be listed and described sep- arately. Horses, wagons, and harness may be of sufficient importance to list separately, in which case the amount should be shown at 98 Other Assets 99 cost with proper deductions for depreciation, or at an appraised value. Funds in the hands of foreign banks and investments of surplus capital in stocks and bonds may be shown under this general head- ing, as well as investments of sinking, in- surance, or other special funds. If large, each of these separate assets should be described and the amount shown. Investments in the stocks and bonds of subsidiary or affiliated enterprises, advances for cash to such enterprises, or charges for goods delivered to them, should be listed here. Treasury Stock Frequently in corporation statements an item called "Treasury Stock" appears as an asset. In some cases the amount represents an asset of the corporation. This is so when the corporation, having issued its capital stock, acquires portions of it for resale. In other cases the so-called Treasury Stock rep- resents merely that portion of the authorized capital stock which has not been issued. In 100 Net Worth and the Balance Sheet the latter class of cases the amount of such unissued stock is erroneously entered at par as an asset and the total authorized capital is entered among the liabilities. A corporation is liable to account to the shareholders for only such capital as has been contributed by them, and therefore the real capital liability can only be the amount of shares actually issued and for which payment has been made. There are, as stated, cases in which its own stock may be acquired by the corpora- tion and become real Treasury Stock. As a rule, capital stock may be issued only for money, property, or services rendered, and it can only be issued at par value for the assets acquired or services rendered. After it is once issued to shareholders and afterward lawfully reacquired by the corporation by purchase or by donation, it becomes the prop- erty of the company and may be sold for any price above or below par. This stock is Treasury Stock in the proper sense. Business Investments Merchants interested in producing com- Other Assets 101 panics will frequently hold stock, bonds, or other assets of various kinds in the concerns for which they act as distributors. As an illustration, many wholesale lumber firms own lumber mills at points distant from their own yards or offices ; also timber tracts for the purpose of acquiring lumber for sale. Care should be taken to describe these holdings, so that it may be seen just what interest the firms have in the mills, and whether the tracts are actually owned or whether the ownership includes merely the stumpage rights. All such items should be so described that the exact nature of the right or title may be clearly seen. Valuation of Patterns Under the head of "Other Assets" also fall the items of patterns, patents, trade- marks, good-will, copyrights, cost of secret processes, formulae, and stereotypes, the val- uation of all of which requires special thought and skill. The first of these assets, patterns, is one the valuation of which has caused much dis- cussion, not only where special castings are made in foundries belonging to the concern, the castings forming one stage only of the process of manufacture, but as well in foun- dries where no other business is carried on besides the manufacture of general castings for other manufacturers. In one case it was found that a concern had been carrying a very large number of pat- terns at full cost value for years, although orders for but few of the castings had been received during that time. In an effort to ascertain the probable value the books were examined for sales. One gear wheel pattern was found to have been unused for over two years, while six of the wheel castings had remained unsold in stock during all of that time. When the expense of making patterns has to be borne by the foundryman, it is hard for him to make up his mind that the value of patterns is very little if the customers do not repeat their orders within a reasonable length of time. What is a reasonable time depends, of course, upon the circumstances Other Assets 103 in each case, but it is much the safer policy to write off the cost of the patterns rapidly until the asset value of such of them as are not in actual use is reduced to a nominal amount. In some lines of manufacture where large varieties of castings are required to produce the articles manufactured, the patterns are valued under general rules more or less rigidly followed by manufacturers in such lines. A rule observed by some manufac- turers is that patterns shall not be carried on the books at a greater value than an amount equal to 10 per cent, of the average yearly sales for the three years preceding the date of valuation. Another rule calls for the writing down of patterns 50 per cent, the first year and 25 per cent, the second year, at which time an appraisement is made and the pattern val- uation adjusted on the books. Another more general rule calls for the establishment of an arbitrary lump sum at which patterns are carried on the books, all expense for patterns during the year in ex- 104 Net Worth and the Balance Sheet cess of that amount being charged off at the close of the year. No general rule adopted by others may be safely followed by any manufacturer. The manager of each foundry and each factory of every kind in which patterns of one de- scription or another are used should study the problem for himself, not leaning too strongly in favor of the thought that some day little-used patterns may be valuable ; nor, on the other hand, leaning too much the other way in favor of reducing the value to a merely nominal sum. Good patterns in a going business possess considerable value, not only because of the reduced cost of re- peat orders but, in addition, because the time saved in reproduction will in itself attract customers, who, in the case of a general foundry, may be in urgent need of castings made from the patterns, or in the case of a factory, may be in need of the manufactured articles of which the castings form a part. There is perhaps no better way to arrive at the value of patterns than by a careful inventory at the end of each year, and an ap- Other Assets 105 praisement. This should be made by those of the management who may be relied upon to be conservative, and take into considera- tion all of the conditions of the business, the part which each pattern plays in the sales, and the prospects of future orders. Valuation of Trade-Marks Trade-marks and brands should not be placed upon the books as assets unless pur- chased from another concern. The actual cost of obtaining original protection of such things is too small to become an expressed asset of the business. Where the business has been incorporated and the trade-marks or brands have been acquired by the com- pany from the former owners, it is perfectly proper for the new owner to enter these items as assets on the books at the purchase prices. Afterwards, serious consideration should be given at each closing period to the book valuation as compared with the actual value. A steel specialty manufacturer has spent considerably over $1,000,000 in advertising his trade-name and trade-mark, and there- 106 Net Worth and the Balance Sheet fore carries the trade-mark on his books at this valuation. He has been successful and could well afford to diminish this amount by writing off freely from it each year for sev- eral years without materially reducing his book profits. But his view is that the trade- mark is worth $1,000,000 and should so show on the books. In this case, being the principal owner of a wealthy concern and the party principally interested, no one can seriously question his judgment. If, how- ever, the amount of the trade-mark asset was essential in his statement in order to produce a surplus or net worth, the actual value would be brought into serious question by an exam- iner for credit purposes, or by any one veri- fying the net worth of the business. In the case referred to the proprietor is mistaking the value of his trade-mark for the value of his good-will, taking everything connected with it into consideration. It is very doubtful whether any one would pay $1,000,000 for the trade-mark separate from the business, its organization, plant, and management. CHAPTER XVI OTHER ASSETS (continued) "New Business" Cost EQUENTLY when manufacturing concerns first begin their operations a large amount of expense must be undertaken in introducing their products before the annual profits on the sales amount to enough to bear the expense of this work. Again, even after the business is established, new policies of expansion may be adopted and large amounts of money be expended in ad- vertising, and for samples, salaries, and ex- penses of special salesmen and representa- tives, before any adequate returns are se- cured. It is quite a common practice among man- ufacturers to carry such expenses along in some form of asset account until the de- veloped or expanded business reaches a point where the expense of obtaining new business can be paid out of the profits. 107 This outlay is sometimes called "Mission- ary Work" or "Introducing Expense," and an account under some such designation may be found on numerous balance sheets. The real asset value of such expenditures is difficult to appraise. The utmost con- servatism is needed if they are to be consid- ered as assets at all. At most, such expenses amount to deferred charges to the regular expense account, since all money expended in obtaining business, whether new or old, must be charged as an expense of the busi- ness sooner or later. In certain cases the extraordinary amounts over and above ordinary selling expense spent in one year may be considered as the cost of obtaining future business and may be spread over a short subsequent period in- stead of being charged in total to the ex- pense of the year in which the money is ac- tually disbursed. Valuation of Good- Will This discussion leads us directly to the subject of good-will, concerning the value of which opinions differ widely. Other Assets 109 An intangible asset, good-will, if admitted to be an asset in any given case, may be of more value than any other item in the entire statement, or, on the other hand, it may be worthless. For this reason it has been sug- gested that it should not appear as an asset at all. In a recent case the question of the value of good-will arose. The owner proposed the sum of $50,000 as the amount which he would accept for the good-will of the busi- ness into which he was about to admit a partner. The business had been running steadily behind ever since it was started, five years before. The proprietor, instead of having built up a profitable business, had, in reality, been able to hold his head above water only by means of the capital ad- vanced to him by friendly banks and indi- viduals. Now in law we say that good-will is the probability that old customers will return to the new proprietors, the assumption being that profits on business brought by these cus- tomers will continue without the exertion 110 Net Worth and the Balance Sheet originally necessary to build up an estab- lished profitable business. What good-will can there be in a losing business? Either the customers are in- herently unprofitable, or the articles do not possess salable merit to a profitable extent, or perhaps the business, while possessing in- herent merit, has been conducted so care- lessly that no real profit can exist until the management is changed. If this last con- dition be found to exist in any given plant, what amount can the proprietor claim for his good-will? He may have many friends who have that good will toward him which impels them to go to him for goods, but will they continue if the prices are raised to a profitable point or if the management is changed? It would seem that when a man claims pay- ment for the good-will of his business he should be able to point to the net worth as shown by his books, and also to the profit he has made in the conduct of his business through increasing numbers of satisfied cus- tomers. He should be able to say, "Here is