THE ARTHUR YOUNG ACCOUNTING COLLECTION Graduate School of Business Administration Library of the University of California Los Angeles This book is DUE on the last date stamped below FEB 1 1007 SOT i r RS |TY OF LIBRARY r s - CAUF. BY PAUL-JOSEPH ESQUERRE, C.P.A. (FIFTH PRINTING) NEW YORK THE RONALD PRESS COMPANY 1917 79505 Copyright, 1914, BY THE RONALD PRESS COMPANY William O. Hewitt Press, Brooklyn, Printers J. F. Tpley Co., New York, Binden Bus. Admin* Library HF 5625 E77a PREFACE Just before the dawn of the French Revolution, there was, at the Military College of Brienne, a young student whom his classmates called the "Visionary." Never mix- ing in their noisy pastimes, he would spend hour after hour in his room, drilling tin soldiers on a large table. Dirt, sand, and pieces of glass became hills, fields, and rivers; twigs picked up in the playground were his cannon, while leaves, planted straight in the sand, were to him as forests. His tin soldiers were led or blue; some were mounted, and others, on foot. Night after night, while his comrades slept, the "Visionary" would pitch the blue soldiers against the red; the cannon would roar, and in- fantry and cavalry, pushed by his thin fingers, would fall dead on the battle-field. A few years later, when the English fleet blockaded the port of Toulon, and threatened the existence of the Revo- lutionary Government, the visionary youth, now an officer in the army of France, pitched his "theoretical" knowl- edge against the "practical" knowledge of men who had grown gray under the soldier's uniform, and to their astonishment, and to the dismay of the invader, he dis- covered the one strategic point which rendered a battery of artillery so effective as to compel the immediate retire- ment of the enemy's fleet. The young officer of artillery knew nothing of war- fare but its theory; yet he succeeded where practical strategists had stood in impotent rage. Later, when he became Emperor of the French, it was said of him that his iii iv PREFACE unequalled knowledge of the theory of artillery opera- tions won his battles before they were fought. It is the purpose of this book to instruct the student in the principles of accounting, as the practice drills with his tin soldiers instructed Napoleon the First in the prin- ciples of war. May the conscientious presentation of these principles of accounts teach the young accountant how to win the bloodless battles of his chosen profession. Accounting is essentially a militant science; if it re- mains passive, it must die. To live, it must war inces- santly against carelessness, ignorance, inefficiency, evil- disposed cleverness, and, possibly, against dishonesty. Having won, it must rebuild where it has destroyed; but the new structure must be such that it can never again be successfully assailed. The accountant is a judge to whom appeals are made by the employer against the employee; by the "cestui que trust" against the trustee; by the stockholder against the director; by the director against his associates or against the corporate officers or agents; by the government against violators of fiscal laws; by the trader, the manu- facturer, and the financier, against the conclusions to be drawn from their own accounts. He is also an adviser who must derive from the arithmetical results of books of account, often purposely confused, facts which will enable him to pass judgment upon financial conditions, to guide the judgment of others, to suggest remedies, and to devise means of safe- guarding the interests of all parties, whether clients or an- tagonists. He must be capable of refuting conclusively all assertions which are mere speculation based on sup- posed or assumed facts which cannot stand the test of accounting analysis; he must be able to defend his ground by submitting proofs so fundamentally correct and so conclusive that they cannot be challenged; he must be so PREFACE r familiar with the anatomy of accounts that the mere men- tion of a financial transaction will present to his mind a diagram of the position which the facts to be recorded will occupy in .the books, and of the effect which they will have upon facts previously recorded; he must be able to perceive at once the accounting principle in- volved, and so to apply it as to compel figures to reveal that which they are prone to conceal from the uninitiated. If it is true that no one can be a great detective who does not know the psychology of the human heart, and that a recruit cannot become an efficient gunner until he has been taught the theory of ballistic curves, it must be true that no one can become an accountant until he has learned the theory of accounts. If one is not so equipped, he may indeed make his way towards practical account- ing truth by luck, by intuition, or by plucky determina- tion, but, before he has reached this goal, he has con- sumed his energy, exhausted the patience of his clients, and too often failed to furnish valuable information at the opportune moment. The theory of accounts has been evolved from the study of economic and financial conditions, from the de- velopment of commercial methods, from careful analysis of the results attained in industries old and new, from the application of the principles expressed by judicial de- cisions in litigation brought about through business rela- tions, from the doctrines of the law merchant, of the common law, and of modern statutes. It is the out- growth of centuries; and while its principles are immut- able, they are, at the same time, susceptible of different methods of application, which though apparently irrecon- cilable among themselves, are worthy of consideration on their individual merits. -When about to pass judgment upon the actions of individuals or of nations, we are careful to inquire into vi PREFACE the motives which actuated them; and although we may not be in sympathy with the methods employed, we do not condemn them provided they were adequate to the purpose in hand. But when we come to .accounting, we are naturally arbitrary; the purpose is forgotten, and the oniy question at issue seems to be the nature of the means employed. And yet, the question of adequacy is as vital to accounting as it is to all the undertakings of man- kind. The purpose of the baker of the rural districts of southern Europe, who in common with the majority of his customers is barely able to read and write, is better served by the sticks on which he notches his sales, than it would be by the most handsomely ruled ledger and cash book. Similarly, as the purpose of the small trader of all lands is to keep accounts with his customers and creditors, he need not trouble himself with what has been termed "the only scientific system of keeping accounts" (double entry), since single entry, much abused as it may be, is able to tell him all that he wishes to know, and is much better adapted to his mental equipment. If the merchandise account of a trader reveals the information of which he is in need, why should he heed the indignant protests of philosophers of accounting who tell him that there is really no such thing as a merchandise account, and that the use of complex accounts will rob him of the fruit of his industry, by hiding from him the business truth? And if the purpose of the modest manufacturer of a staple product, the market price of which is as well settled as the demand therefor, is to be as fairly successful as the conditions of his particular industry will permit, why should he be made to sacrifice a good part of his income, in order that he may know through the use of "production factors" or otherwise, the cost of every atom of the product which he manufactures? PREFACE TU It has been asserted repeatedly that it is impossible to bring together ten accountants whose views will har- monize on any given topic of their profession. This will always be true to a greater or less extent, since the human mind is not adapted to the acceptance of a single standard of truth. But these divergent views will become largely harmonized just as soon as it is realized that if a student of surgery cannot be trusted with an operation until he has mastered the anatomy of the human body, the student of accounting cannot be trusted with the finances of a business until he has mastered the theory of accounts. PAUL- JOSEPH ESQUERRE. New York City, September i, 1914. CONTENTS PART I BUSINESS ORGANIZATION Chapter I. The Copartnership Preliminary Sole Proprietorship The Copartnership Limited Partnerships Nominal Partners Articles of Copartnership The Accountant's Duty The Partnership a Quasi-Legal Entity Acquisition of Partnership Property Partners' Debts General Partnership Rules Precedence of Claims Against Partnership Value of the Good-Will Partnership Paper Status of Retiring Partners Status of Continuing Partners Status of Incoming Partners Chapter II. The Corporation Stock Securities The Corporation Defined Corporations Classified Shares, Capital, and Capital Stock Dividends Kinds of Stock and Its Issue Stock Subscriptions Property Acquired by Stock Issue Labor or Services as a Consideration Stock Issued as a Bonus Borrowed Capital Corporate Bonds Classification of Bonds as to Security (1) Secured Bonds (2) Partly Secured Bonds (3) Unsecured Bonds Typical Bond Issues ix x CONTENTS Chapter III. The Corporation Organization and Management Corporate By-Laws The Board of Directors Stockholders Corporate Officers Chapter IV. The Corporate Records Statutory Requirements (1) Minute Book (2) Subscription Ledger (3) Stock Certificate Book (4) Stock Book or Stock Ledger (5) Corporate (or Stock) Journal (6) Stock Transfer Book PART II THE GENERAL THEORY AND TECHNIQUE OF ACCOUNTS Chapter V. Accounting Systems Single Entry The Principles of Single Entry Single-Entry Ledger Accounts Debits and Credits The Effect of Debits and Credits Equations of Single-Entry System Sources of Gains and Losses Not Shown Proprietor's Account Closing the Accounts Practicability of System Chapter VI. Accounting Systems Double Entry The Purpose of Double Entry Principles of Double Entry A Balancing System Rules for Journalizing Profit and Loss Account and Nominal Accounts Rules for Double Entry Basic Differences Between Single and Double Entry Passing from Single Entry to Double Entry Chapter VII. Accounting Systems Triple and Quadruple Entry Logismography Statmography CONTENTS xi Chapter VIII. The Financial Books The Journals The Journal The Sub-Journals Purchasing Department Purchase Journal Sales Department Sales Journal Treasurer's Department Cash Journal Petty Cash Book Notes and Bills Journal Pay-Roll Journal Specially Ruled Journals Chapter IX. The Financial Books The Ledger and Voucher Record The Structure of the Ledger Variations of the Standard Ledger Private Ledger Voucher Record Chapter X. The Technique of Posting Functions of the Ledger Rules for Posting Chapter XI. Controlling Accounts General and Subsidiary Ledgers Genesis of the Controlling Account Theory of the Controlling Account Self-Balancing Ledger Chapter XII. Classification of Accounts General Classification (1) Real Accounts (2) Nominal Accounts (3) Accounts Partially Real and Partially Nominal Asset and Liability Classification Assets and Asset Accounts Liabilities and Liability Accounts PART III THE THEORY OF THE ASSET ACCOUNTS Chapter XIII. Cash Account Petty Cash The Theory of the Cash Account The Cash Account and the Cash Balance A Correct Cash Account xii CONTENTS Nature of Petty Cash Maintaining the Imprest Fund Theory of the Imprest Fund Special Duties of the Petty Cashier Chapter XIV. Accounts with Customers Entries in Customers' Accounts Trade Discounts "Accounts Receivable" Chapter XV. Notes and Bills Receivable Notes Receivable Treatment of Notes Receivable .Treatment of Contingent Liability on Notes Discounted Dishonored Notes Bills Receivable Chapter XVI. Accounts with Goods Merchandise Account of Trading Concerns Analysis of the Merchandise Account Subdivisions of the Merchandise Account Inventory of Trading Merchandise Merchandise Accounts of Manufacturing Concerns Inventories of the Merchandise Accounts of Manufacturing Concerns Inventory of Raw Materials and Sundry Supplies Inventory of Goods in Process Inventory of Finished Goods Inventory When There Is No Cost System Apportionment of Overhead Expenses (1) Labor Rates (2) Machine Rates The Problem of Expense Distribution Chapter XVII. Consignments Shipments Inward Relations of Consignor and Consignee Consignee's Duties and Liabilities The Factor's Accounts and Accounting Books of the Factor Books of the Factor Agency Accounts Kept in General Books Books of the Factor Agency Accounts Kept in Separate Books The Recording of Consignments Inward Occasional Consignee CONTENTS xiii The Occasional Consignee Theory First Argument and Method Second Argument and Method Chapter XVIII. Consignments Shipments Outward Accounting Methods First Hypothesis Second Hypothesis Third Hypothesis First Method Second Method Chapter XIX. Land and Buildings Distinction Between "Land" and "Buildings' Plant Land Investment in Lands Buildings Capital Expenditures Revenue Expenditures Chapter XX. Building Equipment, Furniture and Fixtures, De- livery Equipment, Patterns, Other Equipment Realty Fixtures and Personalty Fixtures The Law of Fixtures Distinction Between Realty and Personalty Fixtures Furniture and Fixtures Delivery Equipment Patterns Other General Equipment Chapter XXI. Machinery and Tools Classification of Machinery and Tools Machine and Tool Accounting Universal Machines Special Machines Depreciation Shop and Hand Tools Chapter XXII. Good-Will, Patents, Trade-Marks, Copyrights, Franchises Good-Will Definition Personal Character of Good-Will The Good-Will of Corporations x iv CONTENTS Good- Will as an Asset Depreciation of Good-Will Creation of Good-Will Patents Nature of Patents Treatment of Patents Trade-Marks Definition Copyrights Definition Copyrights as an Asset Franchises Definition Primary Franchises Secondary Franchises Charges Against Franchises Chapter XXIII. Investments Surplus Capital Speculative Investments Permanent Investments (1) Loans Secured by Bonds and Mortgages The Mortgage Contract Mortgage Interest Accounting Procedure and the Mortgage Register The Nature of Security (2) Loans Secured by Collateral (3) Investments in Bonds of Other Companies The Interest Account Relation of Cost to Income Investment Accounting (4) Investments in Stocks of Other Companies (5) Investments in Real Estate Accounting for Real Estate Investments Chapter XXIV. Specific Funds, Reserve Funds, and Funded Reserves Specific Funds Reserve Funds Funded Reserves Sinking Funds CONTENTS xv Chapter XXV. Accrued Income Not Due Income from Investments The Cash Basis The Accrual Basis Nature of Dividends Record of Earnings on Investments Income from Bonds Chapter XXVI. Accounts Partially Real and Partially Nominal- Deferred Debit Items Allocation of Periodical Expenses Common Accounts Partially Real and Partially Nominal Fire Insurance Premiums Advertising Contracts Stable Supplies, Stationery and Printing, Advertising Matter Clearing Partially Real and Partially Nominal Accounts First Method Second Method Deferred Debit Items Organization Expense PART IV THE THEORY OF THE LIABILITY ACCOUNTS Chapter XXVII. Capital Stock The Share and Its Functions Capital Stock as a Liability Capital Stock Records The Status of Unissued Stock Premiums on Capital Stock Discount and Premium Accounts Treasury Stock Accounting for Treasury Stock Donation Account Chapter XXVIII. Bonded Debt General Considerations Bond Issues Accounting Theories of Bond Issues Bonds Acquired by Issuing Company Premiums and Discounts on Bond Sales Premiums as Deductions from Principal xvi CONTENTS Chapter XXIX. Secured Debt Unsecured Debt Secured Debt Real Estate Mortgages Chattel Mortgages Interest on Mortgaged Debt Secured Debt Warehouse Receipts Unsecured Debt Notes and Bills Payable Bills Payable Memorandum Checks Promissory Notes Payable Chapter XXX. Accounts Payable Dividends Payable Accounts Payable Records Dividends Declared and Unpaid Profits Available for Dividends Dividends from Income from Increased Valuations Stock Dividends Accounting Treatment of Dividends Chapter XXXI. Accrued Liabilities Deferred Credit Items Accrued Liabilities Taxes, Licenses, Assessments, and Fees Classification of Taxes (1) Business Taxes (2) Property Taxes (3) Excise Taxes (4) Inheritance Taxes Deferred Credit Items Chapter XXXII. Reserves and Surplus Proprietorship Accounts Reserves and Surplus Distinction Between Reserves and Surplus Classification of Reserves (1) Reserves for Depreciation (2) Operating Reserves (3) Reserves for Surplus Contingencies (4) Reserves for Redemption of Debt (5) Secret Reserves (6) Reserves for Exhaustion of Physical Assets Creation of Reserves Provision for Depreciation Provision for Exhaustion CONTENTS xvii Proprietorship Accounts Positive and Negative Components Drawing Accounts PART V FINANCIAL STATEMENTS Chapter XXXIII. Financial Statements Based on Single Entry The Statement of Assets and Liabilities The Statement of Resources and of Their Application Proof of Ledger Assets Chapter XXXIV. Trial Balance and Working Balance Sheet Trial Balance Classified Trial Balance, or Working Balance Sheet Chapter XXXV. The Balance Sheet Arrangement as to Assets and Liabilities Arrangement as to Order of Items Variations in Arrangement of Balance Sheet Double-Form Balance Sheet Periodical Fluctuations in Double-Form Balance Sheet Opposition of Balance Sheet Items Form of General Balance Sheet Reading a Balance Sheet Chapter XXXVI. Special Forms of Balance Sheets Bank Balance Sheet The Balance Sheet of Life Insurance Companies Balance Sheet of Steam Roads Engaged in Interstate Commerce Chapter XXXVII. The Statement of Income and Profit and Loss Elements of Statement Mechanism of Statement Comment on the Statement Cash Discounts Cost of Goods Interest as an Element of Cost Book Increase of Cost Statement in Account Form Statement for Steam Roads Engaged in Interstate Traffic Statement of Cash Receipts and Disbursements xviii CONTENTS Chapter XXXVIII. The Consolidated Balance Sheet "Consolidation" and "Consolidated" Balance Sheets Form of Consolidated Balance Sheet Formation of Consolidated Balance Sheet Chapter XXXIX. The Statement of Affairs Appointment of Receivers Status of the Statement of Affairs Asset Side of Statement Liability Side of Statement Preparation of Statement of Affairs Preparation of Deficiency Account Treatment of Reserves Arrangement of the Statement of Affairs Arrangement of Deficiency Account Chapter XL. Realization and Liquidation Method of Closing Statement of Realization and Liquidation Preparation of Realization and Liquidation Account Principles Involved Peter Post Problem Chapter XLI. The Accounts of Fiduciaries Academic Theories Statutory Provisions Executor's Accounting Payment of Debts and Legacies The Executor's Compensation Form of Executor's Account Contents of Schedules Differentiation Between Principal and Income Practical Problems (Pages 521 to 575) The Applied Theory of Accounts Part I Business Organization CHAPTER I THE COPARTNERSHIP Preliminary The study of the theory of accounts presupposes a good working knowledge of the laws which regulate busi- ness whether conducted, by individuals, by associations of interest known as copartnerships, or by artificial bodies created by law, and known as corporations as well as of the principles of corporation finance. But as it might be considered far too optimistic to assume that every stu- dent, or would-be student, of accounting is thus equipped, a brief sketch of the legal characteristics of the several types of business organization is given here. Sole Proprietorship The business rights and privileges of the individual seeking wealth independently, are affected only by such laws and customs as regulate the ordinary relations of men with their fellow-men and with governing bodies. Outside of such legal steps as every sole proprietor must take to register his business and to comply with local police and fiscal regulations, he is at liberty to conduct his enterprise as he pleases, provided he does not interfere with the rights of others, or with public policy. As to 19 20 BUSINESS ORGANIZATION partnerships and corporations, their activities, through law and time-honored customs, have become subject to restrictions which act for the benefit and welfare of their members, as well as of outsiders who deal with them. The Copartnership An association of men in partnership is thus defined by Chancellor Kent: "A contract of two or more com- petent persons to place their money, effects, labor, and skill, or some or all of them, in lawful commerce and busi- ness, and to divide the profits and bear the losses in certain proportions." In the Federal courts a copartnership has been spoken of as, "A contract of mutual agency, each partner acting as a principal in his own behalf, and as an agent for his copartners."