Other Assets 111 my business. My books do not show all of my assets. I have built up a successful busi- ness, which now has a momentum sufficient to insure profits to you right from the start. That, gentlemen, is my good-will." Good-will, when purchased with the other assets of the business, ought, according to general custom, to be written down each year until it has entirely disappeared from the books. Good-will is an asset of great value when a successful business is being sold, but as a part of a business man's net worth or surplus expressed in the figures on the books it is not so attractive to him or to any one else. When the time arrives for selling the business the buyer will hardly pay any attention to the amount of good-will as expressed in the assets. His judgment will be based upon a thorough examination of the nature and character of the business, its vol- ume, its customers, and its profits, and he will also want to determine from every point of view the effect the staying in or going out of the old proprietors will have on the busi- ness. 1 12 Net Worth and the Balance Sheet Deferred Assets Under the general heading of "Other Assets" on a balance sheet will appear also prepaid items of expense, such as insurance, taxes, interest, rent, and sundry expenses, which, in a finely calculated system of ac- counting, constitute items of expense actually paid in the period immediately prior to the inventorying, but a part of which expense, ascertained by calculation, justly belongs to the following period. These items are some- times classed as "Deferred Assets" or "De- ferred Charges to Operation," the meaning of the term being that the items, while not assets in the ordinary sense, are expenses paid in advance and not expenses of the period closed. They form items of expense which have been deferred until the later period of accounting. Reserve Fund Investments In the specimen balance sheet of the Scar- borough Manufacturing Company are two accounts indicating that the company holds securities of other corporations as invest- Other Assets 113 ments. Just what the nature of these invest- ments is does not appear, but the name of one of the accounts, Reserve Fund Invest- ments, is an indication that whatever the securities may be, they have been purchased in pursuance of the idea of actually setting aside and investing a portion at least of the reserved profits. Among the liabilities will be found Re- serves, $108,417, consolidating several ac- counts on the books, to which have been credited the periodical instalments of reserve taken out of the regular profit and loss ac- counts by means of charges. An analysis of the Reserve accounts is given in the chapter on Reserves, where it will be seen that a part of the amount con- sists of a Sinking Fund Reserve. Under the terms of the mortgage given as collateral for the loan shown in Bonded Debt, instal- ments of $5,000 each year must be set aside so that in twenty years from the date of the loan, when it is due, there will be on hand money to the full amount of the loan ready to pay it off. 114 Net Worth and the Balance Sheet The Scarborough Manufacturing Com- pany set aside the instalments for five years, and invested the amount in first mortgage bonds of several railroad companies. The amount paid for securities, with premium, was, on December 31st, $22,626.79. The treasurer of the company is awaiting a favorable opportunity to invest the unin- vested portion of the reserve. Other Investments The "Other Investments" on the balance sheet represents an investment of $10,000 in some small tenements rented to its em- ployees, on which mortgages had been placed prior to the time the company acquired the property, and also several lots of stocks of corporations which the Scarborough Manu- facturing Company has been obliged to take in part satisfaction of accounts due them from customers, and which are carried at $7,428.72. These stocks have no market value and their actual value could not be de- termined without a special examination of the affairs of the corporations by which they Other Assets 115 are issued. No dividends have been paid on these stocks for a number of years, and the probability is that they are not worth much. CHAPTER XVII NOTES PAYABLE TN THE Scarborough Manufacturing * Company statement provision is not made for a separation of promissory notes given for merchandise purchased, from notes given for money borrowed. In many balance sheets these two different classes of liabilities are shown separately. We will first discuss Notes Payable for Mer- chandise Purchased, which mean unpaid promissory notes or drafts not due, given in the ordinary course of business for mer- chandise, materials, supplies, or other articles used in the business. The term should in- clude all similar notes payable negotiated by branches, or agents acting for the merchant or manufacturer. The term Bills Payable is the one most commonly used to designate this class of commercial paper, and as so used it has a more definite meaning to the courts and to 116 Notes Payable 117 lawyers than the term Notes Payable. It will, however, be found in practical experi- ence that there is frequently considerable confusion in statements of condition between notes given to merchandise creditors and bills received from merchandise creditors, the term Bills Payable being applied to both. Some merchants, manufacturers, and bank- ers too, think of a Bill Payable as being either a promissory note or an invoice for merchandise. While no lawyer or court would misunderstand the use of the term Notes Payable, many merchants and manu- facturers would misunderstand the use of the term Bills Payable, so that it seems best to use the one term which will be best under- stood by all. Banks sometimes scrutinize any large vol- ume of notes given for merchandise, under the belief that the better practice for business houses to pursue is to borrow money from bank and pay for their purchases in cash, taking advantage of cash discounts offered. Banks having this view are inclined to think that notes given for merchandise purchased 1 18 Net Worth and the Balance Sheet indicate inability to properly finance the business. Notes Payable for Money Borrowed Notes Payable for Money Borrowed are unpaid promissory notes or drafts not due, given for money borrowed from banks, bank- ers, or other persons, firms or corporations, for use in the business. Notes payable to commercial note brokers, or to banks through them, should be stated separately. In some cases the relative pro- portion between the loans effected through brokers and those obtained directly from banks indicates conditions which would not be clear if the two accounts were consoli- dated under the general head "Notes Pay- able for Money Borrowed." Some large concerns can best finance their operations through the services of note brok- ers in conjunction with their own banks, while others can be accommodated suffi- ciently through their own banks without out- side assistance. But some smaller concerns mistake the Notes Payable 119 position in which note brokers are most use- ful and go to them to the neglect of their banks. It is usually much wiser for all busi- ness men who desire to secure the valuable services of note brokers to do so with the knowledge and acquiescence of their banks. CHAPTER XVIII ACCOUNTS PAYABLE TN THE general sense, the term Accounts Payable means all unsettled credits to parties for goods purchased, received, and accepted; also credits for unpaid salaries or wages, temporary loans and other unpaid obligations to creditors; amounts owed by a business concern to others as shown by the books, but not represented by promissory notes, drafts, bonds, or judgment of mort- gage. In the more restricted sense, the term Ac- counts Payable is intended to represent only unpaid invoices for merchandise purchased. It includes only the aggregate of unsettled credits for merchandise, materials, supplies, or other articles purchased for sale, either in its present form or to be manufactured, or for use in the business. In the ordinary course of bookkeeping, credits of invoices for goods received and 120 Accounts Payable 121 accepted are entered at once in an account with the creditor, regardless of the date of payment called for by the terms of the pur- chase. Thus any general total of Accounts Payable will not disclose whether the credits are under- or overdue, according to the terms of purchase. In order that a more intelli- gent understanding of the business may be obtained, it is desirable that the accounts with such creditors be divided into "not due" and "overdue." Business men want to know what portion of the Accounts Payable is falling due dur- ing the next week and month, and they will want to know at the same time what part of their Accounts Receivable may be expected to be collected in time to take care of those payments as they mature. In the mind of the careful executive it is not enough for him to know that the cash balance is large enough to meet the payments falling due during the next few days. Be- yond this, and regardless of the cash balance at any time, he will plan, if possible, to have the collections of debts due his concern pro- 122 Net Worth and the Balance Sheet duce the funds with which to pay all concur- rent obligations. For that reason it is clearer to him if a statement is prepared showing amounts "not due" and "overdue" on both sides of the bal- ance sheet. Of course he will want much more detailed information regarding Ac- counts Receivable and Accounts Payable than can be incorporated in a condensed statement, but even if they are only classified into "not due" and "overdue," the informa- tion is valuable and enables him to make searching inquiries should "overdue" appear in connection with either one of the accounts. Explanations may satisfy him, but he will want to know why the Accounts Receivable are not collected more promptly and why the overdue merchandise bills for purchases by the concern have not been settled and cash discounts obtained. Care should be taken to ascertain that all invoices for purchases received are entered on the books and included in Accounts Pay- able. If, according to the method of book- keeping employed by a business establish- Accounts Payable 123 ment, any such invoices are omitted from the books during the year, the amounts thereof should be carefully gathered and stated in the balance sheet. For example, some bookkeepers file bills for such things as office supplies, freight, cartage, and other petty expenses without making any entries concerning them on the books until paid, when the amounts thereof are charged to the expense accounts. At the time a balance sheet is prepared, many such bills may be found on the file, but not among the liabilities on the books. Their amount should, of course, be brought into the balance sheet. CHAPTER XIX DEPOSITS " [DEPOSITS" in the sense used here mean credits for money deposited for safe-keeping or in trust for special purposes, such as deposits of employees' beneficial or savings funds. Among large manufacturing corporations a custom is growing whereby the manage- ment encourages the employees to save a small proportion at least of their wages. Those of the employees who accept the plan consent to the withholding of certain agreed- upon amounts from the pay envelopes, which amounts the company's officers credit on the general books to some such account as "De- posits of Money by Employees," or "Em- ployees' Savings Fund," as a controlling ac- count, the detailed account with each em- ployee being recorded in separate or sub- sidiary books. There are several varieties of these de- 124 Deposits 125 posit arrangements, in some of which inter- est is allowed by the company, and to which the company contributes regular amounts, either voluntarily each time the contribu- tion is made, or according to a stipulated agreement with the employees, the object being to encourage them to accumulate their savings. Another phase of "Deposits" is found when deposits are made by customers of a mercantile concern in expectation of pur- chases at its stores, the amounts of any such purchases being charged to these deposit ac- counts. Interest is allowed on the average balance of such deposits, and, in addition, an amount is credited to the account of the indi- vidual in the form of a certain percentage calculated upon the aggregate of his pur- chases during the year. Deposits as used here should not include any loans of a nature calling for entry in other loan liability accounts, nor should it in- clude deferred dividends to stockholders or salaries allowed to remain in the business, or loans from officers, partners, special friends, 126 Net Worth and the Balance Sheet or relatives, intended to be withdrawn on de- mand. In order to give a clear conception of the liabilities of the merchant or manufacturer, such loans as may or must be paid prior to the other creditors on open account should be listed separately and fully described. CHAPTER XX BONDED DEBT "DONDED DEBT" as used in financial statements means the amount of money borrozved upon a promise to pay at a definite future time, with real or personal property mortgaged as collateral security. Usually the mortgage is executed in favor of a trustee for the bondholders, and bonds in convenient denominations are issued, each one of which describes the nature and amount of the debt in general terms, refer- ring to the mortgage agreement for further information, if desired. Where serial bonds are issued, secured by a mortgage on the plant, the total amount of the bonded indebtedness should be stated "in short," with a deduction of the amount not issued, so that the amount extended in the liability column will represent the net lia- bility. Ordinarily bonded indebtedness is secured 127 128 Net Worth and the Balance Sheet by a mortgage covering all of the real estate used in the business. If more than one mort- gage or lien exists on the whole or any part of the real estate, it would form a clearer statement of the actual condition of the mer- chant or manufacturer if these mortgages or liens were separately listed and described and the property on which they form a lien briefly designated. Where unsold bonds of a corporation are delivered as collateral for loans obtained, a notation of the amount thereof should be made in short under this heading, or in a foot- note at the bottom of the statement. There are various kinds of bonds denot- ing the lien on the property bonded, such as First Mortgage, Second Mortgage, General Mortgage, Refunding, etc. There are also Income Bonds, issued b v y a corporation, the interest on which is payable only out of the income of the corporation. Bonds may be registered with the income payable to the registered holder, or they may be registered as to principal only with cou- pons payable to bearer, or they may be pay- Bonded Debt 129 able to bearer both as to principal and in- terest. Another term applied to a form of securi- ties is "Debentures," which is an English term meaning bond. While a debenture may be secured by a mortgage, it does not neces- sarily include the idea of a mortgage. The security may rest in a charge on definite or indefinite property, while a regular bond and mortgage always constitutes a transfer of the real estate covered, the transfer to be de- feated only upon payment of the principal and interest. A form of debenture sometimes arises after a mortgage has been placed on a manu- facturing plant and the bonds secured by the mortgage do not sell as readily as ex- pected. Banks may be willing to loan tem- porary funds on the promissory note or de- benture of the company, with the bonds de- posited with a trustee as collateral security, when they would not purchase the bonds out- right. CHAPTER XXI MORTGAGES TITE HAVE just discussed Bonded In- debtedness. In the case of most large industrial corporations the bonds issued for capital obtained consist of serial denomina- tional bonds secured by one mortgage placed upon the corporation's property for the se- curity of all bondholders. In other cases, particularly of the smaller concerns, the reg- ular serial bond does not appear, but instead the loan is obtained by the owners on the con- cern's single bond with a mortgage on the real estate as collateral, the mortgage being executed in favor of the individual firm or corporation loaning the money. In this class of loans it is usual to describe the form as that of a loan on mortgage, a term which in this sense, as a liability, means Mortgages or other Hens on real estate; money borrowed with the real estate of the business described in the mortgage pledged as security for payment. 130 Mortgages 131 In many statements the real estate and machinery forming the plant, if mortgaged, are carried at an amount equalling the differ- ence between the full value and the amount of mortgage. This difference is usually styled the "equity" in the property. But this does not give a just presentation, for besides the lien given on the property, the mortgagor assumes personal responsibility to pay the full amount borrowed in case the debt is not paid when due and the mortgaged property does not produce enough money to satisfy the debt. If the sale of the real estate does not satisfy the amount of the mortgage, the mortgagee can collect his debt out of other assets of the business. For this reason, if for no other, the liability to pay the debt should appear on the books as a liability and the full amount of the real estate and ma- chinery as an asset. The amount of the mortgages on the bal- ance sheet should also include any mortgage liability, subject to which the property was acquired by the present owner. When prop- erty is thus taken over by the merchant or 132 Net Worth and the Balance Sheet manufacturer subject to a mortgage pre- viously placed on it, the purchaser does not under ordinary circumstances assume any personal liability to pay the mortgage. In such case the rule stated above, that every mortgage should show on the books as a liability, might not seem to apply, but the desire to present a complete statement would still impel one preparing it to set out the full mortgage liability of the concern. In making up an ordinary statement the question of priority of liens does not arise. It is only necessary to show the full amount of the real estate as an asset and the amount of liability in the form of liens against it. It would be very difficult to prepare the ordi- nary balance sheet of a merchant or a manu- facturer so that it would exactly express the relation between the various classes of his secured and unsecured creditors so that his full and complete legal relation to each and all would be indicated. If real estate other than that used in the immediate operation of his business is owned by the merchant or manufacturer, the Mortgages 133 amount of such real estate should be stated as an asset separately from the amounts of real estate used in the business. Likewise, where mortgages or other liens exist against this separate property, such mortgages or liens should be stated in the liabilities sep- arately from the mortgages or liens on the real estate used in the business. For example, there might appear In the Assets Land and Building in Plant. . . $200,000 Property, I5th Street 10,000 And in the Liabilities Mortgage on Plant 50,000 Mortgage on I5th St. Property 2,000 In order to carry out the idea of fully ex- pressing assets and liabilities on the balance sheet, it is desirable that the full value of land owned subject to an annual ground rent be carried as an asset and the capitalized lien of the ground rent be entered as a liability. In short, the balance sheet should include the amount of all instruments recorded or unrecorded, which are or which may become when recorded a lien on the real estate. CHAPTER XXII OTHER LIABILITIES IN THE usual balance sheet form provided by banks for the use of customers there rarely appear separately listed liabilities other than those which have been described. In ordinary cases all liabilities of the mer- chant or manufacturer are shown in these accounts, except such small incidental ex- penses as are commonly omitted from even carefully calculated statements of condition. Sometimes, however and frequently in some lines of business items not found in the accounts described in the foregoing chap- ters must be entered in the balance sheet. To provide for such items the term "Other Lia- bilities" is frequently printed at the bottom of the statement, with a blank space or two for separate classes of items. Sometimes under this heading appear ac- counts showing the amount of dividends de- clared but not yet paid, unpaid legal fees, 134 Other Liabilities 135 insurance, rent, taxes, interest on ordinary loans and on bonded debt, royalties, and commissions, which items may or may not show under the heading of Accounts Pay- able, according to the method of bookkeeping employed. In many cases when an analysis is made of the lumped accounts described as "Other Liabilities," items are found which materi- ally alter the impression produced by an in- spection of the statement before such anal- ysis is made. Accrued Liabilities In addition to the unpaid items due at the time of the preparation of a statement, and any items which though not due have been passed through the books into Accounts Pay- able, there may be other items for salaries and wages, insurance, rent, taxes, or interest, which, though constituting liabilities to the amount accrued to the time the statement is made, may not be actually due for payment until some time later. In order that the full liability of the concern may be shown, a care- 136 Net Worth and the Balance Sheet ful calculation should be made of the pro- portion or part of the liability accrued on each of these items to the date of the state- ment. For example: If the pay-roll week ends on Thursday, the 28th of the month, and the fiscal year ends on the 30th of that month, there will be the wages of the plant for two days to take into consideration, although the next pay day will not arrive for four working days after the end of the fiscal year. The product on which the men were engaged is taken as an asset, so the unpaid wages for the two days should be stated as a liability. Thus, assuming the total weekly wage roll to be $60,000, the accrued wages will be $20,000. In the ordinary business concern, if the bookkeeping is well managed, the amount of accrued items should not be large enough to materially affect the net worth in most cases, the accrued assets omitted from the state- ment practically offsetting the omitted ac- crued liabilities. But in many cases the addition of these Other Liabilities 137 accrued items will throw quite a different light on the business, especially where such items are large and are paid at infrequent intervals. If, for example, the taxes of all kinds amount to a considerable sum, and are paid but once each year at about the same time, the amount of accrued taxes just prior to the payment would be a material item. But under a good system of bookkeeping the amount of these taxes is spread over the expenses of the year in monthly instalments, which appear on the books as a liability be- fore the actual payment, or, if taxes are paid in advance, their amount is distributed in the same manner, so that the actual cash pay- ment, while depleting the cash balance to that extent, does not disturb the net worth of the concern. CHAPTER XXIII CAPITAL AND CAPITAL STOCK npHE excess of assets over liabilities con- * stitutes the net worth or capital of an individual, firm, or corporation for whose statement of financial condition the balance sheet is prepared. In the economic sense of the word, capital means wealth, and in that sense all of the assets to which the possessor has legal title constitute his wealth or capital, regardless of his unpaid debts, even though these may have been incurred in the purchase of some or all of those assets. In the business sense, however, capital means the amount of one's own capital or in- terest in the business as distinguished from capital borrowed from others, either directly as a loan or indirectly by means of purchases of equipment, material, or supplies for which payment has not been made. Thus, in order to find the net capital of any concern, the liabilities must be deducted from the assets, 138 Capital and Capital Stock 139 the remainder