* There are two broad classes of partnerships: 1. General Partnerships 2. Limited Partnerships As accountants generally understand the term, a gen- eral partnership is one in which all the partners are ten- ants in common, every member sharing with his asso- ciates the liability for such debts as the firm has incurred through the actions of the individual partners as agents of the other members. The law of New York says: "Every general partner is an agent of the partnership in the transaction of business, and has authority to do whatever is necessary to carry on the business in the ordinary manner." Limited Partnerships As distinguished from general partnerships, the limited partnership is characterized by the inability of * Karrick v. Haraman, 168 U. S. 324,328; 18 C. St. 135; 42 L. Ed. 484. THE COPARTNERSHIP 21 some of its members to act as agents for the others or to have any voice whatsoever in the management of the busi- ness; and also by the limitation of the liability of such members to the amounts of the capital contributed by them. In some states, all the members of a limited partner- ship are liable only to the extent of the capital which they have contributed; but in general, limited partner- ships must have at least one general partner who is liable for any deficiency in the assets available for the liquida- tion of the partnership liabilities. The members of a partnership who enjoy the privi- lege of limited liability are referred to as "special part- ners." A peculiarity of their status is that they must contribute capital to become partners, while general partners are not legally bound to contribute anything. In many states, the statutes even require special partners to contribute "cash," or "lawful money of the United States." The most important of the restrictions to which spe- cial partners are subject, is that which prohibits them from withdrawing their capital in the form of dividends, profits, loans, or salaries, etc. If they do so, they forfeit the privilege of limitation, and become liable as general partners. Further, when at dissolution of the partnership the assets are not sufficient to liquidate the liabilities, special partners are, in some states, denied the right of sharing in the firm's assets. Limited partnerships may have members who while enjoying limited liability, are permitted to have a voice in the management of the concern. They are called "dor- mant partners." Their connection with the concern must at all times remain secret, or they lose the privilege of limited liability. An important distinction between limited and general -22 BUSINESS ORGANIZATION partnership is, that as soon as insolvency is ascertained an injunction may, upon the application of a creditor, be ob- tained against a limited partnership and a receiver ap- pointed; whereas, in general partnerships a creditor has no such equitable remedy unless it is shown that by allow- ing the firm to continue, his interest would be grievously injured through mismanagement. While this remedy has sometimes been granted to the creditors of a general co- partnership, it is not generally thought to belong to them by right. Nominal Partners A nominal partner is one who, while not in fact a partner of either a general or limited partnership, holds himself out to be such, to the prejudice of an innocent third party. If the injured party seeks redress, the law makes the nominal partner a general partner for the pur- pose of the particular litigation, and attaches upon him a general liability. Articles of Copartnership In partnerships, whether general or limited, the part- ners are usually bound by a written agreement, known as "Articles of Copartnership," which purports to regulate the actions of the associates, to set forth their duties, rights, and privileges, and to define the scope of the en- terprise. And since copartnerships may be terminated otherwise than through insolvency and bankruptcy, by: (i) the expiration of the term for which created; (2) mutual consent; (3) the death of one of the partners; (4) the transfer by a partner of his interest to third persons not partners; (5) the contemplated admission of a new partner not satisfactory to all the others; and (6) the re- tirement of one of the partners, it follows that articles of partnership, in order to be well drawn, should attempt THE COPARTNERSHIP 23 to foresee, and to provide for, the conditions which may prevail at dissolution. The Accountant's Duty It is, however, because articles of copartnership are seldom thorough, far-seeing, and clearly expressed, that accountants are so often called upon to minister to the partnership about to be dissolved, and to certify to, or deny, the supposed justice of the claims made by one partner against the others. The duty of the accountant is to conform to the spirit of the articles binding the partners; or, if this be impossible, to interpret the pro- visions thereof in the sense in which the questions at issue are generally understood by similar types of business asso- ciation; or this, in turn, failing, to seek the assistance of the law of partnership, of which the salient points are given below. The Partnership a Quasi-Legal Entity While it is generally understood that partnerships are not legal entities, still it seems to be in line with modern ideas to consider them as such. Courts of law have re- ferred to them as "The ideal being, known as the partner- ship"; the United States Bankruptcy Act appears to con- sider them as entities capable of being thrown into bank- ruptcy, although the individual partners may not be. In stating accounts before a master or a referee, or in cases of litigation between partners, it is customary to open an account with the firm; this account is debited with the contributions of the partners (but not with the amount paid by one partner to another partner personally, for a place in the firm) and with all moneys advanced by the partners to the firm or spent by them for the benefit of the firm as such. 24 BUSINESS ORGANIZATION Acquisition of Partnership Property Everything which the partners contribute in the form of capital, either at the incipiency of their relation with one another, or subsequently, is considered as property of the firm as a whole. Although oral agreements may in some cases be deemed valid, it appears to be the rule that real property owned by a prospective partner, becomes firm property only by virtue of a written contract transferring the in- terest in the land estate from the individual to the firm. But when real estate has been acquired with the funds and for the purposes of the firm, it is the property of the firm, even though the title is in the name of one of the partners and there is nothing but a verbal agreement to the effect that it was to become the firm's property. Partners' Debts The debts contracted by individual partners, either be- fore or during the life of the partnership, may become debts of the firm by mutual consent. General Partnership Rules Unless specific provisions to the contrary are inserted in the articles of copartnership, or some fact exists tend- ing to show that the partners intended it otherwise, the following rules prevail: i. All advances made by individual partners to the firm, and all debts incurred by them for the partnership, are loans to the copartnership, and make the partners so contributing, creditors of the same. As creditors, they are entitled to interest on their advances and on such sums as they have paid personally for the benefit of the firm as such. THE COPARTNERSHIP 25 2. Interest is not to be credited on the amount of capital invested, even though the capital contribution of one of the partners is greatly in excess of that of others. 3. Interest is not to be charged on withdrawals. If, however, the amounts withdrawn by a partner are in ex- cess of the limit allowed, fairness requires that he shall be charged with the interest which he has caused the firm to lose. 4. Interest is not to be charged on moneys remain- ing in the possession of a partner pending dissolution and winding up. 5. If no rate of interest is mentioned, the legal rate prevails whenever transactions occur raising the question of interest. 6. Profits and losses are to be shared equally, no mat- ter how unequal the capital accounts of the partners may be. 7. Partners are not entitled to compensation for their services. 8. All partners have an equal duty to keep books of account, each partner having free access thereto. Precedence of Claims Against Partnership While it is true that an individual partner who has ad- vanced money to the partnership or expended his own money for its benefit, is a creditor of the firm, his claims, nevertheless, rank after those of the outside creditors of the concern ; but they rank before the claims of the private creditors of his copartners. An undrawn credit account appearing in the books of a firm to the benefit of one of the partners, is not to be con- sidered as his private or separate estate in case of dissolu- tion of the copartnership, until the firm's debts have been paid. This is all the more essential because individual 26 BUSINESS ORGANIZATION creditors of a partner appear to have a preferred equity in the separate estate of that partner over the creditors of the firm. Value of the Good- Will While numerous court decisions indicate that a surviv- ing partner has the right to continue to use the firm's name, it seems to be a generally accepted doctrine that if the good-will attaching to the name is truly existent and has a value, the surviving partner is not entitled to use it without compensation to the estate of the deceased. In some cases the courts have even gone so far as to say that the basis for computing the value of the good-will which the firm's name conveys, should be the annual profits of the business prior to the death of the partner.* Partnership Paper If negotiable paper is within the scope of the firm's business any one member may issue it; if not within the scope its issue must be ratified by the other members or it is not binding upon the firm. The same is true of accommodation paper, guaranty, and suretyship. Status of Retiring Partners If a retiring partner gives his ex-partners an uncondi- tional contract of sale, he retains no lien against the partnership assets. If the sale is conditional upon specific performances he retains a claim upon the assets available for distribution to the firm's creditors. All obligations incurred by a firm, or binding upon partners who were members at the time of their incur- rence, are binding upon any such members who retire before these obligations are satisfied, even though they Matter of Silkman, 121 N. Y. App. Div. 20*; 105 N. Y. Suppl. 872; affirmed in 190 N. Y.; 560 N. E. 27 have not matured at the time of such retirement. This holds true even though the partners who purchase the interests of those who retire have agreed to liquidate the liabilities, and have given the vendors an indemnity bond against any liability for the firm's debts. The law con- siders retiring partners as sureties for the debts incurred while they were of the firm, and considers the bond as an indemnity against losses, and not as a covenant against liability to suit.* Status of Continuing Partners The continuing partners are liable for the debts of the old firm, jointly with the retiring partners. If a new firm has been organized it is not liable unless by agree- ment to become so, or unless it performs some act indi- cating that it intended to hold itself liable. Status of Incoming Partners Partners coming in after the retirement of other part- ners, become liable for the debts of the old firm only if they agree to undertake such liability, or if they perform an act indicating such intent. And it may be considered that they agree to become so liable if, upon entering the firm, they fail to state their freedom from such liability. * Taliaferro v. Brown, n Alabama 702. CHAPTER II THE CORPORATION STOCK SECURITIES The Corporation Defined Chief Justice Marshall thus defines a corporation:* "An artificial being, invisible, intangible, and existing only in contemplation of law. Being the mere creature of law, it possesses only those properties which the charter of its creation confers upon it, either expressly or as incidental to its very existence. These are such as are supposed best calculated to effect the object for which it was created. Among the most important are immortality, and if the expression may be allowed, individuality; properties by which a perpetual succession of many per- sons are considered as the same, and may act as a single individual. They enable a corporation to manage its own affairs, and to hold property without the perplexing intri- cacies, and the hazardous and endless necessities of per- petual conveyances for the purpose of transmitting it from hand to hand. It is chiefly for the purpose of cloth- ing bodies of men, in succession, with these qualities and capacities, that corporations were invented, and are in use." Corporations Classified Corporations may be divided into stock corporations and non-stock corporations. Non-stock corporations in- clude all chartered associations whose purpose is idealistic, religious, charitable, educational, etc., etc. * Dartmouth College v. Woodward, (4 Wheat) U. S. 518-636; 4 L. Ed. 629. 28 STOCK SECURITIES 29 Stock corporations are frequently divided into: 1. Financial Corporations 2. Business Corporations 3. Public Service Corporations To fulfil the purpose for which they are created, cor- porations require capital; this is either contributed by individuals, copartnerships, or other corporations, or is borrowed; or it may be obtained by both these methods. Shares, Capital, and Capital Stock To show to what extent individual contributors are interested in the wealth of the corporation by virtue of their respective contributions, "shares of capital stock" are issued to them, having a "par" or nominal value, the minimum of which is fixed by statute, the maximum being uniformly $100. In the State of New York it is now legal to issue common stock without a par value, and preferred stock which has no preference as to principal, may also be issued without par value.* The capital contributed by interested parties is the property of the legal entity known as the corporation, while the shares of stock are the personal property of their holders, and constitute a liability of the corpora- tion. Thus, when we refer to the "capital" of a corpora- tion we mean the difference between the assets into which the contributions of capital have been converted, and the liabilities to outsiders incurred as a result of the activities of the corporate being; but when we refer to "capital stock" we mean the actual liability of the company to shareholders for the capital paid in, or subscribed and bound under the law to be paid in; and in addition the "potential stock," that is to say the power given by the * See Chapter 351 of the laws of New York, 1912, "An act to amend the stock corporation law in relation to corporations having shares of capital stock without nominal or par value." 30 BUSINESS ORGANIZATION charter to obtain more capital by incurring a liability to stockholders to the full extent of the unissued, but authorized capitalization. Dividends The profits made by the corporation through the employment of the capital contributed by the share- holders, belong to the latter only after the board of di- rectors has resolved that they shall be distributed as divi- dends and the resolution has become known outside of the board room. When these conditions concur, dividends become debts of the corporation, and the shareholders can enforce their payment. In business corporations it is cus- tomary to separate the capital stock and profits by calling the latter "surplus." Banks and financial institutions, however, frequently refer to the two items as one, "capital and surplus." This is due to the fact that the surplus of banks is usually considered as part of the capital stock and that the transfer or the bequest of bank stock is under- stood to carry with it the surplus earned which has not been separated therefrom by the declarations of dividends. Kinds of Stock and Its Issue The capital stock of corporations is usually divided into two classes, common and preferred. Common stock is that which has no financial preference over any other stock of the company and is generally that to which is given the voting power. It confers upon its holders the right to participate in the management of the affairs of the company through the annual election of a board of trustees, or directors, who are to act for the stockholders at large. The word "preferred," when applied to stock, means that the stock is entitled to first consideration in the dis- STOCK SECURITIES 31 tribution of profits and assets, either or both, as the case may be. Preferred stock may be cumulative as to divi- dends; it may or it may not have voting power, be re- deemable at a certain figure on or before a stated period, or be convertible into bonds of the corporation. If part of the original organization scheme, the issue of preferred stock requires no authorization on the part of the com- mon stockholders; but if it is to be issued after the rights of the common stockholders have been established, it requires their authorization. Corporate capital stock is issued in exchange for a con- sideration, the nature of which varies according to the statutes of individual states, but which may be said to be, in the majority of the states: (1) Cash or its equivalent, the latter term including subscriptions subject to call. (2) Property, the valuation of which it is within the power of the board of directors to establish. (3) Labor or services. Stock Subscriptions Generally speaking, unconditional subscriptions to cap- ital stock bind the subscribers, i.e., they can be enforced; the issue of certificates of stock upon the strength of a subscription agreement, completes the stockholder's lia- bility, and he is bound to pay that which he has promised to pay. This liability of the stockholder is enforceable by the company itself, or by its creditors after insolvency. Courts have held that unless particular statutes provide to the contrary, "it is not essential that a certificate should have been issued, in order to create the relation of share- holder, provided a contract to take the stock has been duly made." It is said that the form of subscription is immaterial, BUSINESS ORGANIZATION 3^ so long as the intention of the parties can be ascertained; but in cases where the statutes require that a certain per cent of the subscriptions be paid in cash upon subscribing, such a payment must be made before the subscription agreement becomes binding. Capital stock to which a prospective stockholder has subscribed, but for which he has not paid, can be declared forfeited only if the statutes of the state in which the cor- poration was created, specifically grant the power of for- feiture. Even then, the exercise of this corporate right should be for the benefit of the corporation, and not for that of the stockholders. And this right can be exercised only by the board of directors. If the statutes do not pro- vide for forfeiture, the existence of a provision to that effect in the by-laws of the company is invalid. The acceptance by a corporation of a subscription to its capital stock, makes the subscriber a stockholder of the company. Bona fide purchasers of capital stock which bears on the face of its certificate a notice that it is fully paid, are not liable either to the corporation or to its creditors for any amount thereof which might, in truth, be unpaid. Property Acquired by Stock Issue The law of New York says in regard to the matter of consideration for stock, that any corporation authorized by its charter to purchase property for its use and lawful purposes, may issue full-paid non-assessable stock for the value of the said property, and that in the absence of fraud, the judgment of the directors in regard to the value of the property thus acquired shall be conclusive. It also requires that whenever a corporation reports on its capital stock in compliance with legal provisions, it shall specify what amount of stock was issued for property. Unless prohibited by statute, corporations may acquire property STOCK SECURITIES 33 by paying therefor partially in stock and partially in bonds and partially in cash. Labor or Services as a Consideration Labor is thought to include manual or brain labor con- tributed by contractors, lawyers, financial interests, etc., etc., for the benefit of the corporation, and anything which the corporation receives in the line of services for which it would have to pay. Under this interpretation of the law, it would be possible to issue stock for organiza- tion expenses, for alterations to buildings, for the particu- lar services rendered by underwriters of corporate stocks and bonds, etc., etc. Stock Bonuses Increase or Decrease of Capital Stock In general, it is held that a corporation cannot issue its shares to its stockholders as a bonus; but in the State of New York the issue of unissued stock as a bonus to bondholders has been upheld as proper, since it was neces- sary to the successful flotation of bonds.