constituting the capital or net worth of the business. When the net profits of an individual sole owner of a business are ascertained, the amount is usually transferred directly to his capital account, which should at the end of every closing period form the exact balance between his assets and his liabilities, and ex- hibit his net worth. In the case of a partnership, the net profits are usually divided at the end of stated periods according to the terms of the part- nership agreement, and the amounts so de- termined are credited to the several partners' accounts, the sum of these accounts forming the capital or net worth ; provided, both as to individuals and partnerships, that care has been taken in adjusting the book value of the assets to agree with the actual value as nearly as possible ; and provided also that all of the assets and liabilities are placed upon the books. In an individual's or firm's statement the capital will be shown by the credit balance of the individual's or partners' capital accounts, 140 Net Worth and the Balance Sheet a capital account being kept in the name of the individual owner, or, in case of a firm, in the name of each and all of the partners. ^fc*. Capital Stock In a corporation, if only one kind of stock is issued, the capital will be shown in the sum of the Capital Stock account on the ledger, or, if more than one kind of stock is issued, then in accounts for all classes of issues. The capital stock should be entered at the par value of the shares issued, unless these are issued when only part of their par value is paid, in which case the amount paid in only should be credited to the capital account./fhe holdings of each individual are shown in a subsidiary book called the "Shareholders' Ledger," the aggregate of the shares credited to the individuals agreeing at par with the amount of capital stock issued, as shown in the one account of each class of stock on the general ledger. The capital stock of a corporation may be divided into several classes, such as common, first preferred, second preferred, etc. There are other kinds of stock that may be Capital and Capital Stock 141 issued, but these are the most frequent. In fact, it is not usual for manufacturing or trading corporations to issue other than "common stock" and "preferred stock." Until comparatively recent years the entire capital stock of a corporation consisted of what is now known as "common stock," and it was issued for cash or for property ac- quired for use in the business. Originally the use of preferred stock was generally lim- ited to cases in which the common stock had all been issued and additional capital was needed. The special stock was then issued to those who would furnish the capital. The use of this stock is not now limited to special purposes. Such stock is known as "preferred" stock because the individuals to whom it is issued possess special privileges or "preferences" not possessed by the com- mon or ordinary shareholders. In some cases the special privileges of pre- ferred stock consist in the right to dividends at a stipulated rate before the common share- holders can receive any of the profits of the business. 142 Net Worth and the Balance Sheet An additional privilege is given to some of the issues of preferred stock described as "cumulative preferred," consisting in the right to receive "back" or unpaid dividends before the common shareholders can receive dividends in case the corporation fails in any one or more years to earn profits to a suffi- cient extent to pay the current stipulated dividend on the preferred stock. In other cases the preferred stockholders are not only preferred as to dividends, but in addition they are preferred as to distribution of assets upon dissolution of the corporation after liabilities are paid. Some of the pre- ferred stock issues possess one or more of these special privileges and some possess all ; the special preferences over ordinary share- holders being granted to make the preferred stock more attractive to purchasers. Formerly when preferred stock was issued, it was intended, as a rule, to call it in and pay the shareholders its par value within a short time, the common shareholders being left in possession of their full rights to profits and property. This idea is still retained in some Capital and Capital Stock 143 issues of preferred stock, but it is not so com- mon as formerly. In later years a great many corporations have been formed to take over existing prop- erties and have issued preferred stock or bonds for the cash and property acquired, while the common stock has either been given along with the preferred stocks or bonds as a bonus, or has been issued for the supposed good-will of the acquired properties. As a result, the common stock has degenerated into a condition in which in many corpora- tions it represents very little, if anything at all, when first issued. Capital Stock and the Property Account In inspecting the balance sheet of a cor- poration it is very important to determine whether all of the stock has been issued for actual property or whether some of the amount outstanding represents nothing of any tangible value. Frequently we find in balance sheets a condition similar to the fol- lowing: 144 Net Worth and the Balance Sheet NATIONAL IRON COMPANY Assets : Property Account $4,552,339.00 Investments 115,714.15 Inventories 53> I 95-35 Bills and Accounts Receivable. . 235,555.00 Cash 64,430.35 Prepaid Expense Items 5>54-75 Total $5,503,738.60 Liabilities : Preferred Stock $2,500,000.00 Common Stock 2,500,000.00 Bonds and Mortgages 20,000.00 Accounts and Bills Payable. . . . 164,282.25 Accrued Items 3,657.60 Surplus 3 I 5.798-75 Total $5.503-738.60 In this statement it will be seen that equal amounts of common and preferred stock have been issued. According to present methods, the natural presumption is that both were issued in acquiring the plant assets which are included in the foregoing statement Capital and Capital Stock 145 under the one heading "Property Account" ; but whether the actual property acquired is worth the amount at which it is carried is not disclosed in the statement. Property ac- count in this case may represent the actual value of the assets, without regard to the earning power or good-will of the business. But, on the other hand, the account may rep- resent, besides the actual value of the plant, the par value of stock, both preferred and common, given in excess of the actual value to cover the good-will. It may also in this case contain discount on preferred stock and other items, which the use of such a general term as "Property Account" properly or im- properly permits. It may be that the bulk of the preferred stock was issued for the property, the re- mainder of the preferred stock being issued for cash capital, in which case the Property account may include the value of the good- will, represented by the amount of the com- mon stock. It is evident that a large part of both classes of stock must be represented by the Property account, because there are 146 Net Worth and the Balance Sheet no other assets large enough to explain their issuance. The capital stock issued amounts to $5,000,000, while the Property account amounts to $4,552,339, showing that the bal- ance of the stock, amounting to $447,661, was probably issued for other assets. It may be, of course, that the entire issues of both classes of stock were given in payment of the property, which was then valued at $5,- 000,000. In this case, since the Property ac- count balance is less than the par value of the stock, the company has presumably ap- plied its earnings to the reduction of the Property account. Enough has been suggested as to the possi- bilities in this case to show that the use of the bulk account "Property Account" pre- vents the observer from accurately ascertain- ing the true condition of a corporation in whose balance sheet the item is found. CHAPTER XXIV SURPLUS PROFITS TN THE restricted sense, surplus means accumulated undivided profits arising from the operation of a business. When used in a less restricted sense, par- ticularly in a corporation statement, it means the excess of assets over liabilities and cap- ital. In this sense surplus may include, be- sides the profits of the business, gains arising from acquisition of assets other than those that form the purpose for which the corpora- tion was organised. An example of surplus under the less re- stricted use of the term is furnished when stock in a corporation is sold to subscribers at a fixed amount per share over and above the par value, the excess providing a surplus at the beginning of existence of the corporation. This method of establishing a surplus is not often used by other than financial or insur- ance institutions. 147 148 Net Worth and the Balance Sheet Surplus Not from Earnings An example, sometimes found in ordinary manufacturing corporations, of an increase of surplus not due to earnings is furnished when subscribers donate to the corporation for its own benefit shares of capital stock previously purchased by them. When treas- ury stock thus acquired without cost to the company is placed on the books in money value, some bookkeepers credit a correspond- ing amount to the Surplus account. To the ordinary observer this gives the false im- pression that the Surplus account shown on the balance sheet has been earned by the com- pany from the operation of the business. Some accountants place the amount so ob- tained to the credit of an account called "Working Capital" or "Capital Surplus," in order to distinguish the book surplus so ac- quired from the earned surplus. Another case of increased surplus not due to earnings is sometimes found when a busi- ness owned by an individual or partnership is sold to a corporation, the payment being made in capital stock of the company. If the Surplus Profits 149 amount of stock issued at par is less than the book value of the net assets taken over and the amounts of the assets are transferred to the books of the corporation without deduc- tions, a surplus of book assets over liabili- ties will be created which the bookkeeper will probably credit to Surplus account. If the net assets are worth the amount at which they were entered on the new books, of course the surplus so constituted is a real surplus, although not earned by the new com- pany ; and nothing further need be said, save that, when subsequent balance sheets of the new corporation are prepared, a clearer state- ment of condition is presented if the surplus acquired from the old business is shown sep- arately from the surplus or accumulated profits earned by the new corporation. But in some cases the assets of the old con- cern are not worth their book value, and the apparent surplus is no real surplus at all. In such cases the Surplus account may be misleading to any one inspecting statements of the corporation, because the natural pre- sumption is that the Surplus account repre- 150 Net Worth and the Balance Sheet sents profits earned, and indicates the ability of the company to build up not only a success- ful dividend-paying business, but as well to provide a reserve against future needs. In- quiry should always be made concerning the Surplus account in order that it may be made clear just what part of it has been earned and what part has been built up by other means. Accounts in Which Surplus May Appear If the excess of assets of a corporation over liabilities equals the capital, there is no surplus, in the general sense, the capital just balancing the excess or net worth of the busi- ness, but if there is an excess of assets over liabilities and capital, there is a surplus, and while it may not be shown under that name, it is there. It may appear in a busi- ness statement as Profit and Loss, Earnings, or Undivided Profits, or be shown in part by a surplus account representing accumu- lated profits earned prior to the current year and in part by a profit and loss account representing only the balance of profits of Surplus Profits 151 the current year after all expenses are paid and dividends disbursed. When any classification of the surplus is shown in the statement, a good arrangement is as follows: (a) Surplus representing accumulated undivided profit to the beginning of the cur- rent fiscal year. (b) Profit and Loss representing the net profits for the current fiscal year. (c) Special Surplus book surplus de- rived from sources other than actual earn- ings. The surplus account is not commonly found on the books of individuals and firms, the profits being accumulated in the owners' capital accounts in the manner already de- scribed. In one sense, the surplus of a business means the excess of assets over liabilities, and it is sometimes called "Surplus Assets." In the case of individuals and firms, surplus means the same thing as capital or net worth. 