* The Supreme Court of the United States has corroborated the sound- ness of this principle to the extent of a decision to the effect that where a bondholder had obtained stock as con- sideration for his purchase of bonds at par, he could not be made to pay for the stock, provided the par value of the bonds was greater than the actual value of the bonds and stocks. f Capital stock may be increased beyond the issue originally authorized, by compliance with the requirements of the state statutes. It may be similarly decreased, but there is often a statutory provision that the reduced capi- tal stock shall at least equal the debts of the corporation. Christensen v. Enu, 106 N. Y. 97; 12 N. E. 648; 8 N. Y. St. 68f ; 60 Am. Rep. 429. t Handler v. Stutz, 139 U. S. 417; n S. Ct. 530. 34 BUSINESS ORGANIZATION The statutes of individual states must be consulted in re- gard to what constitutes the proper legal steps necessary to obtain the authorization to increase or decrease the capital stock. Borrowed Capital Corporate Bonds While the issue of long-time instruments of credit is not a prerogative which only corporations enjoy, bonds are almost exclusively issued by corporate bodies. Unlike stock, they promise to pay a certain sum of principal and a certain sum of interest at specified times; and, unlike stock, they give their holders the privilege of asserting their rights whenever that which they are entitled to has not been received. But since this right of the bondholders appears to place in jeopardy the preexisting rights of stockholders, many states require that all issues of bonds be authorized by a two-thirds vote of the stockholders. Bonds are, generally speaking, long-time promissory notes bearing interest at a stated rate, issued serially in units of like denomination, payable to bearer or to a person registered on the books of the company issuing them, pledging to the aggregate of the bondholders cer- tain specific properties described cursorily in the note itself, and in full detail in the contract which gives the trustee the right to sell the pledge for the benefit of the holders of the notes if either principal or interest is de- faulted at maturity. Classification of Bonds as to Security There are, however, certain classes of bonds which may or may not pledge property to secure the principal of the note, and which pledge no property whatever to secure the interest. Bonds may thus be divided into three gen- eral classes: STOCK SECURITIES 35 1. Secured Bonds a. Pledging personal property b. Pledging real property c. Pledging both real and personal property 2. Partly Secured Bonds a. Unsecured as to interest but Secured or preferred as to principal 3. Unsecured Bonds both as to principal and as to interest x. Secured Bonds a. Pledging Personal Property: (1) Debenture Bonds of Financial Institutions. These bonds pledge first mortgages owned by the company which issues the instruments of credit. The rate of inter- est which these bonds carry is, of course, less than the borrowing company obtains on its own investments in first mortgages. (2) Collateral Trust Bonds. The pledge in this case consists of personal property, such as stocks, bonds, mort- gages, etc., owned by the borrowing company, and placed by it in the hands of a trustee, in accordance with the terms of a contract which provides for the sale of the pledge for the benefit of the bondholders, upon default by the borrower of either principal or interest. (3) Equipment Bonds. Until recent years, the form of these bonds did not vary materially from that of other bonds. They were issued for periods running from ten to fifteen years, and were repayable in total at maturity. They pledged the very equipment for the acquisition of which they had been issued. Lately these bonds have assumed a character which places them in a class by them- selves. They are known as "Car Trust" or "Equipment Trust Certificates." They are frequently repayable in in- stalments, the security pledged under the issue as a whole 6 BUSINESS ORGANIZATION reverting, after payment of each instalment, to the unre- tired proportion. The equipment pledged by the inden- ture is earmarked individually by means of a plate bear- ing the name of the trustee in whom title rests until pay- ment of all the obligations under the issue. When re- payable in instalments, they are issued in series marked "A," "B," "C," etc. b. Pledging Real Property: (1) Real Estate Bonds. When issued by public service corporations, these bonds are secured by such parcels of real estate as are not required for the operations of the company. When issued by other companies, the above distinction does not necessarily apply. (2) Land Grant Bonds. The pledge, under these in- struments of credit, is the landed estate which common carriers receive sometimes as a donation, either from the government, from municipalities, or from large business interests, in consideration of the value of the public services which they render. (3) Terminal Bonds. These pledge the land and the buildings which constitute what is generally known a* the "terminal facilities" of transportation companies. c. Pledging Both Real and Personal Property: (1) General Mortgage Bonds. They offer as a secur- ity the whole physical property of the company, present or to come, whether real or personal. (2) Blanket Mortgage Bonds. They cover the whole property of a railroad system, subject to such prior liens as attach to parts thereof. If they contain specific provisions compelling the retirement of prior liens at maturity, they, in time, become first mortgages; otherwise, not. (3) Divisional Bonds. These are special to railroads which, in the course of their development, have absorbed STOCK SECURITIES 37 other lines now forming subdivisions of the system as a whole. The bonds which mortgaged the property at the time of its absorption by the greater system, are known as "divisional." (4) Purchase Money Mortgage Bonds. These bonds pledge the very property for the partial payment of which they were issued. 2. Partly Secured Bonds a. Income Bonds. The mortgage recites, either that there is pledged some specific property as a security for the repayment of the principal, or merely that the bonds constitute a preference claim on the property of the com- pany. As to the interest on the bonds, its payment de- pends entirely upon the existence of net profits; if net profits do not exist in any given period, the right of the bondholders may or may not cumulate, according to the terms of the indenture. 3. Unsecured Bonds a. Railroad Debentures. These bonds are nothing more than a formal acknowledgment of a debt, under seal. In regard to the interest payable thereunder, they present the same general characteristics as income bonds. Typical Bond Issues In regard to their ultimate disposition, bonds are often referred to as "redeemable" and "convertible," while the names borne by certain other bonds indicate that they came into existence as a result of financing operations the nature of which is shown by the title appended to the in- struments. To the latter category belong, consolidated bonds, refunding bonds, and interest bonds. Redeemable bonds can be repaid by the company liable under them, at the end of a period shorter than the 79505 3 g BUSINESS ORGANIZATION life indicated on their face. The right of redemption be- fore maturity belongs to the maker, and not to the bond- holder. Bonds are said to be convertible when, according to the terms of the indenture, they can be exchanged, at the option of the holder issuing them, for some other form of obligation, such, for instance, as preferred stock. An issue of consolidated bonds takes the place of sev- eral prior issues, and consolidates the pledges given as a security for the individual issues to be retired. Refunding bonds, as their name indicates, are issued in lieu of maturing obligations; they may either be ex- changed for the maturing bonds, or sold in order that the proceeds may be applied to the retirement of the obliga- tions. In either case, the same property is pledged as ap- plied to the redeemed instruments. Interest bonds, as their name suggests, are issued in payment of interest obligations maturing under other bonds which cannot be met otherwise. Bonds may carry as many interest coupons as there are interest periods during their life, or they may carry no coupons at all. In the first instance, they are called coupon bonds; in the second instance, they are known as registered bonds. CHAPTER III THE CORPORATION ORGANIZATION AND MANAGEMENT Corporate By-Laws As it would be manifestly impossible for the stock- holders to manage the affairs of the corporation, and as, besides, they are not recognized by law as agents of the corporate body, they elect a board of directors whose duty it is to manage the corporate affairs. This board exercises its functions by appointing officers to whom it delegates part of its powers; and in order that the rights and duties of all may be well defined and understood, by-laws are enacted which, in so far as they do not conflict with the laws of the land, are the laws regulating the relations of the stockholders with the directors, of the directors with the stockholders and officers, and in some cases of the corporation with outsiders who have knowledge of the existence and import of the by-laws and are thus supposed to accept their validity. Unless vested in the board of directors by the statutes of the particular state in which the corporation is formed, or by the charter of the cor- poration, the right to make by-laws belongs to the stock- holders. The Board of Directors Speaking generally, after the stockholders have elected a board of directors, they cannot act otherwise than through that board; and in the absence of restricting by- 39 An BUSINESS ORGANIZATION 4 laws the board has practically the same powers as the cor- poration. Directors do not, however, possess the right to encroach upon powers that have been given to stock- holders by statute, such, for instance, as the right to re- move a director, to increase or decrease capital stock, to dissolve the company, etc. They cannot, unless authorized by statute, amend by-laws, or make, without consent of the stockholders, any change in the authorized capital stock of the company. If the corporation has that power, the directors may direct the purchase of the company's capital stock in the open market, and hold it in the treas- ury subject to resale, but they cannot order it canceled; they must hold it unextinguished. They cannot cancel subscriptions to stock without consent of the stock- holders; issue more stock than is authorized; execute leases which amount practically to divesting the corpora- tion of its physical assets; issue stock for less than par, unless the statutes permit of the contrary; declare unlaw- ful dividends, or vote by proxy at meetings of the directors. The directors possess the power to borrow money and to pledge therefor the assets of the company, except when the by-laws prohibit it ; to create new debts to pay off old debts; to lease corporate property if such lease does not deprive the corporation of the power to conduct its own business; to use their discretion as to the extent of the dividends to be paid out of the surplus earned; to conduct corporate litigation at the expense of the cor- poration; to ratify a debt which has been barred by the statute of limitation; to make and transfer negotiable paper; to fix the salaries of the corporate officers; to pay wages in advance; and, unless prevented by the corporate by-laws, to make contracts for periods of one year or more, with persons who have services to hire or to sell. CORPORATE ORGANIZATION AND MANAGEMENT 41 Courts of equity are prone to consider directors as the trustees of the stockholders as well as of the creditors of the corporation. This gives to their functions a fiduciary character which places them in a position where they may not secure for themselves any advantage which the stockholders cannot share, or which would cause the rights of the creditors to become inferior to theirs. It has even been held that a director who acquires for himself property which it was his duty to acquire for the corpora- tion, holds it as a trustee for the corporation precisely as if he had acquired property belonging to the corporation.* Stockholders Stockholders have the common-law right to make the by-laws of the corporation. In some states the statutes delegate the right to the board of directors. They may insist upon certificates of stock being issued to them as evidence of the liability which the corporate entity has contracted towards them. In some states they are authorized to issue preferred stock by appropriate proce- dure. They have a common-law right to inspect the rec- ords of the company, but this has been restricted by statute and by the courts, and usually a good reason for such inspection must be shown. A stockholder has the right to subscribe to his due proportion of all increases of capital stock. Unless the statutes or the by-laws of the company specifically authorize mortgages by a vote of the directorate, the directors cannot jeopardize the rights of the stockholders by issuing such obligations without the authorization of at least two-thirds of the stockholders assembled at a special meeting. In the event of insolvency the stockholders are liable for the difference between that which they have paid, and that which they should have paid to make their stock * Robinson v . Jewett, 116 N. Y. 40; 22 N. E. 224. . BUSINESS ORGANIZATION 42 "full-paid," even though the company had agreed to ac- cept the payments made as full consideration. Corporate Officers The number, the titles, and the powers of the cor- porate officers, vary materially according to the im- portance and to the internal organization of corporations. They are, usually: the president, one or several vice-presi- dents, the secretary, the treasurer, and the auditor. The President. In corporations in which the board of directors is active, the president exercises merely the functions of an officer presiding over the deliberations of that body, and of the meetings of stockholders. In cor- porations where the board is inactive, the president has the power of a general agent of the corporation. The nature of this power depends upon the character of the particular enterprise, and upon business custom. The Vice-President. This officer has, at law, no special function or power, except when taking the place of the president. Corporate by-laws may, however, render his office active and important. The Secretary. The duties and importance of the sec- retary's office is determined by the corporate by-laws. Generally speaking, he signs certificates of stock, keeps the corporate seal and the corporate records, reports the deliberations of the board of directors and of the meetings of stockholders. He signs or attests, or both, all sealed instruments of the corporation, and issues all official notices of meetings. The Treasurer. As the name indicates, the treasurer has charge of the corporate finances. He usually has the power to sign checks, to select depositories when the board has not acted, and to sign jointly with the presi- dent, or other officer, all instruments pertaining to finances. CORPORATE ORGANIZATION AND MANAGEMENT 43 The Auditor. This officer has charge of all matters pertaining to the keeping of the financial records. He plans books of account, devises methods of recording and accounting best calculated to fulfil the purpose of the company, and watches over the faithful recording of all facts. He submits, at stated periods, statements showing the financial status of the enterprise, and the causes which have contributed to its success or to its failure. CHAPTER IV THE CORPORATE RECORDS Statutory Requirements The financial records which a concern may keep whether partnership or corporation will be considered at length in the course of this book. But inasmuch as the corporate books have little to do with accounting prin- ciples, it may be well to treat of them at this point. The requirements in regard to the number and form of corporate books vary greatly in the different states. Gen- erally speaking, it may be said that the scheme of corporate accounting comprises : 1. Minute Book 2. Subscription Ledger 3. Stock Certificate Book 4. Stock Book or Stock Ledger 5. Corporate or Stock Journal 6. Stock Transfer Book i. Minute Book The minute book should record the facts in connection with the organization of the company, the framing and the amendment of the by-laws, the election of the directors, the appointment of officers and ministerial agents, and a true history of the meetings, deliberations, and resolutions of the board of directors and of the stockholders. The facts recorded should be expressed in clear, unequivocal language. The book is usually kept by the secretary of 44 THE CORPORATE RECORDS 45 I J< 1 c i s 3 fi .S S 92 THEORY AND TECHNIQUE OF ACCOUNTS 3 a a. J~J .3 =3 5> 9 b 6 9 6 THEORY AND TECHNIQUE OF ACCOUNTS JOURNAL Names and Explanations Dr. Cr. Feb. i, 1914 Cash $200.00 To Customer A $200.00 For settlement in cash of our bill of Jan. 25, 1914, subject to a cash discount of 2% for 10 days. Discount $4-00 To Cash $4-00 For discount of 2% on $200.00 to Customer A on our bill of Jan. 25, 1914. The foregoing method of handling the cash book was open to the objection that it did not show the actual cash transactions as they occurred, and that it rendered the audit of the cashier's accounts very lengthy and compli- cated. This objection, serious as it may have been, was as nothing to the defects developed by the books so kept when, having evolved with the business, the cashier be- came treasurer, that is to say, when the clerk of the shop became an officer of the now highly organized body economic. The treasurer needed information of the most varied nature, and he had to make his records reflect it. He quickly realized that if the receiving and disbursing of cash gave rise to deductions from the face of the amounts to be received and paid out (in the form of dis- counts, allowances for claims, returns of goods sold or purchased, etc.), it was possible to transform the cash book into a cash journal which would not only record accurately the status of the asset "Cash," as affected by the transactions of the period, but indicate as well the accounts which were to be debited (or credited) and main- tain equilibrium between cash and the accounts which were to be credited (or debited) as a result of the cash transactions. Accordingly, he built up the cash journal (Figures 14, 15), which provides on one side of the page, columns for THE JOURNALS 97 UJ Q CD UJ O ^ 'i O -J O < CD z I iSS SI s (0 o 1 I 9 8 THEORY AND TECHNIQUE OF ACCOUNTS THE JOURNALS 99 accounts to be debited and accounts to be credited; and on the other side, columns for accounts to be credited, and accounts to be debited. This journal, like all others, is capable of limitless extensions to suit particular cases. Petty Cash Book When used by the cashier as a memorandum of petty disbursements, the petty cash book has no particular anatomy. All it is intended to do is to record faithfully the cash transactions which, while small in amount, occur so frequently as to make their daily posting a matter of inconvenience. The disbursements may be recorded in the petty cash book in any way which is deemed satis- factory. Monthly or oftener, an analysis is made which forms the basis of an entry (properly supported by vouchers) to appear in the general cash journal. When used in connection with all disbursements made otherwise than by check, the petty cash book may be- come a journal in the true sense of the word and be used as a posting medium, in so far at least as the disburse- ments are concerned. It is, in this case, nothing more than a portion of the general cash journal assigned to dis- bursements for petty expenses. Under the "imprest fund" system of providing for petty cash disbursements (of which we will speak later) a book such as shown in Figure 16 could be used to advan- tage; it would not, however, be treated as a posting medium, but as an analytical record from which the re- quired data could be readily obtained. Notes and Bills Journal With the possible exception of the pay-roll book, which is discussed later, the recorder of the notes and bills receivable and payable is probably the book of orig- J00 THEORY AND TECHNIQUE OF ACCOUNTS PETTY CASH JOURNAL (IN PETTY CASH BOOK) | . DISBURSEMENTS I O | 'i. "tn 6 Other Accounts I ^ Roll Journal In its simplest form, and when used by concerns which do not keep their books on the accrued basis, and whose organization is not departmentalized, the pay-roll book can hardly be said to be a journal, since it merely states the names of the employees, and the amounts earned by them during a given period. (See Figure 19.) In such cases as the above, the book is merely a mem- orandum record, gathering weekly or monthly, the de- tails which will support the entries appearing in the cash journal to the credit of cash and to the debit of office salaries, or such other accounts as are indicated by the analysis of the pay-roll book in so far as official capacity is concerned. When, however, departmental organization exists and when, besides, the accrued liabilities (or assets) are placed on the books at the end of each weekly or monthly division of the accounting period, the pay-roll book may be developed into an invaluable book of original entry. (See Figure 20.) THE