152 Net Worth and the Balance Sheet The Corporate Surplus In corporation accounting more formality is required than in that of firms or individ- ual owners, and the usual procedure when a balance sheet is taken calls for the finding of the net profits for the year and then for the determination of how those profits shall be appropriated, including the amount to be dis- tributed in the form of dividends to the shareholders. After the deductions for ex- traordinary expenses, investments, etc., are all made, the net amount is usually trans- ferred to the Surplus account, where it re- mains as a fund which may be drawn upon to meet extraordinary occurrences or for payment of dividends in years when the net profits are not sufficient in themselves to pay the customary or desired dividends to stockholders. As will be seen, the term "Surplus," when used in corporation accounting, does not merely indicate the excess of assets over lia- bilities, but is used to show the excess of assets over both liabilities and the contrib- uted capital as represented by the shares of Surplus Profits 153 stock issued. This is shown in the following: o illustration : Assets $500,000 Liabilities 250,000 Net Worth $250,000 Capital Stock 200,000 Surplus $50,000 or put in the ordinary balance sheet form: Total Assets. .$500,000 Total Liabilities$25O,ooo Surplus 50,000 Capital Stock.. . 200,000 $500,000 $500,000 This use of the term surplus does not at all affect the idea of net worth, which means, in each and every case, the excess of the actual value of the assets over the total of all the liabilities at the time the calcula- tion is made, regardless of the capital con- tributed originally or the amount of the cap- ital stock issued and outstanding. Thus in the foregoing example the net worth is $250,000, divided into Capital Stock $200,000 Surplus 50,000 154 Net Worth and the Balance Sheet Corporate Liability for Surplus The corporation, as a separate entity from the shareholders as individual contributors, is certainly answerable to the shareholders not only for the money contributed, but as well for the amount of surplus or accumu- lated profits not previously distributed to them in the form of dividends. This liability of the corporation to its shareholders is, however, of a different na- ture from that of its liability to its outside creditors, for while it must ultimately ac- count to the shareholders for the amounts of their contributions and profits, its accounts with creditors must first be settled. If the corporation is liquidated, and after settle- ment with all creditors a balance of assets is found to be in hand, the shareholders are entitled to a distribution of those assets pro rata according to the number of shares held by each, taking into account, of course, the prior rights of the preferred shareholders, if any. If the balance of assets so distributed equals or more than equals the amount of the shareholders' contributions, well and Surplus Profits 155 goo'd; but if the settlement with creditors leaves a balance of assets too small to repay the shareholders, they must suffer whatever loss they sustain without complaining, unless, indeed, some action may be taken by the shareholders against the officers and direct- ors for the mismanagement that has pro- duced the unfortunate or criminal condition. But, except in cases where the mismanage- ment is such that the law will compel those in charge of the affairs of the corporation to reimburse the shareholders, they have no redress for their losses. Hence the state- ment that the liability of a corporation to ac- count to the shareholders is not a liability in the usual meaning of the term. Corporate Deficit Sometimes we find in balance sheets this condition : Assets $450,000 Liabilities $300,000 Deficit 50,000 Capital 200,000 Total .$500,000 Total .$500,000 which means that while the net worth of the 156 Net Worth and the Balance Sheet concern is $150,000, its capital has been im- paired to the extent of $50,000. The surplus not only does not exist, but in its stead there is a deficit, or shrinkage in the actual book value of the capital stock. Stated in another way, the condition would be : Assets $450,000 Liabilities 300,000 Net Worth $150,000 Capital Stock $200,000 Less Impairment 50,000 $150,000 In whatever form the surplus appears on a balance sheet, inquiry should be made as to its source, and an analysis of this account for a period of not less than five years imme- diately preceding the date of the balance sheet will throw much light upon the condi- tion of the concern whose net forward or backward movement it represents. CHAPTER XXV RESERVES T3ESERVE accounts consist of charges **' against the earnings of the business transferred to these accounts as credits, for the purpose of offsetting shrinkages in asset values. The most common of these reserve accounts are ordinarily designated as "Re- serve for Bad and Doubtful Debts," and "Reserve for Depreciation of Plant." In some cases an account representing the same thing appears as "Contingencies Account" or "Reserve for Contingencies." In the ordinary form of balance sheet the total of the debit balances, or assets, is shown at the foot of one column and the total of the credit balances including capital, sur- plus, and reserves is shown at the foot of the other column. Of course such items as reserves are not liabilities, but they are placed in the liability column to offset the book values of the assets. In other words, 157 158 Net Worth and the Balance Sheet when the assets are listed in the statement at the full cost value, reserve accounts should be shown under the head of liabilities. Reserve for Bad and Doubtful Debts Reference has been made to the care which must be exercised in valuing open accounts due from customers. After all accounts known to be worthless are eliminated and the remainder seem perfectly good, there is still some probability that the actual cash to be realized in the collection of the accounts will fall short of the full face value thereof. It is rarely that accounts representing several thousands of customers and aggregating hundreds of thousands of dollars will each and every one be settled without loss or ex- pense for collection. For this reason an amount calculated as a certain percentage of the total of sales, based upon past experience, should be set aside out of the profit as a reserve to provide against shrinkages of this kind which would other- wise render the statement of the concern's net worth misleading. Reserves 159 The amount so set aside becomes an esti- mated loss for bad and doubtful debts, though these debts are not known to be bad or doubtful at the time the statement is made. The amount set aside is placed to the credit of the reserve account. Sometimes the cor- responding debit is charged direct to Profit and Loss account, but more often, and partic- ularly in bookkeeping systems where it is desired to show the full operating expenses, the amount is charged to some one of the operating expense accounts, the credit of course being, as before, to "Reserve for Bad and Doubtful Debts." During the year, if the amounts of all cus- tomers' balances actually found to be worth- less are charged off i.e., credited to the cus- tomers' accounts and entered as debits to the Reserve for Bad and Doubtful Debts and all the other accounts open at the beginning of the year have been collected, the balance of the reserve account will show how closely the real shrinkage has been approximated. If the account shows a credit balance re- maining over and above the total amount 160 Net Worth and the Balance Sheet charged against it, the excess of credit will indicate the amount by which the bad debts were overestimated. If, on the other hand, the charges or debits for bad debts exceed the amount credited as a reserve, this indi- cates that the amount of the bad debts was greater than anticipated, and a larger amount should be reserved for the next year. Reserve for Depreciation of Plant Sometimes, on books of large manufactur- ing corporations, there are several accounts showing reserved profits set aside to guard against overvaluation of assets, but more often one general account is used to include all depreciation credits for the buildings, ma- chinery, and miscellaneous articles of equip- ment constituting the plant. In some cases the amount of depreciation is roughly estimated, while in other cases the amount is carefully calculated after consid- erable investigation and consultation with the superintendent and foremen of the vari- ous departments, or with outside experts. In some systems of bookkeeping, besides Reserves 161 the general ledger showing the plant assets in two or three general accounts, a separate plant ledger is regularly kept, in which de- tailed accounts for every important building and machine are entered, showing the orig- inal cost, the repairs expended thereon since the asset was acquired and also during the year, and the estimated annual depreciation. The total sum of the annual depreciation against each item forms the aggregate amount of the depreciation charge for the year as shown on the general books. Any calculation of net worth must take into consideration the amount of deprecia- tion and the expenses of keeping the plant in good condition. Many manufacturers think that a certain definitely stated percentage of depreciation used by one manufacturer may be safely used by all manufacturers, regardless of the character, location, and condition of the man- ufacturing plant, and also regardless of the varied personal skill exercised in the opera- tion of the machinery. For example, a pamphlet prepared by a 162 Net Worth and the Balance Sheet "committee of accounts" was sent to all the manufacturers belonging to a certain associ- ation, and in this pamphlet it was stated to be well settled that buildings depreciate 5 per cent, and machinery 10 per cent, per annum. There is no such settled fact or prin- ciple. Buildings and machinery of exactly the same materials and make will not de- preciate at the same rate in Colorado as upon the Atlantic coast. Nor will two managers in the same kind of business direct the opera- tion of the machinery of their different plants in the same way and with the same percentage of depreciation, even though the volume of business is exactly the same. If two plants exactly alike at the start do not depreciate in the same proportion, how can any arbitrary figure be applied to build- ings and machinery generally? Each plant must be carefully studied and depreciation reserves fixed with regard to the circum- stances affecting the plant. S CHAPTER XXVI RESERVES (continued) OMETIMES in balance sheets the re- serve for bad debts or for depreciation is stated as a "Reserve Fund," and the ques- tion is raised as to the meaning of the word "Fund" used in that connection. In the ordi- nary use of the term, "Fund" indicates an asset such as cash or its equivalent. Those who regard this as the proper and only mean- ing of the word wonder why it appears on the liability side of a balance sheet. Those who use the term to designate a reserve of profits explain that a reserve is, in effect, a setting aside of profits of a business to obtain funds for replacement of worn-out build- ings and machinery and that the reserve ac- count shows the amount of such fund. In other words, it is an account of the profits reserved to provide a fund a Reserve Fund account. With some concerns it is the practice not 163 164 Net Worth and the Balance Sheet only to set the profits aside, but to go one step further and invest cash in securities of other corporations