JOURNALS 105 o o ^s I 3 eo Ov I0 6 THEORY AND TECHNIQUE OF ACCOUNTS < & D O I i. THE JOURNALS 107 I I0 g THEORY AND TECHNIQUE OF ACCOUNTS 3 V '1 Q LJ .J Of _J < U fel ^ J and tions Da xpl _ r o "- o u ^ -S a o THE JOURNALS 109 The pay-roll journal shown in Figure 20 is designed for a warehouse. During certain seasons, certain depart- ments are very active, while others are slack; the men of one department may be put to work in other depart- ments. This necessitates the distribution columns, which are so headed as to show the ledger account to which the total of the items appearing therein, will have to be debited. The adaptability of the pay-roll journal to the require- ments of the treasurer's department, is illustrated by Figure 21. The form is supposed to be "loose-leaf" and used by concerns which find it convenient to have the em- ployees paid in the department in which they work. Specially Ruled Journals One sometimes finds, in certain businesses, journals providing on either side of the space allotted to the ex- planations of the entries, special debit and credit columns in which are entered the names of the active accounts, one column being reserved for inactive ledger accounts. These books are sometimes referred to as day-book journals, because they unite in a single book, the original blotter, that is to say, the chronological and historical records, and all the components of the original journal in which the data of the blotter used to be classified. CHAPTER IX THE FINANCIAL BOOKS THE LEDGER AND VOUCHER RECORD The Structure of the Ledger The ledger has been aptly called by the Italians "Libro Maestro." It is, indeed, the master book, or the book of the master of the business; the proprietor should be able to find in it the synthetic grouping of the analytic labor of the journal. We have referred to the journal as "the scales" in which the transactions are weighed and classified as be- tween debits and credits. We might compare the ledger to a chest of drawers, each unit of which is divided into two vertical sections, the left being known as the debit side, and the right, as the credit side. Each drawer is given a name indicative of the subject matter which will be placed therein as soon as the iournal has classified the transactions. In order that information concerning the contents of each drawer may be readily obtained, each side of it is subdivided into four compartments of unequal dimen- sions, intended to contain: 1. The date of the transaction 2. The explanation or name of the value which the journal has classified as the counterpart of the one to be placed in the particular drawer in question no THE LEDGER AND VOUCHER RECORD III 3. The particular journal scales which attended to the weighing of the transaction as a whole 4. The money value of every item Thus we have the ledger account form which usage has consecrated: Name of Account* Dr. Cr. Date Explanation Refer- ence Amt. Date Explanation Refer- ence Amt. Variations of the Standard Ledger Every book of accounts which is built upon lines similar to the ruling given above for the ledger account, is said to be "ledger-ruled." A slight alteration of the conventional frame has been made in what is generally known as "The Boston Ledger," and, less commonly, as "The Bank Ledger." This book is the result of the demand of certain types of financial organization for daily balances; it places the credit column alongside of the debit column, and intro- duces a third column for balances. The accounts are arranged, according to individual preference, one, two, or four to the page. An example is given in Figure 23. In practice, the headings appearing in the columns are omitted. II2 THEORY AND TECHNIQUE OF ACCOUNTS #*> (0 cS tt U IU THE LEDGER AND VOUCHER RECORD d II I Ad 10 2 80 i 8s A 89 e OI 6 07 Cr. 500.00 150.00 loo.oo 75-00 025.00 1,250.00 E F To close, in the general ledger, the individual accounts of the above customers, and transfer the aggregate to the controlling account. The in- dividual accounts are to be carried in a subsidiary ledger to be known as customers ledger. The journal provides for a debit to the controlling ac- count, and a credit to each individual account to be closed; this, in effect, means that the equilibrium having been disturbed by the debit, is reestablished by the credit; but another debit to each individual customer's account must be made in the underlying ledger to open the in- dividual accounts. The student is unable to find a bal- ancing credit therefor, and begins to believe that the whole theory is erroneous. A few words of explanation may serve to dispel such doubts, as well as to review some of the principles expressed in the preceding chapters. All financial books are either journals or ledgers; the journal may be kept in its entirety, or it may be cut up into its component parts, but whether found under one form or the other, it is nevertheless the journal, and its nature and its importance do not change. The ledger may also be cut up in as many parts as may best be adapted to the requirements of the business; for instance, there might be a section for impersonal assets, another for impersonal liabilities and capital, a third for nominal ac- counts, and a fourth for personal accounts of customers 128 THEORY AND TECHNIQUE OF ACCOUNTS and creditors; one-half of this last section being personal assets, the other half being personal liabilities. To illus- trate: General Ledger in Four Sections Impersonal Impersonal Li- Nominal A c - a. Personal Ac- Assets abilities & Cap- counts, Debits counts Cus- ital and Credits tomers' b. Personal Ac- counts Cred- itors' I. 2. 3- 4- This would not make parts 2, 3, or 4, subsidiary ledgers; it would merely make them units of the whole. But if we were to add the balances shown by the individ- ual accounts in part "a" of section 4, and enter the total thus obtained, among the assets found in section i ; if, further, we were to do the same thing with the accounts found in part "b" of section 4, and embody the amount in section 2, we would have: General Ledger Subsidiary Ledger Impersonal As- Impersonai Li- Nominal a. Personal sets and Con- abilities, Capi- Accounts Accounts trol of Personal tal and Control Customers' Assets of Personal Li- b. Personal Ac- abilities counts Cred- itors' I. 2. 3- Thus, we would find in section I an account con- trolling part "a" of the subsidiary ledger, and in section 2 an account controlling part "b" of the subsidiary ledger. CONTROLLING ACCOUNTS I2 g It becomes plain that (since the journal establishes and maintains the equilibrium between the positive and negative values found in the general ledger), when we say that two postings must be made of every debit and of every credit entry affecting the controlling account of the customers or of the creditors, we mean that one of the postings is necessary to show that the equilibrium has been disturbed and reestablished, owing to the occurrence of certain transactions, and that the other posting is merely in the nature of a memorandum, involving no prin- ciple of any kind, and intended merely to contribute to the gathering of facts which, in the aggregate, will sup- port other facts expressed elsewhere in concrete form. Self-Balancing Ledger One of the indirect applications of the controlling ac- counts is found in what is sometimes qualified as a "self- balancing ledger." Taking the customers ledger as an instance, the bookkeeper operating a self-balancing ledger of the customers' accounts, is supposed to post daily the details of the transactions affecting them individually, and when this is accomplished, to post the total of the said transactions into a "control" to which a special place is given, either at the beginning or at the end of the book. It goes without saying that the data which constitute the "control" posting, are supposed to be taken independ- ently of the detail. Monthly, or oftener, the bookkeeper is in a position to control his own work, since the special account gives him the aggregate amount which the open balances of the individual accounts must reflect and support. It must be remarked, in connection with the self- balancing ledgers, that if the subsidiary "controls" are really what they claim to be, they reduce the general ledger accounts which usually operate in the capacity of THEORY AND TECHNIQUE OF ACCOUNTS controllers, to the rank of aggregate asset or liability ac- counts, that is to say, mere memorandum accounts. The accounts which the private ledger and the gen- eral ledger keep one with the other, are sometimes quali- fied as "controlling." The same is true of the general ledger and of the income ledger. This, however, is con- trary to principles. We have seen that the effect of a controlling account is to eliminate from the general ledger the detail of what was originally a part of that book, and that the part thus removed becomes a sub- sidiary unit of the accounting scheme. Few accountants would be willing to say that the general ledger is a sub- sidiary of the private ledger because the latter contains a controlling account with the former, and that, for the same reason, the private ledger is a subsidiary book of the general ledger. In reality, the accounts which one sec- tion of the ledger contains with other sections of the same book are not controlling accounts, but balance accounts, precisely as the would-be "control" of the self-balancing subsidiary ledger is only a balance account. CHAPTER XII CLASSIFICATION OF ACCOUNTS General Classification For purposes of general classification on the basis of financial status and earning capacity, accounts are classi- fied as: ( Personal Accounts 1. Real Accounts T , . I Impersonal Accounts ( Fictitious, Economic, Loss 2. Nominal Accounts < and Gain, Representative ( Accounts 3. Accounts Partially Real and Partially Nominal i. Real Accounts Accounts are said to be real when they represent positive or negative elements of invested values, the net amount of which measures the equity of the proprietor in positive values. In other words, the real accounts are all the assets and the true liabilities, the latter term excluding accounts expressing proprietorship, accounts of sole traders, and accounts of copartnerships. Liabilities resulting from, or incident to, the issue of capital stock, are real liabilities, as will be seen later, when speaking of capital stock. Real accounts are subdivided into personal and im- personal. The personal accounts include all the accounts with persons, whether such persons have an individual ac- count in the general ledger, or whether the aggregate of their accounts is reflected by a controlling account. The term "impersonal" applies to all other real accounts. THEORY AND TECHNIQUE OF ACCOUNTS 2. Nominal Accounts The term "nominal" applies to all accounts opened during the accounting period to record the causes for such fluctuations of real accounts as have resulted in an operating loss or gain, an expense, an addition to, or a deduction from, income. They are called nominal be- cause, in so far as inventorial value is concerned, they exist in name only. Cash, buildings, land, are called real, because they exist in some tangible form; good-will is called real, because, although intangible, it has or is sup- posed to have a salable value; interest (received or paid otherwise than in advance) is called nominal, because it represents no inventorial value, tangible or intangible, positive or negative. Interest merely gives the result of a series of transactions the effect of which has been to bring about the income or the outgo of a value (cash or claim) in exchange for financial assistance given or received. The term "fictitious" which is sometimes applied to nominal accounts is objected to by many accountants, because of the generally accepted meanings of the word, i.e., imaginary, false, not genuine, fabulous, etc. It is not easy to see how misleading accounting terminology can in any way make clear' to the student the principle underlying the nominal accounts. The term "economic accounts" is also given to nom- inal accounts. The word economic means: pertaining to the management of the household, the state, the nation, the business, etc. And as it is through management that gains are made, losses sustained, and expenses incurred, it follows that every account recording such occurrences may rightly be termed economic. The expression "loss and gain accounts" is open to the objection that it tends to obscure principles by convey- ing the idea that expenses are losses. "Salaries," for ex- CLASSIFICATION OF ACCOUNTS 133 ample, which some textbooks call a loss and gain ac- count, is not a loss, but an expense necessary to obtain for the business the benefit of the services which it re- quires. To call expenses losses, is to ignore one of the main purposes of accounting, which is to differentiate be- tween them. The word "representative" is also sometimes used in connection with the accounts which show causes. It is said of them, to explain the use of the term, that they "represent" the particular subject matter which their name indicates. Thus, rent is called a representative ac- count, because it represents the transactions relating to rent. 3. Accounts Partially Real and Partially Nominal The assets of a concern may be said to be invested, or acquired: 1. To remain permanently invested in the business and serve as a basis for operations 2. To be used as current resources, that is to say, as financing media 3. To be sold at a profit, either in the very form in which they were invested or acquired, or after they have been subjected to a process altering their nature 4. To be consumed pending operations, for the benefit of the business as a whole Groups i and 2 are real values at all times, and the fluctuations to which they are subject are accounted for by nominal accounts in all cases where the fluctuations have resulted in increases or decreases. Group 3 contains elements which, under certain methods of accounting, may be partially real and partially nominal. If, for instance, a merchandise account is kept, 134 THEORY AND TECHNIQUE OF ACCOUNTS it contains a real element the value of which is ascertained only at inventory times, and a nominal element the ex- tent of which is known as soon as the real element is ob- tained. Of this, more will be said later. As to group 4, if the items which it contains are shown by inventory to have been consumed entirely, the accounts representing them have ceased to be partially real, and have become essentially nominal. If they are shown not to have been entirely consumed, their inven- torial value is real, the consumed proportion is nominal, and the accounts must be relieved of either the real or the nominal elements, as will be shown subsequently. Asset and Liability Classification For purposes of recording and expressing the finan- cial status of a business, accounts are classified as: 1. Asset Accounts, including: All real values actually possessed, or earned and receivable, as well as all prepayments ap- plicable to periods subsequent to any par- ticular period 2. Liability Accounts, including: a. For Corporations : (1) The liabilities to outsiders (2) The liability of the artificial being "The Corporation" to the stock- holders, at time of dissolution, for: (a) The outstanding capital stock (b) All the surplus earnings not declared in dividends (c) The income and the benefits held out of surplus, for ap- plication to the profits of subsequent periods (d) Unapplied reserves CLASSIFICATION OF ACCOUNTS 135 b. For Sole Proprietorships and Copartner- ships: (1) The liabilities to outsiders (2) The proprietorship accounts, repre- sented by : (a) Capital accounts (b) Undrawn, undistributed, or unapplied profits (c) All credit accounts which do not constitute liabilities to outsiders, whether re- serves unapplied or per- sonal credit accounts Assets and Asset Accounts The word "asset" comes from the French word "assez" or from the Provencal "assatz," both meaning "enough" or "sufficient." Commenting upon assets, Blackstone says that "the term receives its name because its posses- sion is sufficient to render the executor or administrator liable to discharge the debts and legacies of the deceased person, so far as the assets may be sufficient for the pur- pose." The report of the special committee of the American Association of Public Accountants, on accounting terminol- ogy, defines assets : "Property, fixed or liquid ; resources of any kind capable of being converted into money or value. The term is used sometimes as applying to good-will, concessions, franchises, deferred charges, and in English accounting even to preliminary expenses incurred in the formation of a company." Greendlinger's "Accounting Practice" states broadly that "any part of a man's property or business that may be used for the extinction of his debts is called assets." Bentley's "Science of Accounts" speaks of assets in these terms : "The assets of a business are anything of value belonging to it, such as real estate, ma- THEORY AND TECHNIQUE OF ACCOUNTS chinery, horses and wagons, office furniture, book debts, notes receivable, merchandise on hand, insurance premiums paid in advance, etc." The accounting meaning of the word "assets" does not appear capable of being reduced to general definitions like the above, for values may be assets under certain condi- tions and not under others; nor is it necessary that a value "may be used for the extinction of a man's debts" in order that it may be raised to the dignity of an asset. Sta- tionery and printed matter, for instance, are often referred to as assets of a going concern; still they might have no value available for the liquidation of any of the debts of the business. It seems, then, that the definition of assets might be extended to cover their peculiarities. The term "assets," when this is done, means : 1. For a going concern: That which is owned and invested in the busi- ness; that which is earned, although not received, and constitutes a collectable claim; that which has been expended for the bene- fit of future periods 2. For a concern about to liquidate: a. If the concern enjoys the benefit of limited liability: That which is owned, invested in the business, and convertible into re- sources applicable to the liquida- tion of the liabilities of the concern b. If the concern does not enjoy the benefit of limited liability: That which the proprietors of the busi- ness own and is not exempt by law from being seized and converted into resources applicable to the liquidation of their liabilities. CLASSIFICATION OF ACCOUNTS 137 Asset accounts are the accounts in which are recorded the initial value of assets, and all subsequent transactions affecting them. Liabilities and Liability Accounts There is perhaps no term used in accounting which has caused so much discussion as the word liability. Ac- cording to the revised edition of the Encyclopaedic Dic- tionary, liability means: "The quality or state of being liable, responsible, or bound in law or justice. That for which one is liable; specifically the debts or pecuniary en- gagements for which one is liable." The report on ac- counting terminology which has been mentioned in con- nection with assets, says that "liabilities embrace all the debts or obligations due by the firm to its creditors, or the debts and obligations of a corporation, partnership or in- dividual." Lisle says that "the liabilities of a business consist of all the sums due to outside creditors, as distin- guished from the sums due to partners or stockholders." The foregoing definitions do not appear to take into consideration the manifold phases of liabilities; they seem to ignore the ever-present possibility of accountabilities becoming liabilities as a direct result of the materializa- tion of contingencies. The liabilities of a going concern may be said to be: 1. Those which are past due. 2. Those which are due, but not as yet payable, in consequence of the terms of credit extended. 3. Those for which indebtedness has been incurred, but which are, at present, neither due nor payable. 4. Those for which the possibility of becoming liable depends upon contingencies of the future. THEORY AND TECHNIQUE OF ACCOUNTS On the other hand, the word liabilities might be made to apply, for a concern enjoying limited liability, and about to liquidate, to: 1. Those which are due, about to become due, or certain to become due as a direct result of operations, and payable out of the proceeds of the sale of invested assets. 2. Those which will become due if certain contin- gencies materialize. 