to the amount of the re- serve. Thus the invested cash becomes the real reserve fund, and the amount which may be invested is shown by the Reserve Fund ac- count. Since the word "account" on a bal- ance sheet is unnecessary, as all of the items found there constitute balances of accounts on the ledger, or of accounts which would be there if the method of bookkeeping were complete, the word "account" is dropped, leaving "Reserve Fund," a somewhat cloudy term when used as a liability. But the term does not present any difficulty to one familiar with the examination of balance sheets, although the title "Reserve for Deprecia- tion" or "Reserve for Replacements" is clearer. Another important account appearing on some balance sheets as a liability consists of the "Sinking Fund," which appears when, under the terms of a mortgage, certain defi- nite amounts must be set aside periodically for thepurpose of extinguishing the mortgage Reserves 165 liability when it matures. In some of these cases the fund must be created out of profits earned, while in other cases it is immaterial how it is created, the only requirement being that instalments be actually set aside and in- vested each year. If, under the terms of the mortgage, or according to the adopted policy of the com- pany, the actual money must be set aside and invested, the asset side of the balance sheet should show the account of the investment of such funds. If the mortgage contract does not provide for the actual investment of the fund, it may be left in the business as part of the assets of the business, the ac- count thereof being kept as a liability, or Sinking Fund Reserve, increased by periodi- cal transfers from the Profit and Loss or Surplus account. The form of statement shown in Chapter I provides for a grouping of the "Reserves" in one amount, which, in the case of the Scar- borough Manufacturing Company, consists of the following : 166 Net Worth and the Balance Sheet Sinking Fund $25,000 Bad and Doubtful Debts 3> OI 7 Depreciation on Buildings 32,000 Depreciation of Machinery and Fixtures . . 48,400 Total $108,417 The Sinking Fund Reserve consists of five credits of $5,000 each. The Reserve for Bad and Doubtful Debts amounts to about 3 per cent, on the total of the outstanding accounts, which in this case, based on past experience with the company's customers, is a sufficient provision. The Depreciation on Buildings consists of an accumulation of lump sum charges ex- tending over a period of ten years, and while not based upon any special plan, seems to be more than sufficient for depreciation. The same comment may be made on the Reserve for Depreciation of Machinery and Fixtures. In fact, this company has accumulated re- serve credits to a larger amount than is ordi- narily found in manufacturing plants of its size. Reserves 16/ Hidden Reserves Some merchants and manufacturers ir preparing balance sheets are so conservative in their valuations of assets that the balance sheets do not represent the full net worth of the business. While it is commendable for the proprietor of a business to understate rather than overstate his net worth, except, of course, under conditions wherein the understatement would be of advantage to him as, for example, in preparing tax re- ports or returns it is a much better prac- tice for a manufacturer or merchant to cal- culate his net worth as accurately as may be without either over- or understating. Since the accumulated profits of a concern, set aside in reserve accounts for the purpose of guarding against embarrassment from unexpected shrinkages of the assets, consti- tute reserves built up to protect those assets, the excess of the actual value of assets over the amount shown on the books is considered in the nature of another reserve. For want of a better name the term "Hidden Reserve" or "Secret Reserve" is used to indicate that 168 Net Worth and the Balance Sheet a concern possesses secret or hidden reserves not disclosed on its balance sheet, these secret or hidden reserves consisting of resources not claimed in the process of striking a bal- ance and producing the amount of net worth. The practice is one of doubtful propriety. Of course, an individual sole owner of a busi- ness who is under no obligation to state the full value of his business may follow his own inclinations in this matter without question. An example of the extent to which it may be carried is given in the case of a wealthy manufacturer, among whose assets is listed a large wharf or pier, on which are erected numerous buildings for shipping purposes and from which a large income is derived. While this pier is easily worth $750,000, the owner carries its value on his balance sheet at $1 only, its real value having been reduced from time to time out of the earnings derived therefrom. This manufacturer's actual net worth, as compared with the statement of his balance sheet, would thus contain a secret or hidden reserve of almost the entire value of this pier, taking, of course, into account Reserves 169 reasonable provision for ultimate replace- ment. In the case of a small firm the condition might be such that the inclination of the members to build up secret reserves could be safely followed, but even in such cases less difficulty would arise upon dissolution of the firm by death or otherwise if the assets were shown within a reasonable degree of value accuracy. But when we come to the accounting of a corporation, particularly one whose shares are more or less widely held, the propriety of materially understating the assets may be questioned, because the rights of sharehold- ers, past, present, and future, may be seri- ously affected by their lack of knowledge of the actual conditions. Methods of Building Up Secret Reserves One of the most common methods of cre- ating the so-called hidden or secret reserve consists in an excessive charge to profit and loss for depreciation of plant assets; the amounts being charged direct to the Profit Net Worth and the Balance Sheet and Loss account, and the credits being made direct to the plant asset account, the effect being to reduce the book value of the plant asset account below its real value. Another method of hidden reserve build- ing consists in the charging of enlargements of a plant to current operating expenses. One large concern whose published statement has been issued for years has made from time to time extensive additions to its plant, and without any effort whatever to conceal the practice, charged the cost of these additions to operating expenses. The result is that the property accounts as shown on the books are to-day carried at a value far below their real worth. In this case, while there is no attempt at deception, the practice being known to all concerned, there is no way by which the total amount of such improvements and additions can be readily obtained, and for this reason the plan is not to be recommended. In another case an entire new plant was erected without any increase in the book value of the plant accounts of the company, Reserves the instalments due to the contractor as the building progressed being paid out of the current earnings of the company, so that to- day this large building, worth over a million dollars, does not appear on the books of the company at all. CHAPTER XXVII CONTINGENT LIABILITIES /CONTINGENT LIABILITIES are those ^ amounts not directly owed by the mer- chant or manufacturer, but zvhich may be- come direct liabilities upon the happening of certain contingencies. Since the balance sheet is intended to in- clude only direct liabilities, such contingent liabilities should not be included in the reg- ular statement of financial condition, but should be stated as footnotes. Notes Discounted An example of a contingent liability is found in Notes Receivable which have been received from customers, endorsed by the merchant or manufacturer and discounted at bank. Having been received from customers for goods sold, the makers are expected, of course, to pay them at maturity. Should, however, the maker of any such note fail 172 Contingent Liabilities 173 to meet his obligation, the merchant or man- ufacturer receiving and discounting the note may become primarily responsible and be obliged to pay. If he keeps a proper notes receivable record, he will at all times be able to ascertain the amount of the Notes Receiv- able not yet due on which he may become liable in the event that the maker does not pay. The Notes Receivable Book referred to is a useful record, showing details of notes received, such as date, amount, maker, in- dorsee, maturity, etc. It is sometimes in- corporated in the bookkeeping system, but is more frequently used only as a memorandum book. It will be remembered that under the dis- cussion of Notes Receivable it was said that some concerns show the contingent liability for Notes Discounted in the body of the bal- ance sheet. This is done by crediting on their books in a Bills Receivable Discounted ac- count all of the notes discounted, against which they charge all notes as they are paid by the makers, so that the balance of this ac- count shows the amount of unpaid notes 174 Net Worth and the Balance Sheet which have been discounted but which have not yet been paid. Where such a system is in use, of course, no footnote showing the contingent liability for notes discounted is required. Accommodation Paper Another form of contingent liability con- sists of that arising from accommodation indorsements. Any accommodation paper made by the merchant or manufacturer or indorsed by him for the benefit of other parties, the pro- ceeds of which are not received by him and entered on his books, should be stated as a Contingent Liability. Any liability for exchanged notes, drafts, or checks, and any liability for guaranty or suretyship should also be stated. Ordinary business concerns are usually very chary about lending the use of their names on promissory notes for the accommo- dation of the makers. In fact, in some cor- porations this favor is prohibited under the charter and by-laws, and in some partner- Contingent Liabilities 175 ship agreements no one member of the firm is allowed to indorse promissory notes, either in his own name or the name of the firm, for any outside parties or for any outside pur- pose. So many business failures have been brought about through friendly but unwise indorsement of promissory notes that such provisions must be regarded as measures of mere ordinary business procedure. Unfortunately, concerns whose credit and capital are limited do sometimes exchange such accommodations with each other. In one case, a small manufacturing corporation, through the aid of certain loose-principled note brokers, managed to exchange notes with thirteen other manufacturing concerns in similarly crippled financial condition. Of course the inevitable collapse took place after a short period of easy financing, and the one concern having least need for such irregular methods had to bear the brunt of the total failure of all of the other concerns on whose paper it had indorsed its name. Besides its own direct liability on promissory notes given to the others for their accommodation, this 176 concern had, in addition, its contingent lia- bilities for its indorsements on the notes of all of the others a condition which even- tually brought it into the bankruptcy court. Liabilities Not Shown by Books In examining his own balance sheet or that of others the business man or investor should satisfy himself by inquiry that there are no liabilities, contingent or direct, other than are shown on the statement. Merchants or manufacturers may and fre- quently do enter into contracts for purchase or sale of goods, and sometimes participate in syndicates or subscribe for corporation securities, thereby incurring liabilities which by their nature may not be entered on the books in any ordinary bookkeeping. These may, however, have a material effect on the financial condition of the individual or con- cern at the time the balance sheet is made, according to the favorable or unfavorable happening or turn of events. At the time the balance sheet is prepared, any knowledge of events which may forecast loss or disaster Contingent Liabilities 177 should be