3. The remainder of the assets (if any) after liquida- tion of all liabilities to outsiders, which the proprietors will withdraw from the enterprise, or which the corporation in its capacity as an artificial being about to lose its legal entity, owes to the stockholders. Lastly, the liabilities of a concern not enjoying the privilege of limited liability and about to liquidate, might be said to be: Those which are due, about to become due or certain to become due upon the materialization of con- tingencies, and are payable out of the proceeds of the sale of any value owned by the members of the concern which is not exempted by law from seizure, whether or not it is invested in the busi- ness. Liability accounts are so named because they record the original amount of the liabilities, and all subsequent transactions in regard thereto. Part III The Theory of the Asset Accounts CHAPTER XIII CASH ACCOUNT PETTY CASH The Theory of the Cash Account Under the tenets of the personalistic theory of ac- counts the cash account is, in principle, an account with the cashier. Without going into the merits of that theory, it may be said to have the advantage of restricting the treatment of cash to the recording of actual receipts and disbursements. This may sound like a truism, and it will no doubt be advanced that the same restrictions apply, no matter under what theory the cash account is kept. Still, every accountant knows that a great many ledger accounts with cash contain items which are called receipts merely because they have not been disbursed, and items which are called disbursements merely because they have not been received. It is because this latter treat- ment is not generally thought to be wrong, that so many students of accounting find great difficulty in solving practical problems which present the cash account of a trustee, without stating as receipts the proceeds of the securities held for creditors and sold for them under the indenture of the pledge, and as disbursements the reduc- tion or the liquidation of fully or partially secured liabili- 139 140 THE THEORY OF THE ASSET ACCOUNTS ties. It is also because the average bookkeeper does not clearly understand the purpose of the cash account that so many entries are made which deprive the books of a concern of that harmonious relation which should exist between them and the books of all other concerns with which business relations have existed. Let us illustrate the cash account by the following example : A owes Bank B $50,000, representing a time loan se- cured by 600 shares of stock, of par value of $100 each, which A carries on his books at $59,500. A being unable to meet the loan at maturity, the bank sells the securities for $57,000, deducts from the proceeds the principal of the loan, plus $1,500 of interest due under the loan, and credits A with the balance, i.e., $5,500. If we were to examine the books of Bank B we would find, as a result of the foregoing: Cash debited with $57,000.00 Loans Receiv- able credited with $50,000.00 Accrued Interest on Loans. ... credited with 1,500.00 A credited with 5,500.00 If, on the other hand, we were to examine A's books, it is not improbable that we would find: Cash debited with $57,000 Investments credited with $57,000 Cash credited with 51,500 Loans Payable debited with 50,000 Interest Accrued on Loans debited with 1,500 Investments credited with 2,500 Profit and Loss debited with 2,500 CASH ACCOUNT PETTY CASH I4 i Whereas, if proper respect had been paid to the pur- pose of bookkeeping and to the principles underlying the double-entry system, we should have found on A's books: Cash debited with $5,500 Interest Accrued on Loans debited with 1,500 Loans Payable debited with 50,000 Profit and Loss debited with 2,500 Investments credited with: Cash $5,500 Sundry 54,ooo This latter handling of the facts would make A's books harmonize perfectly with the books of the bank, in so far as the loan transaction is concerned, and besides would have the advantage of applying the following principle: The outgo of a positive value (investments) has been counterbalanced by : 1. The income of a positive value (cash) 2. The outgo (liquidation) of two negative values: a. Loan principal b. Loan interest 3. A loss sustained through the sale of a ledger asset The first set of entries makes it appear that the bank has paid A $57,000; that A has paid back to the bank $51,500; that because the bank has paid A only $57,000, A has suffered a loss of $2,500, since his property, which the bank held, was worth $59,500. What makes matters worse, is that A's ledger, being posted from his cash book, shows that loans payable and interest accrued on loans were repaid in cash. If we had taken an abstract of A's ledger for audit purposes, and we were attempting to find documentary evidence of the individual transactions sup- porting the totals shown by the abstract, we would look THE THEORY OF THE ASSET ACCOUNTS in vain for evidences of the above disbursements. Nor could we find anywhere in the statements furnished by the bank a credit to A of $57,000. Reverting to the ledger account with cash, we would find that while the initial and closing balances are correct, the intervening facts on both sides are misleading in so far as they do not reflect what took place. In view of the foregoing, it may be said that the theory of the cash account demands that it shall be made to re- flect actual, not theoretical, receipts and disbursements, and a balance resulting from actual positive and negative facts, which can be readily proved and supported. To make this possible, the cash journal must be used strictly as the scales in which the cash transactions are to be weighed as they occur, and not as they might occur. The Cash Account and the Cash Balance One of the disadvantages of the cash account as it is usually kept, no matter whether or not the foregoing principles are applied, is that under the generally estab- lished method of crediting cash when a check is drawn instead of when it is paid by the bank, the ledger account with cash may not represent the actual amount of cash in bank. To some accountants this spells misrepresentation of the facts. They claim that a check being an order to the bank to pay cash, the financial status of the enter- prise has not changed until the payee under the order has presented it to the bank, and has actually received pay- ment. This, of course, means that since the check was issued to liquidate a liability, the liquidation has not taken place, and the liability exists until the check is paid. Go- ing still further, they say that if on December 31 the books of A show that he has paid B $50, while the books of B say that A still owes him $50, one set of books does not state the truth at December 31. CASH ACCOUNT PETTY CASH 143 We may, with all propriety, decline to allow a love for logic to lead us so far from the domain of actuality. Still we must, in all justice, present the favorite argu- ments of all schools. It has been said that a cash account which does not show the true balance held by the de- positories to the credit of a concern is useless in checking the accuracy of the interest credited by a trust company, say, on daily balances. A Correct Cash Account This is not the place for a discussion of the merits of the foregoing claims, but it is the place for the presenta- tion of a very interesting handling of the account with cash, which some railroads, and at least one of the largest life insurance companies, have adopted, either substanti- ally as given in the following or with slight alterations. The method may, or may not, be the result of the belief of its originators in the- accounting fallacy of the one which it replaces, but, strangely enough, it is not subject to any of the criticisms which have been made of its rival. Its proper operation requires, besides the keeping of the usual financial books: 1. That all expenses incurred and all payments to be made be entered in a voucher record (or a series of records assigned to typical classes of ex- penses). 2. The keeping of as many check registers as there are depositories. 3. A ledger account with audited vouchers unpaid. 4. A treasurer's memorandum book intended to show daily the available balance of cash subject to check. It presupposes an arrangement whereby the depos- itories will agree to return daily the canceled checks. This 144 THE THEORY OF THE ASSET ACCOUNTS CASH ACCOUNT PETTY CASH 145 a od .6 fI4 6 THE THEORY OF THE ASSET ACCOUNTS 4- 3 I I I 1 CASH ACCOUNT PETTY CASH 147 vital prerequisite of the method is sufficient to make it impracticable to the average concern. As to its technique: The checks drawn are recorded daily in the proper check register, and the amount drawn is recorded by the treasurer in his memorandum book of available cash. The check registers provide for the insertion of the numbers of the vouchers for which checks are drawn, as well as for any other information which may facilitate checking from book to book. The amount of canceled checks returned by the banks is posted daily in the cash book to the credit of cash, and to the debit of audited vouchers unpaid. The returned checks are also recorded in the check register and in the voucher record. At the end of a given month, the situation is as fol- lows: 1. The ledger account "Cash" represents exactly the balance held by the banks to the credit of the concern. 2. The treasurer's memorandum book of available cash shows the amount of funds held by the banks, against which the concern can draw by check. 3. The cash book makes it possible to obtain the daily balances, and to compute the amount of interest which has been earned. 4. The ledger account "Audited Vouchers Unpaid" represents: a. The amount of vouchers for which no check has been drawn b. By reference to the check register, the amount of vouchers for which checks have been drawn but remain unpaid 5. The voucher record gives, no matter how required, the exact detail of the liability for audited vouchers un- paid. I4 g THE THEORY OF THE ASSET ACCOUNTS 6. The balance sheet shows: a. As the books stand, what is sometimes called the only true financial status of a concern. b. By the application of the following journal entry the financial status of the concern as it is customary to present it : Audited Vouchers Unpaid . . $ .... To Cash $. . . . The amount of vouchers for which checks have been issued, but are still unpaid by banks. Expressed in book totals and ledger accounts, the cash situation, say at June 30, 1914, irrespective of former balances, is shown by Figures 27-29. Nature of Petty Cash Petty cash may be: i. A part of the cash receipts of a certain period, re- corded in the cash book, but not deposited in the bank be- cause it is to be used for small current disbursements. In this form, petty cash is part of general cash, and should figure in the cash book balance of the funds available at the end of the period. Disbursements made out of petty cash are temporarily withheld from the cash book, to be recorded periodically, or when they have reached a stated amount. Any petty cash book which may be used under this method of handling petty cash, is merely a memo- randum which has no part in the scheme of the financial books of the concern. No entry of any kind is necessary to record the withholding of receipts for petty cash purposes. CASH ACCOUNT PETTY CASH 149 2. An amount withdrawn from the bank, the with- drawal being recorded in a ledger account known as "Petty Cash," raised to reflect the outgo of small sums of cash disbursed currently for items of expense which are too small to be conveniently paid by check. In this form, the account is independent of the general cash account, and its balance does not figure in the cash book balance of available cash (unless sent back to it periodically). The petty cash book is also an independent journal which is used as a posting medium, precisely like its more im- portant prototype, the general cash journal. The expression in general journal form, of the cash book entry creating a petty cash account as described in class 2, is: Petty Cash $ To Cash $ The expression in general journal form, of the entry necessary to record the petty cash disbursements of the period in the proper general ledger accounts, is, say: Telephone and telegrams $ 7.50 Postage 5.00 Office supplies 2.30 General expense 17.20 To Petty Cash $32.00 To record the petty cash transactions of the period. 3. An amount withdrawn from the bank, and set up as a fund intrusted to a petty cashier whose duty it is to give change and to make all disbursements for petty ex- penses, and in settlement of invoices deemed too insig- nificant to be passed through the purchase journal. The fund is recorded in a special ledger account, bearing as a '50 THE THEORY OF THE ASSET ACCOUNTS CASH ACCOUNT PETTY CASH 15 j title "Petty Cash Fund," or "Petty Cash Fund John Doe," or some other appropriate name. The expression in general journal form, of the cash book entry creating this class of petty cash, is: Petty Cash Fund John Doe $ To Cash $ To create an imprest fund, to be used by John Doe for petty cash disbursements. This method of treating petty cash differs from the one described under 2, in that it is supposed to show no fluctuations. Until returned to the general cashier it remains on the ledger at the same figure. In order to make this possible, all sums of money paid out by the petty cashier are returned to him periodically, or when- ever the petty cash fund has been depleted to a stated figure. Maintaining the Imprest Fund When the petty cashier desires to replenish his fund he presents to the general cashier a statement setting forth his expenditures, supported by proper vouchers. The statement may be as shown in Figure 30. The voucher may assume a much simpler form; the essential point is that the general cashier may readily obtain the data necessary to properly record in the cash book the expenditures made for him by the petty cashier. The check issued is either cashed by the petty cashier at the bank, or cashed by the general cashier himself. Which- ever way it is done, the fund of the petty cashier is now re- stored to its original amount. The expression in general journal form of the entry made by the general cashier in the cash book is: THE THEORY OF THE ASSET ACCOUNTS A* . $4O.OO B 20.00 C 6 5-oo D 20.00 E 72.20 G 3 2 -8o To Cash $250.00 For disbursements made by the petty cashier. Theory of the Imprest Fund It will be noticed that at the time the fund was cre- ated, the cash book entry merely recorded the setting aside of a portion of the asset "cash," for purposes of petty disbursements. Thus the cashier set apart from his gen- eral funds, a sum of money which he intrusted, as an "im- prest" fund (money advanced, money loaned, money in- trusted to a paymaster), to the petty cashier. This ex- plains why the word "imprest" is used in qualifying the above mentioned method of handling petty cash. The system appears to have originated in the Imprest Office of the British Admiralty, in connection with the disburse- ments made by subaltern paymasters for the account of the general paymasters. Special Duties of the Petty Cashier In some concerns one of the duties of the petty cashier is to cash checks for the officers, the clients or the cus- tomers, and the employees. This brings about complica- tions which necessitate the opening of a special bank ac- count in the name of the petty cashier. He deposits daily to his credit the checks which he has cashed, and draws against the account whenever he requires funds. The handling of the fund is the same as indicated in the fore- going, but the memorandum petty cash book is arranged to show the exchange and bank transactions. (Figure 31.) * Letters refer to ledger accounts. CASH ACCOUNT PETTY CASH 153 OK PETTY CA5H IS 1 n 4 ^ -M dj'33 *5 1 5 JN H J4 4^ \\ CHAPTER XIV ACCOUNTS WITH CUSTOMERS Entries in Customers' Accounts Cash may be affected by such a diversity of transac- tions, that it is not possible to state in advance the sources from which it will come or the channels through which it will go. Hence, it may be said of the cash account that it possesses no well-defined mechanism. In contradis- tinction, the customer's account presents a series of anatomical units with which we may become so thor- oughly familiar as to be able to locate and assemble them readily, no matter how scattered they may be. As soon as the word customers is mentioned, the mind of the accountant reverts naturally to the business trans- actions which affect their status on books of record. We think of charges to them for: 1. Sales on credit 2. Refunds when, having overpaid their accounts, they receive back that which was paid by them without being due and of credits to them for: 1. Returned sales 2. Settlements by them in cash or its equivalent 3. Deductions from the amount receivable from them in the line of cash discounts, trade discounts, allowances for defective goods, damaged goods, old goods, shortages in shipments, freight paid by them and chargeable to the vendor, etc., etc. 154 ACCOUNTS WITH CUSTOMERS 155 Trade Discounts The only one of the foregoing components of the cus- tomer's account which might confuse the student, is trade discounts. Trade discounts are said to be "deductions from price lists allowed to the trade." They differ from cash dis- counts in that the taking advantage of the latter depends upon the financial status or prompt payment of the one to whom it is offered, whereas the amount of the former will positively not be included in the customer's remit- tance. A bill might include two kinds of discounts: one of, say, 10% to be deducted from the face of the bill, and another of, say, 2% to be similarly deducted provided re- mittance is made within ten days. It is clear that unless the debtor is in a position to pay within the allotted time, the only deduction which he can make from the bill is for the trade discount which, under all conditions, is no part of the contract of sale to which he has become a party. If the policy of the concern is to charge all its cus- tomers with the list or catalogue price, there are two pos- sible ways of relieving the accounts of the beneficiaries of trade discounts, of the excess charged to them over the amount which they are expected to pay: 1. Let the customers deduct the trade discounts from their remittances, and use the cash book as the journal through which they will receive credit for the amount not remitted. 2. Before the customers remit, clear their account by journal entry crediting them and debiting: (a) Trade Discounts (o) Merchandise, or Sales, or any other account which may have been originally inflated on the credit side by the amount of the trade discounts i 5 6 THE THEORY OF THE ASSET ACCOUNTS It will be noticed from the above that the treatment indicated under "a" compels the raising of a general ledger account with trade discounts; whereas the second treatment, "b," eliminates the account entirely. This means that, in the first instance, there has been created a special nominal account measuring the extent of the de- duction from the income to be received from sales, due to the desire of the administration to favor dealers in order that other expenses (such for instance, as advertising, or salesmen's salaries and commissions) may be correspond- ingly reduced; and that, in the second instance, the special nominal account has been avoided, in order that the already existing account with merchandise or with sales may show the net result of the sales as far as income is concerned. If the policy of the concern is to charge all customers with the net amount collectable under the contract of sale, there can be no ledger account with trade discounts, and that component will be found neither in the account with customers, nor in the account with merchandise. Hence, whatever information might be required in re- gard to the extent of the reductions which have been made from the catalogue price, is lost in so far as the ledger is concerned, and must be sought elsewhere. "Accounts Receivable" Before leaving the subject of customers' accounts, it may be well to call to the attention of the student the fact that the term "Accounts Receivable," which is often applied to them, is to be condemned so far as the general ledger is concerned. The term as generally understood, refers to a balance sheet group, which is likely to embrace a multitude of accounts other than with customers. Since the balance sheet is a financial statement purporting to show the true financial condition of the concern at a given ACCOUNTS WITH CUSTOMERS 157 date, it can afford to speak in concrete form, and to state broad classes of facts which, if not sufficiently illuminating by themselves, can be supported by explicit schedules. It is eminently proper for it to include in the group "Ac- counts Receivable," accounts current with customers, ad- vances to agents, and claims against transportation com- panies which have been recognized as valid and are await- ing settlement, etc. But it is not proper for the ledger to speak vaguely; it must index the facts with at least as much care as the journal takes in weighing them, and it must adopt a terminology which will place each account in a position to state clearly what it contains. CHAPTER XV NOTES AND BILLS RECEIVABLE Notes Receivable F. A. Cleveland, in "Funds and Their Uses" says of promissory notes : "A promissory note is a written contract for the future delivery of a specified sum of money * * * The delivery must be made on or before a stated time, and nothing will satisfy the contract except the delivery of the particular thing promised." Treatment of Notes Receivable Assuming that a promissory note has been given by a customer in settlement of his account, it would appear from the above definition that the execution of the in- strument of credit has so altered the status of his account