faced squarely by the merchant or manufacturer if he wishes to avoid self- deception, even though such knowledge comes to him before the time for the per- formance of the disastrous contract or en- gagement. CHAPTER XXVIII ANALYSIS OF BALANCE SHEET 1-J AVING considered the nature of the ac- counts forming the balance sheet shown in Chapter II, let us see whether we can de- rive any information from the grouped accounts of this same balance sheet, express- ing as they do the net worth of the business. The balance sheet of the Scarborough Man- ufacturing Company presents a typical case of a corporation statement reshaped to con- form to the requirements of the American Bankers' Association. One of the first things to consider in the analysis of a balance sheet is the "liquid" condition of the assets as compared with its immediate liabilities. The statement of the Scarborough Manufacturing Company pre- sents a very favorable condition from a banker's point of view. Cash, Bills Receiv- able, Accounts Receivable, and Merchandise, representing what are usually called "quick" 178 Analysis of Balance Sheet 179 or "liquid" assets, amount to about $370,000, while the "quick" liabilities Notes Payable, Accounts Payable, and Deposits amount to but $88,000 in round numbers. This con- dition presents a desirable one, in that the "quick" assets exceed the "quick" liabilities in the ratio of about 4J4 of assets to 1 of liabilities. Of course the nature of the business is taken into consideration, but banks as a rule do not look with favor upon a statement unless it shows at least $2 of "quick" assets for every $1 of "quick" liabilities. Readings from the Balance Sheet That the Scarborough Manufacturing Company is somewhat easy-going is evi- denced by the large cash balance as compared with the amount of accounts payable out- standing. It is probable that active efforts directed toward reducing that liability might result in material savings in the way of cash discounts. Again, the credit terms of this concern to its customers average 45 days, but through 180 Net Worth and the Balance Sheet easy collection methods it has allowed about $25,000 of overdue outstanding accounts to remain uncollected. Another evidence of slack methods is shown in the large amount of merchandise on hand, which equals about one-third of the total volume of sales for the year, while, as we have seen, the natural "turn-over," ac- cording to the accounts receivable, occurs about nine times each year. In other words, with a volume of sales of $680,000, and with a credit period averaging 45 days, the amount of stock on hand in excess of $80,000 could only be justified by a process of manufacture requiring an unusually long period as com- pared with the credit terms upon which this stock is sold a condition which does not exist in the case under consideration. Another evidence of an easy-going man- agement, not pressed by necessity or keen watchfulness, is shown in the mortgage of $5,000 on certain property owned by the company, on which it is paying 6 per cent, interest. Its bank balance is producing no interest whatever. Keen financial men abhor Analysis of Balance Sheet 181 conditions under which they unnecessarily pay more interest than is earned. It is very evident from the statement that the company has enjoyed rather more than average prosperity since it has been able to accumulate a large surplus, besides setting aside ample reserve provisions, in spite of its easy-going propensities. Those in charge probably know very much about what is called the practical end of the business, and in that are evidently sufficiently successful to be able to ignore phases of the business which in other concerns receive the utmost care. Of course, the net result would be better if the loose ends could be gathered in without sacrifice elsewhere. CHAPTER XXIX COMPARISON OF SUCCESSIVE BALANCE SHEETS TF a single balance sheet will convey solid * information regarding the concern whose condition it represents, how much more is gained by a comparison of the balance sheets of the same concern for two or more con- secutive years? Let us take the balance sheets of a large public service corporation for the years 1910 and 1911 and set the figures side by side for comparison. THE INTERNATIONAL SERVICE COMPANY Assets 1910 1911 Cost of Property $557,417,146 $610,999,964 Contracts in Process .. 7,212,781 2,943,381 Inventories 17,048,196 20,987,551 Accounts Receivable. . 49,744,919 26,077,802 Cash 32,055,866 27,548,933 Investments 38,166,284 64,766,089 Total... $701,645,192 $753.323.720 182 Comparison of Balance Sheets 183 Liabilities I9IO I9II Capital Stock $352,904,063 $344,645,430 Surplus and Reserves. 95,700,385 119,598,526 Bonded Debt 187,685,339 224,791,696 Bills Payable 40,721,625 42,566,943 Accounts Payable 24,633,780 21,721,125 Total $701,645,192 $753,323-720 Cost of Property Account It will be observed that in the foregoing form of balance sheet the accounts are ar- ranged somewhat differently from those of the two other balance sheets which have already been shown. The property account of one of the prior examples appears here in a more definitely named "Cost of Property" account. While an analysis of the account might perhaps show the assets to be worth less than the amount at which they are carried on the books, the balance sheet is evidently intended to convey the impression that whatever the value of the property, its cost is here stated. Xow we naturally turn to the record of depreciation to learn the amount charged off 184 Net Worth and the Balance Sheet as a provision against the shrinkage of prop- erty values, but here we are met with an obscurity. The surplus and the reserve ac- counts, instead of being stated separately, are thrown together in one lumped account, so that we cannot tell just how much the com- pany has thought necessary to set aside as a reserve against the depreciation of its costly plant. We may observe, however, that the cost of the property exceeds the entire amount of capital stock issued. In fact, it exceeds that amount in addition to the entire bonded debt. This is as far as we can go in this direction without asking the management questions. Results of Operation Now let us see the result of the operations of this company as disclosed in these two statements. We notice that no two of the amounts, either of the assets or liabilities, re- main the same for both years. What funds did this company handle during the year and what did it do with them ? Comparison of Balance Sheets 185 Take the assets first. Which of them were decreased ? We ask this question because we know that if an asset was decreased during the year, it is probable in the natural course of events that the amount of the decrease represents cash realized. Assets may be, of course, writen down or taken off from the books altogether without producing anything but loss, but where reserve accounts are kept and property is carried at cost, it is not prob- able that the asset values were reduced ex- cepting for cash realized. The Accounts Receivable, On December 31, 1910, amounted to. .$49,744,919 While on December 31, 1911, the amount was 26,077,802 A decrease of $23,667,117 which means that an amount equal to the entire current accounts for the year was col- lected, and additional collections were made to the extent of $23,667,117, thus increasing the company's working capital by this amount. 186 Net Worth and the Balance Sheet On the other hand Cost of Property in 1911 was $610,999,964 While in 1910 the amount was 557,417,146 An increase of $53,582,818 which shows that an increase of property took place during the year, consuming funds to the extent of $53,582,818. That this did not all come from capital, either in the form of share capital or increase in bonded in- debtedness, is clear when we observe that the outstanding capital stock actually decreased. While the bonded debt increased $37, 106,357, the amount is still about $16,000,000 less than the additions to plant. Comparison of Asset and Liability Variations Where did the company obtain the funds to purchase this additional property? We know that the increase of liabilities, repre- sented by accounts or notes payable, or by bonded debt or share capital, should produce a corresponding increase of assets in some form, and that the reduction of such liabili- ties calls for the parting with assets. Comparison of Balance Sheets 187 Combining the decrease of assets and the increase of liabilities, we get the following results : DECREASES OF ASSETS AND INCREASES OF LIABILITIES: Contracts (decrease) $4,269,400 Accounts Receivable (decrease) 23,667,117 Cash (decrease) 4,506,933 Bonded Debt (increase) 37,106,357 Bills Payable (increase) 1,845,318 Surplus and Reserves (increase) 23,898,141 Total $95,293,266 This represents the total amount which during the year became available for expen- diture on any one of the items in the balance sheet. Of course this calculation does not furnish us with the gross earnings or the operating expenses. We do not have the profit and loss statement before us. That has all been boiled down to the remaining "Surplus and Reserves," the increase of which is all we have to serve as a guide. Fur- ther along the line of detailed operation we cannot go, but we do know that after cur- 188 Net Worth and the Balance Sheet rent operating revenues and expenditures have been accounted for, there is a decrease of assets and an increase of liabilities aggre- gating $95,000,000, which was spent some- where. Where did the money go ? Our answer will be found if we take all of the items of INCREASES OF ASSETS AND DECREASES OF LIABILITIES: Cost of Property (increase) $53,582,818 Inventories (increase) 3.939,355 Investments (increase) 26,599,805 Capital Stock (decrease) 8,258,633 Accounts Payable (decrease) 2,912,655 Total $95,293,266 We have thus fully accounted for the ex- penditure of the funds. That part of the funds expended which was not derived from an increase in the bonded debt, less retire- ment of share capital with the small increase in Bills Payable, came from the earnings of the company and collections of accounts. A Study of Earnings We have one more fact, obtained from the Comparison of Balance Sheets 189 public records, showing that this company paid 7 per cent, dividends during 1911 on its entire capital stock; an aggregate of over $24,000,000 being so disbursed. Taking this fact into consideration with the balance sheet, where we see an increase in the surplus and reserve accounts of nearly $24,000,000, it will be seen that this company earned about 14 per cent, on its capital stock. When we know something about the earn- ings of a corporation we can go still further in a dissection of its balance sheet. In one case it was claimed by parties interested that a certain corporation was charging off for depreciation entirely too large an amount. Upon analysis it was found that the depre- ciation charge for the year was $270,000. The amount of this depreciation charge was stated as a Reserve for Replacement, the annual amount being charged to the Profit and Loss account and credited to the account as described. Condensed statements of as- sets and liabilities and earnings only were submitted. The increase in the amount of the plant during the last year aggregated 190 Net Worth and the Balance Sheet $407,375.12, while the capital account was not increased at all. An analysis was made as follows: Net earnings from operations $485,330.33 Add increase in current liabilities. . . . 27,648.65 $512,978.98 Deduct increase in current assets. . . . 42,392.64 $470,586.34 Reserve account at the beginning of the year $60,133.63 Add appropriation for the year 270,000.00 Amount available for replacements during the year Amount of Reserve account at end of year 266,922.41 Amount expended in replacements... $63,211.22 Now if we bring down the amount of available funds as shown in the foregoing statement, $470,586.34, and deduct the amount expended for replacements of worn- out equipment, $63,211.22, we have a re- Comparison of Balance Sheets 191 mainder of $407,375.12, which represents the amount taken out of earnings to provide new capital items, agreeing with the differ- ence between the plant account at beginning and ending of the year. Two things are observed here. First, the management, instead of paying dividends, used the earnings to buy additional plant; and, second, the depreciation charge to Profit and Loss for the purpose of providing a re- serve for the replacement of worn-out equip- ment was larger than was actually neces- sary. The cash earnings of the company were thus consumed and no dividends declared a matter in which the stockholders would nat- urally be interested. Tracing Increases of Assets Another interesting phase of increased assets is shown in the following comparison of two balance sheets of the Rodman Pro- duction Company, taken at the close of two successive years: 192 Net Worth and the Balance Sheet Assets 1908 1909 Cash .................. $27,37077 $17,909-97 Accounts Receivable. ...165,659.31 146,293.18 Stock ................. 97,049-75 496,439-8o Real Estate ............ 223,329.30 251,572.52 Good-Will ............ 150,000.00 150,000.00 Deficit ................. 50,123.99 $7I3,533-I2 $1,062,215.47 Liabilities Notes Payable ........ $133,565-96 $165,989.59 Accounts Payable ..... 79,967.16 230,026.21 Surplus .............. 166,199.67 Capital Stock ......... 500,000.00 500,000.00 $1,062,215.47 It will be noticed that on the face of the statements this company did remarkably well during the last year, changing a deficit or impairment of its capital in the amount of $50,123.99 to a surplus of $166,199.67. If we had access to the books we would probably find that these two amounts added together represent the credit to the Profit and Loss account as its earnings for the year. Comparison of Balance Sheets 193 But note carefully the increase and de- crease of assets and see whether anything exists there to warn us against a too quick conclusion that the company has actually made all of the money that the improved con- dition of its Surplus account would seem to indicate. The cash and accounts receivable among the assets decreased about $28,000, and the notes and accounts payable increased about $180,000. But notice the increase in the stock of manufactured goods, the amount in excess of that of the previous year being nearly $400,000. The first thought which comes to mind is that the stock has been piling up. Then one is inevitably moved to ask at what price the goods were valued in the inventory. If taken at actual cost, the profit on the goods actually sold during the year is remarkable. But if the inventory was taken at selling price, the large increase of stock is seen to be less than it appears to be, and the large profit apparently made in the one year is partly explained as a book profit, not of course actually earned. 194 Net Worth and the Balance Sheet It is obvious that if finished goods are in- ventoried by the manufacturer at any value above cost, it will be possible for him to man- ufacture a large stock of goods, and show a profit, without selling a dollar's worth. This concern borrowed about $180,000 additional capital, and probably put it all into the increased stock, which if carried at cost might show an increase of approximately the amount borrowed; this in addition, of course, to the increase made possible by the expenditure of funds arising out of the profits on the business which was actually transacted. Since the stock increased to an amount over twice the amount of additional capital obtained, it may be quite necessary for an examination of the inventory values to be made, in order to determine whether the ap- parent profit was real and to eliminate any profit taken in advance of the actual sale of the goods. In the case of a large tool manufacturing company, this method of inventorying was carried so far that in one year, when its sales Comparison of Balance Sheets 195 had decreased to about one-half of normal, it was not only able to pay the usual dividend, but to show in addition an increase in its Surplus account. If this process could go on indefinitely the bed of a business man might easily be con- structed of roses ; but the practice of realiz- ing on anticipated profits leads sooner or later to serious trouble. There is no safe course for a merchant or manufacturer to pursue other than that based upon a complete understanding of his affairs. Such a statement, if prepared according to the outline which we have discussed in this little book, ought to furnish him with at least the foundation of that understanding. INDEX Accommodation Notes, 39-41, 174-176. Account, Cost of Property, 183, 184. Accounts, Changes in, 17, 18. Accounts Payable, 120-123. Not Due, 121, 122. Overdue, 121, 122. Accounts Receivable, 17, 18, 48-61. Advances, 61. as Collateral, 49-51. Bad and Doubtful, 56, 57, 74. Collecting, 58-60. from Allied Interests, 60, 61. "Good," 52, 53. in which Surplus May Appear, 150, 151. Overdue, 53-55. Restricted Meaning of, 49, 51, 52. Unsettled Charges, 57, 58. Accrued Liabilities, 135-137. Advances of Cash, 61. Analysis of Balance Sheet, 178-181. of Earnings, 190, 191. Arrangement of Balance Sheet, 19-22. Assigned or Pledged Notes Receivable, 45-47. Entry of, 47. Assets, Deferred, 112. Increases of, Tracing, 191-195. Other, 28-29, 98-115. (See also Other Assets.) 197 198 Index Assets (Continued) Valuation of, 15, 16. Variations in, 186-188, 191-195. B Bad and Doubtful Accounts, 56, 57, 74. Reserve for, 158-160. Balance, Cash, 23, 24. Balance Sheets, 17-22, 178-195. Analysis of, 178-181. Arrangement of, 19-22. Comparison of Successive, 182-195. A Study in Earnings, 188-191. Cost of Property Account, 183, 184. Results of Operation, 184-186. Tracing Increases of Assets, 191-195. Form of, 18-22, 144. English, 19, 20. Readings from, 179-195. Bank, Cash in, 24-28. Bills Payable, 116, 117. Bills Receivable, 31. Bonded Debt, 127-129. Bonds, Kinds of, 128, 129. Books, Notes Receivable, 173. Building Up Secret Reserves, 169-171. Buildings, 89, 90. Depreciation of, 162, 166. Business Investments, 100, 101. C Capital or Net Worth, 138-140. Capital Stock, 140-146. Common, 140, 141, 143. Entry of, 140. Issued for Property, 143-146. Index 199 Capital Stock (Continued) Preferred, 140-143, 145. Cash, 23-30. Balance, 23, 24. in Bank, 24-28. Deposits, 25-27. on Hand, 28, 29. Petty, 29, 30. Changes in Accounts, 17, 18. Classification of Surplus, 151. Collateral, Accounts Receivable as, 49-51. Merchandise as, 70, 71. Notes Payable as, 118, 119. Notes Receivable as, 45-47. Collecting Accounts Receivable, 58-60. Collections, 27, 28. Common Stock, 140, 141, 143. Comparison of Asset and Liability Variations, 186-188, 191- 195. Comparison of Successive Balance Sheets, 182-195. A Study in Earnings, 188-191. Cost of Property Account, 183, 184. Results of Operation, 184-186. Tracing Increases of Assets, 191-195. Consignments, 76, 77. Contingent Liabilities, 172-177. Accommodation Paper, 174-176. Not Shown by Books, 176, 177. Notes Discounted, 172-174. Corporate Deficit, 155, 156. Corporate Surplus, 152-156. Liability for, 154, 155. Cost, Manufacturing, 69, 73-76. of New Business, 107, 108. Records and Prices, 68-70. Cost of Property Account, 183, 184. 200 Index D Debentures, 129. Debt, Bonded, 127-129. Debts, Bad and Doubtful, 56, 57, 74. Reserve for, 158-160. Decreases of Assets and Liabilities, 186-188. Deferred Assets, 112. Deficit, Corporate, 155, 156. Deposits, 25-27, 124-126. Depreciation of Machinery and Fixtures, 166. of Plant, 160-164. Reserve for, 160-164, 166. Discounting Notes Receivable, 32-37, 172-174. Entry of, 33-36. Earnings, A Study in, 188-191. Surplus Not from, 148-150. Employes' Savings Fund, 124, 125. Entry of Capital Stock, 140. of Mortgages, 131-133. of Notes Receivable, 33-36. F Finished Product, 72-77. Consignments, 76, 77. Manufacturing Cost of, 73-76. Valuation of, 73-76. Fixtures, Furniture and, 96, 97. Machinery and, 91-95. Depreciation of, 166. Form of Balance Sheet, 18-22, 144. English Form, 19, 20. Fund, Employes' Savings, 124, 125. Imprest, 29, 30. Index 201 Fund ( Continued ) Reserve, 163-166. Sinking, 164-166. Furniture and Fixtures, 96, 97. "Good" Accounts Receivable, 52, S3. "Good" Notes Receivable, 37, 38. Goods. (See Merchandise.) Good-Will, Valuation of, 108-111. H Hidden Resents, 167-171. I Imprest Fund, 29, 30. Increases of Assets, Tracing, 191-195. of Assets and Liabilities, 186-188, 191-195. Inventory, Machinery, 94, 95. Perpetual, 79-82. Investments, Business, 100, 101. Reserve Fund, 112-114. Land and Buildings, 89, 90. Leaseholds, 89. Liability of Corporation for Surplus, 154, 155. of Mortgagor, 131, 132. Liabilities, Accrued, 135-137. Contingent, 172-177. (See also Contingent Liabilities.) for Taxes, 137. Other, 134-137. Pay Roll, 136. Variations in, 186-188, 191-195. 202 Index M Machinery Fixtures, 91-95. Depreciation of, 166. Inventory, 94, 95. Partly Paid, 95. Valuation of, 92-95. Manufacturing Cost, 69, 73-76. Materials, Finished, 72-77. Partly Finished, 78-82. Raw, 83-85. Merchandise, 62-71. as Collateral. 70, 71. on Hand, 70, 71. Valuation of, 62-70. Missionary Work, 107, 108. Mortgages, 127-129, 130-133. Entry of, 131-133. Securing Bonds, 127-129. Mortgagor, Liability of, 131, 132. N Net Worth, 13-16, 138-140, 153, 167, 168. Definition of, 13. Indicates Business Progress, 16. Theory of, 13-15. What Constitutes, 14, 15. "New Business" Cost, 107, 108. Non-Negotiable Notes, 39. Notes, Accommodation, 39-41, 174-176. Notes Payable, 116-119. for Money Borrowed, 118, 119. Notes Receivable, 31-47. Accommodation, 39-41, 174-176. Index 203 Notes Receivable (Continued) as Collateral, 45-47. Assigned or Pledged, 45-47. Entry of, 47. Book, 173. Discounting, 32-37, 172-174. Entry of, 33-36. "Good," 37-38. Non-Negotiable, 39. Not in Ordinary Course, 41-45. Pledged as Collateral, 47. Operation, Results of : 184-186. Other Assets, 28, 29, 98-115. Business Investments, 100, 101. Cost of "New Business," 107, 108. Deferred Assets, 112. Other Investments, 114, 115. Reserve Fund Investments, 112-114. Treasury Stock, 99, 100. Valuation of Good-Will, 108-111. Valuation of Patterns, 101-105. Valuation of Trade-Marks, 105, 106. Other Liabilities, 134-137. Overdue Accounts Payable, 121, 122. Overdue Accounts Receivable, 53-55. Analysis of, 54, 55. Paper, Accommodation, 39-41, 174-176. Partly Finished Product, 78-82. Cost of, 78-82. Perpetual Inventory, 79-82. 204 Index Partly Finished Product (Continued) Patterns, Valuation of, 101-105. Pay Roll Liability, 136. Perpetual Inventory, 79-82. Petty Cash and Imprest Fund, 29, 30. Plant, Depreciation of, 160-164, 166. Pledged Notes Receivable, 45-47. Entry of, 47. Preferred Stock, 140-143, 145. Prices, Fixing, 68-70. Product, Finished, 72-77. Partly Finished, 78-82. Fronts, 147-156. (See also Surplus.) Taking, 63, 64, 68, 69. Property Account, 183, 184. Stock Issued for, 143-146. R Raw Material, 83-85. Valuation of, 83, 84. Real Estate, 87-90. Leaseholds, 89. Mortgages on, 127-133. Valuation of, 87, 88. Reserve Fund Investments, 112-114. Reserves, 157-171. for Bad and Doubtful Debts, 158-16U for Depreciation of Machinery and Fixtures, 166. for Depreciation of Plant, 160-164, 166. Fund, 163-166. Hidden or Secret, 167-171. Building Up, 169-171. Index 206 Reserves ( Continued ) Sinking Fund, 164-166. Rights of Stockholders, 155. Secret Reserves, 167-171. Building Up, 169-171. Sinking Fund, 164-166. Stock, Capital, 140-146. Common, 140, 141, 143. Issued for Property, 143-146. Preferred, 140-143, 145. Treasury, 99, 100. Stockholders, Rights of, 155. Supplies on Hand, 85, 86. Surplus, 147-156. Accounts in Which It May Appear, 150, 151. Classification of, 151. Corporate, 152-156. Liability for, 154, 155. Meaning of, 147. Not from Earnings, 148-150. Where Entered, 150, 151. Taxes, Liability for, 137. Theory of Net Worth, 13-15. Trade-Marks, Valuation of, 105, 106. Treasury Stock, 99, 100. Valuation of Assets, 15, 16. of Finished Product, 73-76, 206 Index Valuation (Continued) of Good- Will, 108-111. of Machinery, 92-95. of Merchandise, 62-70. of Patterns, 101-105. of Raw Material, 83, 84. of Real Estate, 87, 88. of Trade-Marks, 105, 106. Variations in Assets and Liabilities, 186-188, 191-195. UNIVERSITY OF CALIFORNIA LIBRARY Los Angeles This book is DUE on the last date stamped below. Form L9-32tn-8,'57(.C8680s4)444 UNIVfcKSlTY of CAL1FOKNIA library AT Graduate School of Uni^rsity of Angeles ?' California A 000186162 4