that the change must be recorded. He has indeed entered into a second contract quite different from the contract of sale under which he became liable for the goods sold to him on credit; he has substituted a written promise to pay a certain sum of money in a determinate future, for an oral or implied promise to pay a certain sum of money within a time more or less definite. While under the terms of the first contract, he could reduce his liability by mak- ing claims for allowances, or even by returning part of the goods sold to him, nothing will satisfy the second con- tract, except the delivery of the particular thing promised. Still, there are accountants who claim that since the con- sideration for the second contract is precisely the same as 158 NOTES AND BILLS RECEIVABLE 159 the consideration for the first contract, nothing has hap- pened, so far as accounting is concerned, on account of the execution of a promissory note, and no entry is neces- sary in the customer's account until the note has been met at maturity, or discounted. Nevertheless, it appears to be the almost universal custom to credit customers with the amount of the prom- issory notes which they give in settlement of their ac- counts. This treatment of the matter is based upon the theory that an open account with a customer must be proved if contested, whereas the promissory note is prima facie evidence of value received; that the time at which settlement of an account current is demanded does not alter the liability of the debtor, whereas the maker of a promissory note is liable only if the instrument is pre- sented for payment at the specified time, and surrendered; that when the payee under a note sues the party who gave it and dishonored it, he does not sue for payment of a customer's account, but for payment of the note. The usual way of treating the general ledger account with notes receivable is to debit it with the face value of the notes received, the counter entry being a credit to the customers' controlling account,* and, if the occasion de- mands, to an account with interest for the excess which the note carries over the value of the account for which it settles; and to credit the account with the amount of the note when it is met at maturity, or as soon as it has been discounted at the bank, the counter entry being a debit to cash, in the first instance, and a debit to cash and to interest and discount in the second instance. Treatment of Contingent Liability on Notes Discounted The discounting of notes receivable raises the ques- tion of the liability of the one who has discounted it, to * This, of course, necessitates a credit to the account of the customer in the subsidiary ledger. i6o the broker or bank which has purchased the paper. Leslie J. Tompkins says in regard to the liability of the parties to a note: "Every party to a negotiable instrument, whether he be the drawer or maker, acceptor or indorser, enters into a contract which, in some respects, differs from that entered into by each of the other parties named. This contract carries with it certain liabilities which he cannot evade." Since the customer's note has been transferred to the discounting bank by indorsement, it follows that the liability of the transferrer is contingent upon the dis- honor of the note at maturity. The desire to express this contingent liability on the books of concerns which re- ceive many promissory notes and discount them regu- larly, has brought about a handling of the account with notes receivable, which appears to give quite a twist to the principles of double entry. We have said that an incoming value is counterbal- anced by an outgoing value equal, inferior, or superior to it. Applying this principle to the discounting of a prom- issory note, we would say that there has come in a value (cash) inferior to the outgoing value (promissory note re- ceivable) and that, as a consequence, there has come into the business a loss under the form of discount. Thus, equilibrium having been disturbed by the outgo of the note, has been reestablished by the receipt of cash, and the recording of a loss equivalent to the excess of the outgo over the income. But under the theory that the contingent liability must be recorded, this is what takes place: Notes Receivable remains unaffected in so far as the books are concerned; Cash is debited with the amount re- ceived, Interest and Discount is debited with the amount charged by the bank, and a liability account known as ''Promissory Notes Discounted" is credited. As soon as information is obtained in regard to the payment of the NOTES AND BILLS RECEIVABLE I ^ I rotes at maturity, the liability account is debited, and Notes Receivable is credited with the face value of the note which has been met. If we were to submit this treatment to the rigid test of the principles of accounting, we would see that it does not express the transactions as they occurred. When the bank discounts a note, it does not purchase the vendor's contingent liability under the note; nor does it give its money in exchange for that liability. It purchases a com- mercially negotiable instrument which, at the time of sale, was recorded on the books of the vendor concern as an asset. In other words, it purchases an asset. Of course the bank buys the instrument subject to its being met by the maker at maturity, and if the instrument proves with- out value, the purchaser will call upon the vendor to make good the loss; 'but that liability of the vendor is prob- lematic, whereas there is no question but that his asset "notes receivable" has been sold. This is precisely the reason why some accountants object to showing the lia- bility for discounted notes on the balance sheet otherwise than as a footnote. Somewhere between the two methods, other accountants claim to have found the only true expression of the facts. They show the notes receiv- able at the full value of the instruments unmatured, whether held or discounted, and deduct therefrom on the asset side of the balance sheet, the contingent liability. Hence, the asset as extended represents the exact value of the notes held. Dishonored Notes In regard to the dishonor of promissory notes at ma- turity, the handling differs according as to whether they were discounted or held until due date. In the former case, the treatment differs also as to whether the record- ing of the discount was made in the account "Promissory THE THEORY OF THE ASSET ACCOUNTS Notes," or in the "Contingent Liability" account. Dis- honored notes which have previously been discounted and credited to the asset account, are treated as follows: 1. Credit Cash with the amount of the note and of the protest fee paid to the bank. 2. Debit the maker of the note with the face value of the dishonored instrument, as well as with the amount of the protest fee, or: Debit customers' controlling account with the face value of the note and the amount of the fee. Dishonored notes which have been discounted, and credited at the time to the contingent liability account "Promissory Notes Discounted," require the following entries: 1. Credit Cash with the amount of the note and of the protest fee paid to the bank. 2. Debit "Promissory Notes Discounted" with the face value of the note, and the maker of the in- strument with the protest fee. 3. Credit Notes Receivable with the face value of the note. 4. Debit the maker of the note with the face value of the dishonored instrument, or: Debit customers' controlling account with the face value of the note, and the amount of the fee. Dishonored notes which have not been discounted, re- quire the following entries: 1. Credit Notes Receivable with the face value of the note. 2. Credit Cash with the amount of the protest fee paid. NOTES AND BILLS RECEIVABLE 163 3. Debit the maker of the dishonored instrument with the face value of the note as well as with the amount of the fee, or: Debit customers' controlling account with both the amount of the instrument, and the amount of the fee. The theory underlying the debit to the maker of the dishonored instrument, is to the effect that since the note so altered the status of the customer's account that it had to be closed, it cannot now be reopened. The theory underlying the debit to the customer who gave the promissory note which is now dishonored, is to the effect that the consideration for the promissory note being the same as the consideration for the recording of the claim against the customer in the first instance, it is quite correct to reopen an account which was closed, upon the assumption that the instrument of credit would be met at maturity. This latter theory does not appear to have the courage of its convictions; if it is true that the nature of the customer's account was not sufficiently altered by the execution of the promissory notes to pre- clude its being reopened, then it seems that it should not have been closed at all. Bills Receivable The asset account "Notes Receivable" is frequently found, in practice, under the name of "Notes and Bills Receivable," and not infrequently under the generic name of "Bills Receivable." So far as accounting is concerned, the theory of these two classes of commercial instruments does not differ materially; still, there is good reason why it might be better to keep separate accounts with them. "A bill of exchange," says Mr. Tompkins in his book, "The Law of Commercial Paper," is an unconditional order in writing addressed by one person to another, 164 THE THEORY OF THE ASSET ACCOUNTS signed by the person giving it, requiring the person to whom it is addressed to pay on demand, or at a fixed or determinable future time a sum certain in money to order or to bearer." Thus a bill of exchange introduces into the relations between the proprietor of the business and his customer, a third person, the drawee, who, after the bill has been presented to him, becomes the acceptor, that is to say, the party liable to the payee. This alters the liability of the customer to the proprietor of the business; from primary it becomes secondary. No such alteration of liability is found in a promissory note. Whether or not the keeping of separate accounts with notes and bills is deemed advisable by a concern whose custom it is to receive both classes of instruments, it seems that a concern which receives promissory notes only, should not permit the use of the term "bills receiv- able" on its ledger. The very name of the ledger account gives misleading information. The opinion held upon this subject by W. M. Cole, of Harvard University, is quite different from the one ex- pressed above "The account in which negotiable notes are recorded is called 'Bills Receivable.' Drafts which have been ac- cepted by those upon whom they are drawn, are also recorded in Bills Receivable; but drafts which have not been accepted are not recorded at all on the principal books, for until accepted they have no value other than that of any written request. It should be noted that Bills Receivable has a restricted significance, and does not at all include ordinary so-called 'open accounts' or 'book accounts,' i. e., sums owed to a business by customers to whom it has sold goods on trust. The term 'Bills Receivable' is used only of promises to pay, written in the form of promis- sory notes or of accepted drafts." CHAPTER XVI ACCOUNTS WITH GOODS Merchandise Account of Trading Concerns The original purpose of this account was to gather the factors which affected the gross profits on merchandise. It will be remembered that when speaking of the prin- ciples of double-entry bookkeeping,* it was said that in- coming values greater than the outgoing values which they replaced, produced a gain which should be recorded in a nominal account. So far as merchandise is concerned, this could not be done conveniently, unless the cost of every object sold were known by the bookkeeper. If this were the case and he were able to furnish the physical effort which such bookkeeping would require, his entry would be, for every sale : Customer (or Cash) $50.00 To Merchandise $35-QO " Profit on Merchandise 15.00 It was found convenient to credit the goods account with the sale price of the goods sold, and, periodically, to apply to it the value of the inventory remaining on hand. Thus the skeleton of the merchandise account is merely this: Debits Initial inventory Purchases of the period Gross profit on sales * Page 70. Credits Sales of the period Closing inventory THE THEORY OF THE ASSET ACCOUNTS But since both goods purchased and goods sold are likely to prove unsatisfactory to the buyer, it follows that original debits made to the merchandise account are true only if none of the goods have been sent back to the ven- dor; and that original credits are true only if none of the goods have been returned by the customer. When goods sold are returned, the merchandise account is debited in order that the sale may be canceled ; and when goods pur- chased are sent back, the merchandise account is credited in order that the purchase may be canceled. At this point, the structure of the account is as follows: Debits Initial inventory Purchases of the period Returned sales of the period Gross profit on sales Credits Sales of the period Returned purchases of the period Closing inventory Inasmuch as the purpose of the merchandise account is to show the true gross profit on sales, it is evident that losses due to merchandise being destroyed as unfit to be sold, or to deterioration reducing its value, must be ac- counted for; and it is also plain that unless this is done before inventory time, by a credit to the goods and a debit to profit and loss, the profit shown by the merchandise account will not be the profit on sales, and the profit and loss account will fail to convey proper information in re- gard to extraordinary losses. Thus, the components of the merchandise account have become : Debits Initial inventory Purchases of the period Returned sales of the period Gross profit on sales Credits Sales of the period Returned purchases of the period Merchandise destroyed Closing inventory It has been denied that the merchandise account should ever go further than this. On the other hand it has been claimed that if thus restricted it cannot show'- ACCOUNTS WITH GOODS 167 1. On the debit side: a. The cost of freight and cartage incurred on the goods purchased. b. The cost of the freight and cartage on sales, which the vendor has agreed to pay in order that he might obtain for his goods the price recorded by the sales. c. The deductions which the vendor has agreed to make .from the catalogue price, if his policy is to record all sales at that price. d. The freight and cartage paid by the vendor on goods returned to him by customers. 2. On the credit side: a. The proportion of the freight and cartage in- ward which applies to goods unsold. b. The freight and cartage paid on goods pur- chased which have been returned to the vendors. c. The trade discounts which would reduce the cost of the goods purchased, in case they have been recorded at catalogue price. The above components, gathered according to their nature, show the structure of the merchandise account to be : Debits 1. Initial inventory 2. Purchases of the period 3. Freight and cartage inward on purchases 4. Freight and cartage outward on sales 5. Returned sales 6. Freight and cartage inward on returned sales 7. Trade discounts on sales 8. Gross profit on merchandise Credits 1. Sales 2. Returned purchases 3. Freight and cartage inward, paid at time of purchase, on purchases now returned 4. Trade discounts on purchases 5. Merchandise destroyed as un- fit for sale 6. Deterioration of merchandise 7. Freight and cartage inward on purchases, applicable to goods unsold 8. Closing inventory X 68 THE THEORY OF THE ASSET ACCOUNTS Analysis of the Merchandise Account Prior to the division of the journal into its components (purchases, sales, purchases returned, sales returned, cash, etc.) the merchandise account, being posted daily, con- tained a multitude of unclassified facts which required ex- tensive analysis in order to show how the gross profit was obtained. This is still the case whenever detail posting is in vogue. But when books of original entry are so con- structed as to permit of the monthly gathering of posting material, the merchandise account becomes a perfect sum- mary of trading transactions. As each class of facts is sup- ported by details to be found in analytical journals, no analyses are necessary, and the material for financial state- ments is obtained by merely adding together the compo- nents of like nature as found in the accounts for the ac- counting period. Subdivisions of the Merchandise Account It has become the fashion to advocate the abandon- ment of the "old-fashioned merchandise account." A series of "simple" accounts, each one containing one of the components of the old account, will, it is claimed, give better results without analysis. It must be borne in mind, however, that after all the components of the merchandise account have been raised to the dignity of individual ac- counts, they represent nothing more than the monthly footings of columns of journals, and that in order to lead to a conclusion in regard to the result to which they all have contributed in a positive or in a negative way, they must be methodically gathered either in a trading ac- count, or in the profit and loss account. ^ The accounts which are to be opened, to satisfy the re- quirements of this theory, are the very components ex- pressed in the foregoing, in connection with the merchandise ACCOUNTS WITH GOODS ify account. Their accounting treatment at the end of the period is expressed by journal entries as follows : Freight and Cartage Inward on Purchases Returned $ To Freight and Cartage Inward on Purchases $ To reduce the latter account to the amount of the uncanceled transaction. Freight and Cartage Inward applicable to subsequent periods $ To Freight and Cartage Inward on Purchases $ To set up as a deferred debit item the portion of freight applicable to future sales. Returned Purchases of Trading Merchandise $ To Purchases of Trading Merchandise $ To reduce the latter account to the amount of the uncanceled transactions. Inventory of Trading Merchandise $ To Purchases of Trading Merchandise $ For portion of purchases of the period, not sold, and still held as an asset. Trade Discounts on Purchases of Trading Mer- chandise $ To Purchases of Trading Merchandise $ To deduct from cost of purchases the price list de- duction to which we are entitled. Profit and Loss $ To Purchases of Trading Merchandise $ " Freight and Cartage Inward on Purchases. To close in the summary account the purchase cost of the goods sold, and the additional cost of handling. Sales of Trading Merchandise $ To Returned Sales of Trading Merchandise.. $ To reduce the former account to the amount of the uncanceled transactions. Sales of Trading Merchandise $ To Trade Discounts on Sales $ To deduct from the income from sales the price list deduction to which our jobbers are entitled. Sales of Trading Merchandise $ To Profit and Loss $ To close in the summary account the gross in- come obtained from sales. I70 THE THEORY OF THE ASSET ACCOUNTS $. . Profit and Loss ' ' ' To Freight and Cartage Outward on Sales of Trading Merchandise * For cost of forwarding to f. o. b. points, according to agreement with customers. $ Profit and Loss To Trading Merchandise Unfit for Sale " Deteriorated Trading Merchandise For loss of capital having no relation with pur- chases and sales, but connected with trading merchandise. As a result of the above entries, the Profit and Loss account will exhibit the following skeleton : PROFIT AND Loss 1. Cost of Purchase of Merchandise Sold: a. Cost of Purchases Sold b. Cost of Handling, Inward 2. Freight and Cartage Outward on Sales... 3. Merchandise Unfit for Sale 4. Deteriorated Trading Merchandise Sales of Trading Mer- chandise The gross profit on merchandise results from the deduc- tion of the above debits i and 2, from the only credit con- tained in the account. It is pointed out that whether the gathering of merchan- dise components is done monthly in the merchandise account, or only at the end of a period, in the Profit and Loss account, makes no difference whatever. Since one of the main ob- jects of accounting is so to gather financial facts that it will be possible readily to obtain financial statements, it must be admitted that complex accounts posted from analytical books of original entry are equally as satisfactory as simple ac- counts which are supposed to render the ledger analytical. ACCOUNTS WITH GOODS ^ Inventory of Trading Merchandise The inventory of a trading concern should be valued at cost. It has been held that it is proper to compute it on the basis of the market value, if such a value is smaller than cost; but it is generally denied that a market value higher than cost can be used. If the lower value is al- lowed, there is no reason why the higher one should not be. There is, however, a good reason why market values should not be used at all. Accounting is not interested in what would have happened "if," but in what has actually happened; and since the goods unsold were purchased at a certain price, the profits realized are to be measured by comparing that price with the proceeds. To reduce the inventory to a value lower than cost, is to add to the cost of the goods sold during the period; and to raise the in- ventory to a value greater than cost, is to reduce the cost of the goods during the period. In either case, the result is contrary to the truth. The taking of a physical inventory at the end of every accounting period is customary with all trading concerns selling goods which are subject to shrinkage, to deteriora- tion by exposure, to thefts, or to errors in weighing at time of purchase and of sale. When, however, these con- ditions are not present, it is not unusual to find that a book inventory is considered quite satisfactory. In such cases, the purchases of merchandise are entered by classes of goods, in a "merchandise stock book" showing, on the debit side, the quantities purchased, their cost per unit, and their money value; in the credit column, the quanti- ties sold, their cost per unit, and the money value of the sales, an average being established if the occasion arises; in the balance column, the quantities remaining, their cost per unit, and their money value, and, if prices are sub- ject to fluctuations, or have fluctuated, the average cost and money value. (See Figure 32.) 172 THE THEORY OF THE ASSET ACCOUNTS i I* ACCOUNTS WITH GOODS 173 Merchandise Accounts of Manufacturing Concerns Traders sell their goods in the shape in which they purchase them; manufacturers sell "finished goods" which have undergone a "manufacturing process" in the course of which labor has been expended, materials and supplies consumed, and expenses incurred. Thus, so far as the goods are concerned, there are three distinct stages: 1. The stage when they are in their raw state 2. The stage when they are "in process" (or in "progress") 3. The stage when they are "finished" As they pass from stage to stage, the goods accumu- late cost, until, upon completion, they stand precisely in the same relation to the manufacturer as trading goods do to the trader. Thus, it may be said that the "Finished Goods" account is the "Merchandise" account of the manufacturer, built up from its sundry components: Debits Initial inventory Cost of goods finished during the period Returned sales Gross profit on sales Credits Sales Closing inventory As to the elements of cost which the goods manufac- tured accumulate while passing from stage to stage, they may be briefly stated as follows: i. Raw Material Stage (Ledger Account: "Raw Ma- terials") : a. The cost of purchase of materials and supplies b. The cost of freight and cartage inward thereon c. The cost of handling and storing them The last two items have sometimes been referred to as "Pre-Process Cost." I74 THE THEORY OF THE ASSET ACCOUNTS 2. Goods in Process Stage (Ledger Account: "Goods in Process") : a. Cost of raw materials transferred from stores b. Productive labor, that is to say, the skilled labor which produces the finished goods, and can be allocated: (1) To the product at large if only one class of goods is manufactured (2) To individual units of production if several classes of goods are manufactured (3) To job numbers in either case This labor is consumed for the production of the manufactured goods only, and has nothing to do with the other phases of the activities of the factory. c. Manufacturing burden (also called manufacturing overhead), that is to say, the expenses incurred in connection with the operations of the factory, which, while part of the cost of manufacture, cannot be allocated to any given unit of the production, and must be apportioned thereto on some scientific basis. It includes: ( i ) Unproductive labor : (a) Superintendence and supervision, in- cluding the salaries of the superin- tendent, and of his assistants, and the wages of the foremen. (b) All the unskilled labor which, while not directly expended on the manufac- tured product, is necessary and beneficial thereto, or is required in order that the factory may continue as an organized body. ACCOUNTS WITH GOODS 175 (2) Factory expenses, such as fuel, light, power, rent, sundry supplies, repairs to machinery and tools, tools consumed as a result of operations, and, if operating reserves are considered better than surplus appropria- tions, the estimated depreciation of machin- ery and tools. d. General factory burden (also called general fac- tory overhead). When the organization of the factory is such that it is run as a distinct de- partment, any expense which is called for by that very organization, such, for instance, as the keeping of factory records, the cost of station- ery and printing, the estimated depreciation of the factory buildings and factory building equip- ment, etc., must be apportioned to the cost of the goods in process. Finished Goods Stage (Ledger Account: "Finished Goods"): a. When goods have passed through the "process" stage, and are ready for sale, their cost is cred- ited to the account "Goods in Process," and debited to the account "Finished Goods." At this point, we really have a manufactured mer- chandise account, which differs from the trad- ing merchandise account, only in that the latter shows every unit of its mechanism, while the Finished Goods account receives from an inter- mediary, a .unit composed of: Ci) Purchase cost of goods ready to be sold, including the following components of the merchandise account: (a) Initial inventory of goods purchased (b) Purchases of the period 176 THE THEORY OF THE ASSET ACCOUNTS (c) Freight and additional cost of goods purchased Less: (d) Closing inventory of goods pur- chased, inflated by additional cost applicable thereto (2) Manufacturing cost of goods purchased and made ready to be sold The components of the Finished Goods account are : Credits Sales Closing inventory Debits Initial inventory of goods finished and unsold during the prior period Cost of goods manufactured dur- ing the present period Returned sales Allowances on sales Trade discounts Gross manufacturing profit If the system of bookkeeping which has been adopted, provides for separate accounts for sales and for the trans- actions incident thereto, the Finished Goods account is reduced to the functions of a species of Inventory ac- count, of which the following are the components: Debits Initial inventory Cost of goods manufactured dur- ing the period Credits Closing inventory Cost of manufactured goods sold (debited to profit and loss or to a group account "Cost of Goods Sold," which is, in turn, closed into the Profit and Loss ac- count) Inventories of the Merchandise Accounts of Manufacturing Concerns At the close of the accounting period, the valuation of inventories of raw materials, sundry supplies, goods in ACCOUNTS WITH GOODS process, and finished goods, presents serious difficulties, unless the cost system of the concern is sufficiently de- veloped to give positive and ready data concerning the manufacturing process. Inventory of Raw Materials and Sundry Supplies If, in connection with the raw materials and the sun- dry supplies, there is kept a stock ledger (Figure 33), a book inventory may be obtained which will check the accuracy of the physical inventory, or which may even be allowed to take its place. The stock ledger is so arranged that it contains an account with each class of merchandise. Individual accounts are debited with the quantity, the cost per unit, and the total money value of the initial in- ventory (if any) and of the purchases of the period; and credited with the quantity, cost per unit, and money value of the material which goes out upon requisitions. In- formation is supplied also as to the destination of the out- going material. The difference between the debits and credits gives the quantity and money value of the goods remaining in store; it also gives the cost per unit if the units have been acquired at a uniform figure. In the con- trary case, the average cost price must be obtained as well for the amount of the goods remaining on hand as for the value of the goods requisitioned for factory or other purposes. If no stock ledger is kept, a physical inventory is essential, the pricing of which will have to be established by reference to the purchase invoices of the period. The process will be not only lengthy, but inaccurate, unless a great deal of care is exercised. It will be noticed that the example submitted affords useful information to the purchasing agent, in that it in- dicates the exact quantity of material ordered which has not as yet been received at inventory time, or at any other time. It also gives, under the -heading "General Order THE THEORY OF THE ASSET ACCOUNTS ACCOUNTS WITH GOODS 179 No.": the quantity and the amount of material which has been consumed for purposes other than for manufacture, such as repairs and maintenance, additions to plant, etc. Inventory of Goods in Process If the concern has an adequate system of cost account- ing, the recapitulation of the cost sheets (Figure 34) estab- lished for job numbers or for stock numbers (or for both) still in progress, will give the inventory value of the asset "goods in process," provided it is customary to apply the overhead burden of a period to the processes of that period. If the custom is to apply the burden to finished goods only, either the pricing of the inventory of "goods in process" will have to take into consideration, subject to a subsequent reversal of the entry, the propor- tion of the burden applicable to the goods when com- pleted; or there will have to be created a special account which will contain the said burden, in order that it may be withheld from the cost of operations, and shown in the balance sheet as a deferred debit to cost of goods under- going process of manufacture. With minor alterations in the descriptive and statisti- cal part thereof, Figure 34 can be used for factories which operate on job numbers. Inventory of Finished Goods Under a proper cost finding and cost recording system, the valuation of the inventory of finished goods is estab- lished precisely like that of goods in process, by recapitu- lating the cost sheets relating to the job (or stock) num- bers which have not been sold during the period. Inventory When There Is No Cost System If there is no cost system, the valuation of the inven- tories of goods in process and of finished goods will have THE THEORY OF THE ASSET ACCOUNTS ACCOUNTS WITH GOODS igi to be established by what might be called the "dead- reckoning" method. A satisfactory basis will have to be found for the application of labor and overhead ex- penses to the material represented by the two classes of goods. Under these conditions, it is evident that no ac- countant is in a position to pass upon the accuracy of the figures submitted. His task, however, instead of being lightened by this exemption from responsibility, will be materially increased owing to the difficult character of the periodical adjustments to be made in order that the general books may support the financial statements which he will submit. The inventory of raw materials and sundry supplies, when applied to the net debit of the general ledger ac- count therefor, will give the consumption of materials and supplies during the period, either for manufacturing pur- poses, or for the general purposes of the plant. The divid- ing line between these two classes of facts will be given by an analysis of all the available factory records and memoranda which may throw any light whatever on the subject. The amount used for manufacturing purposes will be transferred to the debit of a ledger account "Goods in Process" raised for the purpose of obtaining the cost of the goods put in progress during the period, while the amount used for the plant will be debited to the different accounts with subdivisions of the plant, or to Repairs and Maintenance account. To the account "Goods in Process" will be debited separately : 1. The productive labor 2. The factory manufacturing overhead 3. The factory general overhead applicable thereto, as ascertained from analyses of the pay-roll and other records, and from the classification of the nominal factors disclosed by the general books or by !g 2 THE THEORY OF THE ASSET ACCOUNTS analyses thereof, and as distinguished from the propor- tion of these items which is to be charged to capital ac- counts or to repairs and maintenance accounts. At this point, the account "Goods in Process" will contain the total cost of the manufacturing activities of the factory for the whole period. It will now be necessary to credit the account, and to debit Finished Goods, with the difference between the total value of the individual items i, 2, and 3, and material, and the amount thereof said to be applicable to the goods unfinished and still on hand at the end of the period. The balance remaining in the account "Goods in Process," will be the inventorial value of that asset. The last step will be to credit the Finished Goods ac- count with the value of an inventory which will be estab- lished by adding to raw material value of goods on hand, a proper proportion of productive labor, and a proper pro- portion of the two classes of factory burden. The balance of the account will be transferred direct to Profit and Loss, or to an intermediate account "Cost of Goods Manufac- tured and Sold," which will in turn be transferred to the Profit and Loss account and opposed to the sales in order that the gross profit may be known. Apportionment of Overhead Expenses The application of overhead expense, at inventory time, to quantities remaining in process, reveals the im- portance of the subject of distribution, and raises, naturally, the question of the basis for such distribution. x. Labor Rates It is claimed by some accountants that a satisfactory basis is found in the division of the total of each class of overhead (or of the two classes together), by the total amount of productive labor consumed during the period. ACCOUNTS WITH GOODS 183 This, they say, gives the rate to be used in the distribu- tion of overhead, to jobs, to orders, or to general classes of goods manufactured. Others maintain that this basis will be moderately accurate, only if the operators relate to a single class of product, and if the quantity produced is practically the same from month to month. They suggest that a more accurate application of the burden could be made on the basis of the ratio which the annual total bur- den bears to the annual total hours of direct labor con- sumed by each class of goods, or each job number or order number. 2. Machine Rates There are still others who claim that while productive labor has been, up to modern times, the essential and prob- ably the basic factor of cost, it has so far ceased to be so in these days of machinery as to practically eliminate the element of human skill from the work performed by the so-called "productive laborers." They suggest the "machine rate" as the only satisfactory basis on which to apply overhead expenses. This means that the burden is to be distributed on the basis of the ratio that it bears to the total number of hours of work produced by the oper- ating machines. Going still further, some claim that neither basis will be effective if applied to the manufacturing as a whole, but that both may work well when applied to each and every department of the factory subdivided into as many de- partments as there are phases of the process. To continue the nomenclature of distribution bases we may mention the "material" rate, the "labor and ma- terial" rate, and the "old machine" rate, the "new ma- chine" rate, and the "pay" rate. The "new machine" rate is especially interesting be- cause it attempts to accumulate upon the machines which jg 4 THE THEORY OF THE ASSET ACCOUNTS produce the goods in a particular department, the total cost of operations of that department, including all labor; and thus, it is possible to obtain the hour cost of operat- ing a machine. The manufacturing cost of the goods pro- duced in a department is then found by multiplying the machine hours required for the production of the goods, by the cost of the machine hour. The Problem of Expense Distribution Whatever may be the views of accountants upon the matter of expense distribution, "production and effi- ciency" engineers scorn them. Hamilton Church says in his book on "Production Factors in Cost Accounting and Works Management": "The error which dominates and vitiates all the usual and popular methods of dealing with indirect expense is simply 'analysis.' This is the rock on which they all founder. For the purposes of the accountant this analysis is suffi- cient, because the accountant is concerned neither with the efficiency nor with the improvement of production. "It does not matter greatly to him whether a particu- lar item of expense is due to inefficient power distribution, or to worn-out machinery, or to buildings imperfectly adapted to their uses. To him an expense is an expense; but to the production engineer it may be more than an ex- pense it may be a revelation. Yet, as long as we persist in looking on all the activity and all the expenditure go- ing on in and about a works as due to production, so long will the accountant's point of view necessarily hold the field. As long as we shut our eyes to the fact that actual production is the last organization in a chain of separate organizations, so long will the present confused ideas about indirect expenses or establishment charges hold their ground unshaken." It is not the intention to enter into a discussion of ACCOUNTS WITH GOODS 185 cost accounting, or, as it has been termed of late "cost finding." This branch of accounting is far too extensive to permit of its being even sketched in the present volume. Be it sufficient to state that articles are published almost daily on the application of factory overhead, and that the subject deserves the special attention of the student who has mastered the principles of accounting. CHAPTER XVII CONSIGNMENTS SHIPMENTS INWARD Relations of Consignor and Consignee While the subject of consignments, from the point of view of modern business practice, is far less important to- day than it was fifty or sixty years ago, it has lost none of its importance from the viewpoint of the accountant, since it gives rise to the difficult problems of agency ac- counting. So far as the consignee is concerned, he may be: 1. A "factor," otherwise known as a "commission merchant," whose business consists in selling merchandise belonging to others in considera- tion of a "factorage" or "commission" agreed upon. 2. An individual or concern engaged in any line of business, whose facilities for selling in a desir- able market make it profitable to engage him or it occasionally to act as a factor in return for proper compensation. Consignments made to either class of consignees estab- lish, between the parties, the relation of principal and agent. There is, however, this difference: certain states of the Union license regular factors and bond them, whereas no state requires either bond or license from an occasional consignee. 186 CONSIGNMENTS SHIPMENTS INWARD 187 Consignee's Duties and Liabilities The factor (or commission merchant) and the occa- sional consignee (or correspondent) owe the principal for whom they act as agents, such ordinary care of consigned goods as a prudent person would take of property in- trusted to him. They are not liable for losses due to causes over which they could not, in reason, be expected to have control; but they are liable for all losses due to their failure to carry out instructions which they have re- ceived from their principals.* . Factors may act under specific or under general in- structions. In the first instance, they must sell at the price fixed by the consignor; in the second instance, they must sell at the highest price obtainable, and exert due diligence to that end. The term "due diligence" is not understood* to include foresight in connection with sudden fluctuations of prices. If the agreement entered into is to the effect that the goods will be sold at no less than a certain price, a sale by the consignee at less than the said price is in the nature of a violation of specific instructions, and makes him liable for the difference. In the absence of specific instructions to the contrary, a factor may sell on credit; if he does so, and exercises proper diligence in ascertaining the financial responsi- bility of purchasers, he is not liable for losses due to their subsequent failure. What is still more important to the accountant, the factor is not liable to his principal for the money value of sales until he has collected the amount due thereunder. This rule, however, does not apply where the factor has lacked prudence in giving credit; or where he has been negligent in attending to collections; and, lastly, where he operates under the provision of a "del credere" agreement, that is to say, when he has agreed, in * Scott v. Rogers, 31 N. Y. 676, holds that a consignee who had received in- structions to sell goods on a certain day at a specific price, or to ship them to a certain place, and had done neither, was guilty of a "conversion" of the goods. i88 consideration of a higher commission, to hold himself re- sponsible for the proceeds of all sales made by him as agent. If the consignee is under specific instructions to sell for cash, or on credit upon the pledge of security, he is liable for all losses due to his failure to comply. A consignee may incur, for the account of his prin- cipal, such expenses as are necessary for the protection of the merchandise consigned to him, and such losses or al- lowances as are necessary to the validity of his sales. His doing either or both, creates in his favor a lien on the goods, similar to the one which he obtains by making ad- vances to his principal. The lien for expenses extends to customs duties, marine and fire insurance, freight and cart- age, storage, weighing, handling, packing, unpacking, etc. The lien for losses extends to allowances for defective goods, shortages in weight, faulty packing, etc. The question of advances by the consignee to the con- signor is all the more important, because some legal authorities hold that advances give the factor the right to sell enough of the consigned goods to satisfy his claim. Even when selling for advances, however, some of the authorities hold that he is bound to obey his instructions regarding the price at which the goods should be sold. The consignee has no right to pledge as his own, goods received by him on consignment. But if he has made ad- vances to his principals, he may, in order to secure his own debts, deposit an amount of goods equivalent to his ad- vances, provided he gives the third party due notice that the goods are merely liened to him, and not owned by him.* Unless the instructions received by the factor ex- pressly forbid him to do so, he may accept promissory "Urquhart v. Mclver, 4 Johns (N. Y.) 103; Silverman v. Bush, 16 111. App. CONSIGNMENTS SHIPMENTS INWARD 189 notes in settlement of consigned goods sold; if he has duly ascertained the standing of the maker of the note at the time of its execution, and has not discounted the note for his own use, he is not liable for the dishonor of the instrument, due to a subsequent failure of the maker. The acceptance of consignments by a factor, makes it imperative for him to comply with such disposition of the proceeds as his principals may wish to make. If money is due his principals he cannot refuse to accept a draft drawn by them to the order of a third party, provided he has notice of the draft. Unless specific provisions to that effect exist in the agreement between the principal and the factor, or unless such a provision can be implied, either from the contract or from custom, the factor is not chargeable with inter- est except when he fails to render account at the proper time, and to remit when he should do so. The Factor's Accounts and Accounting Under this general heading, the Cyclopaedia of Law and Procedure says of factors:* "The factor must account to his principals for goods sold * * * he must, when reasonably requested, present to his principal a full, complete, and specific account of his dealings between themselves, and between the factor and the purchasers. It is held that it is the factor's duty to be prompt in rendering an account of his sales, whether requested to do so or not, and that a failure to render an account for an unreasonable time will render him liable, especially where a demand is impracticable or highly in- convenient. That he may render a satisfactory account, it is his duty to keep books in which are entered correct accounts of his transactions, and the books should be subject to the principal's inspection, and the principal is Cyc., Vol. XIX, p. 135- THE THEORY OF THE ASSET ACCOUNTS entitled to a correct copy of the entries in the books, in- cluding all memoranda connected therewith. Accounts current are necessarily provisional until settled, and even after settlement may be rectified for errors and omissions, subject to which every settlement is made; but if the fac- tor render his account in good faith, and the principal makes no objection to it, the principal's assent to it as correct is presumed; and unless objection is made within reasonable time his principal will be bound by the ac- counting rendered." Francis B. Tiffany, in his "Handbook of the Law of Principal and Agent," says of the agent's duty to account : "It is the duty of the agent to account to the principal for all the money and property coming into his hands by virtue of his employment, including all profits resulting from the transactions, either as agent, or on his own ac- count in breach of his duty as agent. "His specific duties in this respect are: 1. To keep accounts of all his transactions in the course of the agency, and to render his accounts whenever required by the terms of his employ- ment, or upon demand. 2. To keep money and property of the principal sepa- rate from his own, and from those of third per- sons. 3. To pay or deliver to the principal all money and property of the principal coming into his hands as agent, whether required by the terms of the employment, or upon demand." Books of the Factor The foregoing remarks concerning the rights, duties, and privileges of the factor, commission merchant, or con- CONSIGNMENTS SHIPMENTS INWARD igi signee, appear to leave him no choice but to make his ac- counting comply with the spirit of the statutes. As to the accounting method which he will adopt, he may choose between two distinct treatments: 1. He may record in his own general books all the transactions affecting consignments, in such a manner as to keep what he owns and what he owes as a business man separate from that which he holds as factor, and for which he is accountable to his principals. 2. He may record in special agency books, all the transactions affecting consignments, and periodi- cally transfer to his own books the results of his activities as factor, in so far as they have affected his assets, his liabilities, and his income. Books of the Factor Agency Accounts Kept in General Books Since one of the accounting duties of the factor is to keep the money and the property of his principal sepa- rate from his own, and from those of third persons, it fol- lows that, if he keeps only one set of books, he must: 1. Open a separate account with each consignment and with each consignor. 2. Keep a separate bank account for each individual consignor, and one for himself. 3. Record separately purchases and sales of, and profits on, merchandise traded in by him on his own account. 4. Separate the accounts of his own customers from those of the customers of his principals, and keep separate controlling accounts with the cus- tomers of each consignor. IQ2 THE THEORY OF THE ASSET ACCOUNTS 5. So plan his books of account, that they will differ- entiate: a. The factor's own assets, and the assets of his individual principals, the latter includ- ing: (1) The goods held on consignment, re- corded at their consigned value. (2) The cash deposited in his name, but as agent for his individual principals, and, if conditions warrant, the un- settled consignments, customers' bal- ances, and unmatured promissory notes receivable. b. The factor's own liabilities, and the credit ac- counts necessary to counterbalance the prin- cipals' assets held by him; these credit ac- counts, which are merely contras of the prin- cipals' unrealized assets, or represent matur- ing liabilities to the extent of the realized assets, comprise : 1 i ) The contra of the consigned goods ac- count, that is to say, the consignor's individual goods account. (2) The consignor's individual account cur- rent containing the proceeds of the sales, less the charges made by the factor for advances or expenses, or both and for commissions. Thus, a theoretical trial balance, before the closing of the general ledger of the factor whose books have been kept according to the above described method, might be: CONSIGNMENTS-SHIPMENTS INWARD 193 TRIAL BALANCE Of the books of John Harrison, Commission Merchant (Before Closing) Furniture and Fixtures J. Harrison $ 3,000.00 General Cash J. Harri- son 1,650.00 Customers J. Harrison. 725.50 Allowances to Customers J. Harrison 25.00 Merchandise J. Harri- son 5,000.00 General Expense J. Harrison 300.00 $10,700.50 Consignment No. i $ 4,000.00 " No. 2 3,500.00 " No. 3 1,660.00 Cash J. H., Agent- Account No. i 4,015.00 No. 2 340.00 " No. 3 509.00 Promissory Notes Con- signor No. 3 150.00 Customers Consignor No. 3 500.00 $14,674.00 Total Debits $25,374.50 Creditors J. Harrison.. $ 1,561.50 Notes Payable J. Har- rison 750.00 Sales J. Harrison 7,000.00 Commissions J. Harri- son 551-40 Capital J. Harrison 3,499-OO $13,361.00 Consignor No. i Goods Account $ 4,000.00 Consignor No. 2 Goods Account 3,500.00 Consignor No. 3 Goods Account 1,660.00 Consignor No. i Ac- count Current (a) 1,613.50 Consignor No. 2 Ac- count Current (b) 196.00 Consignor No. 3 Ac- count Current (c) 1,043.10 $12,012.60 Total Credits $25,374.50 (a) Charged with commissions of $401.50, and with advances of $2,000.00 (b) " " " 34.00, " " expenses" 110.00 (c) " " " " 115.00 $551.40 $2,110.00 194 THE THEORY OF THE ASSET ACCOUNTS It will be noticed that the difference between the assets of his principals, held by John Harrison, and the credit accounts which he has created to offset them or to reflect his accountability therefor, is precisely the amount of the commission, advances, and expenses, charged by him to the individual account current of the consignor liable therefor. We shall shortly see what accounting steps the factor must take to close his books, and to ad- just his own assets, as well as the assets of his principals: let us now express in concrete form the journal entries made by him so far as consignments are concerned, dur- ing the period which is about to close: consignment ac- 1. Debit: Individual counts Credit: Individual consignors' goods accounts 2. Debit: Individual consignors' goods accounts Credit: Individual consignment ac- counts 3. Debit: Individual consignors' cash accounts (or promissory notes receivable, or con- signment customers' con- trolling accounts) Credit: Individual consignors' ac- counts current with the consigned value of the goods received. with the consigned >- value of the goods sold. > with the sale price of the goods sold. CONSIGNMENTS SHIPMENTS INWARD IO ,5 4. Debit: Individual consignment ac- counts Credit: Individual consignors' goods accounts 5. Debit: Individual consignors' ac- counts current Credit: Individual consignors' cus- tomers' controlling ac- counts ac- or or 6. Debit: Individual consignors' counts current Credit: a. Factor's cash account, creditors' accounts both b. Factor's commission account 7. Debit: a. Individual consignors' cash accounts or promissory notes receivable b. Individual consignors' ac- counts current Credit: Individual consignors' tomers' controlling counts cus- ac- with the consigned value of sales re- turned. with the sale price of the goods sold, now returned.* with advances made to, and expenses paid and incurred for the account of the principal, and with the commis- sion earned on the sale of his goods. a. with settlements made by customers. b. with allowances and rebates made by the factor in accord- ance with his in- structions. In connection with the return of cash sales credit the individual consignor"! cash account with the amount of the refund. THE THEORY OF THE ASSET ACCOUNTS 8. Debit: Individual consignors' ac- counts current Credit: Individual consignors' cash accounts with the cash re- mittances made by the factor, or with the disposition of the cash proceeds as per instructions. Passing now to the closing of the factor's books, let us assume: 1. That the inventory of his own merchandise shows a value of $1,500. 2. That the end of his accounting period corresponds with the time at which he must account to his principals, and remit the cash proceeds of the sales, there being in his agreement with them no specification as to his being liable for un- collected proceeds of sales. The expression in journal form of the entries which he will have to make to adjust his own accounts is: First Entry : Merchandise, New Account, J. H $1,500.00 To Merchandise, Old Account, J. H $1,500.00 To set up the inventorial value of my trading merchandise, as per inventory of Second Entry: Profit and Loss $3,825.00 To Merchandise, Old Account, J. H $3,500.00 ' Allowance to Customers, J. H 25.00 " General Expense, J. H 300.00 To close into profit and loss, the cost of the trading goods sold by me for my own ac- count, and my expenses and losses of the period. CONSIGNMENTS SHIPMENTS INWARD 197 Third Entry : Sales, J. H $7,000.00 Commissions, J. H 551.40 To Profit and Loss $7,551.40 To close into profit and loss income obtained by me on the sales of my own trading mer- chandise, and the commissions which I have earned as factor, as follows : Consignor No. i $401.50 Consignor No. 2 34-OO Consignor No. 3 115.90 Fourth Entry: General Cash, J. H $2,661.40 To Cash, J. H., Agent, Account No. i $2401.50 "2 144.00 " " " " " " 3 115.90 For checks drawn to my order, in settlement of: a. My advances to Consignor No. I $2,000.00 b. Expenses paid for the account of Consignor No. 2 IIO.OO c. Commissions on sales: Consignor No. i $401.50 Consignor No. 2 34.00 Consignor No. 3 1 15.90 551.40 The expression in journal form, of the entries neces- sary to adjust the accounts of the principals, is: Consignor No. I, Account Current $1,613.50 "2, " " 196.00 " 3, " " 393-10 To Cash, J. H., Agent, Account No. i $1,613.50 " " " " " " 2 196.00 " 3 393.10 For remittance to my principals, of the pro- ceeds of the cash sales of the goods con- signed to them, in accordance with the terms of my employment as factor. At this point the trial balance of the factor's ledger will show: I9 g THE THEORY OF THE ASSET ACCOUNTS TRIAL BALANCE Of the books of John Harrison, Commission Merchant (After Closing) Furniture and Fixtures J. Harrison $ 3,000.00 General Cash J. Harri- son 4,3ii-40 Customers J. Harrison. 725-50 Merchandise J. Harri- son 1,500.00 $ 9,536.90 Consignment No. i $ 4,000.00 " 2 3,500.00 " " 3 1,660.00 Promissory Notes Con- signor No. 3 150.00 Customers Consignor No. 3 500.00 $ 9,810.00 Total Debits $19,346.90 Creditors J. Harrison.. $ 1,561.50 Notes Payable J. Har- rison 750.00 Profit and Loss J. Har- rison 3,726.40 Capital J. Harrison 3,499-OO $ 9,536.90 Consignor No. I Goods.$ 4,000.00 " 2 " 3,500.00 " " 3 " 1,660.00 " 3 Ac- count Current 650.00 $ 9,810.00 Total Credits $19,346.90 The nature of the account sales which the factor will have to render his principals, will be sufficiently explained by the following illustration: ACCOUNT SALES New York, June 30, 1914 Sale of 40 Cases of Merchandise by John Harrison, Commission Merchant, for the Ac- count of H. Marlow, Boston, Mass. June i, 1912 Received, by Steamer Commonwealth, freight and charges prepaid: 123 cases at $20.00 $2460.00 3O Inventory : 83 cases at $20.00 1,660.00 Sale of 40 cases Consigned to me at $20.00 $800.00 CONSIGNMENTS SHIPMENTS INWARD 199 June 9 " IS 22 E. & O. E. Sales and Proceeds : On Credit, 60 days: Sales c HIT 11 tr ui Cases Pnce Proceed! S. Muller, Hoboken, N. J 10 $29.00 $290.00 Th. Kemp, Middle- town, N. Y 7 30.00 210.00 $500.00 On Credit, Secured by Note, 60 days : M. Turner, Buffalo, N. Y 5 30.00 150.00 For Cash: S. Archbold, New York, N. Y 18 28.277 509.00 Total 40 $1,159.00 Held until Collection, as per agree- ment : Accounts Receivable $500.00 Promissory Note 150.00 650.00 Proceeds Subject to Remittance $509.00 Charges to Your Account : Freight, Cartage, etc. (None) .... $ Allowances to Customers " Commissions of 10% on all sales, as per agreement My Check No drawn against you 115.90 H5-QO Net Cash Proceeds, Remitted Here- with, Check No $393-io JOHN HARRISON, Commission Merchant. It will be noticed that the foregoing account sales gives, practically, a copy of the transactions recorded by the factor on his books. This is no more than he owes to his principals. The account reflects the debits and the credits made to the consignment account (Dr. $2,460.00; Cr. $800.00), and the balance of the account ($1,660.00). It also re- 2OO THE THEORY OF THE ASSET ACCOUNTS fleets the credits given and the debits made to the current account of the consignee, and the balance of that account (Cr.., $1,159.00; Debits: Commissions, $115.90; Cash, $393.10; Total, $509.00; Balance, $650.00) and finally, it gives the amounts debited to Cash, to Accounts Receiv- able, and to Promissory Notes Receivable, and the amounts credited to Cash. Books of the Factor Agency Accounts Kept in Separate Books The second method differs from the first, only in that it compels the factor to keep, in connection with the agency work, a separate set of books comprising: 1. General ledger 2. Consignments received book 3. Consignment sales book 4. Agency cash book 5. Agency journal 6. Consignment customers ledger Each book must be so arranged that all the trans- actions will be classified with due respect to the individual consignor whose accounts they affect. The accounts kept will be precisely the ones referred to in connection with the first method and the results obtained will be similar in every respect. Figures 35 and 36 illustrate forms of these books. These books may be either loose-leaf, or bound. In either case as many pages are devoted to each consignment as may be needed according to the tenor of the agreement. The space allotted to each individual consignor is ear- marked by a tab bearing the number given to the series of accounts which contain all the transactions with him. Reference to the consignment agreement, the number of which appears in the consignments received book, will give all required information when the occasion arises. CONSIGNMENTS SHIPMENTS INWARD 201 CONSIGNMENTS RECEIVED BOOK Jn. .MaAjCAid $ No | CONSIGNMENT AGREEMENT N- v- Zo y o I CONSIGNMENTS SHIPMENTS OUTWARD 219 After the accounts are closed as shown in the fore- going examples, the account of the consignee and the account with consigned shipment are purely statistical, and have no place on the balance sheet. Second Method i. If goods are consigned at cost: a. When shipping: Record the facts relating to consignments in a memorandum book, as per example on page 218, and make no entry whatever in the general books. b. After receipt of account sales: Record the facts contained therein, in the memorandum consigned shipments book, as per example in Figure 37. c. At any time during the accounting period, using the data furnished by the memorandum book, make in the journal and in the cash book the entries expressed here in general journal form : Cash $850.00 Commissions Consigned Shipment No. i loo.oo Freight and Expense on Consigned Shipment No. i 35-OO Allowances to Customers on Con- signed Shipment No. i 15.00 To Merchandise $500.00 " Profit and Loss $500.00 To record the transactions of the period concerning con- signment No. i, in so far as they have affected the assets 220 THE THEORY OF THE ASSET ACCOUNTS and the income, as per ac- count sales No. received this day from Consignee No. i, and as reflected by the memorandum consigned ship- ments book. The amount credited to merchandise is the cost of the goods sold. 2. If the goods are consigned at sales price, plan the memorandum consigned shipments book in such a manner that the cost of the goods will be opposed to the sale price, as well when they are consigned as when they are sold. The journal entry to be made at the time the account sales is rendered, is identical in every respect with the above. Before leaving the subject of consignments, it may be well to state that since the consignee is not liable for uncollected sales unless he has agreed to hold himself so liable, the consignor should not consider as sales what has been sold on credit. Unless this be done, there will exist no harmony whatever between the books of the principal and of the agent; the books of the consignor will show that he has a claim against the consignee, whereas the latter's books will fail to reflect a liability therefor. CHAPTER XIX LAND AND BUILDINGS Distinction Between "Land" and "Buildings" To the average layman, there is no difference between the two elements of the account "Land and Buildings." Giving as his authority the common law, which made the term "real" apply to land, tenements, and hereditaments, he is satisfied to call both real estate. The courts do not usually attempt to differentiate the two terms, except in special cases, as that of Truesdell v. Gay,* where the court, referring to the word "building," seemed to be of the opinion that, taken in its broadest sense, it could not be made to apply to such erections on land as fences, gates, and other such structures. The accountant, how- ever, must often draw a very sharp line not only between the two values, land and buildings, but as well, between that part of the land which is necessary to the proper working of the plant, and that part which could be sold without in any way interfering with its operations. The components of the cost of plant land vary materially from those of investment land; the considera- tion of increases in market values, while of much im- portance in the case of the latter, is merely an incident in the case of the former, since the asset cannot ordinarily be sold without causing operations to come to an end, at least temporarily. On the other hand, buildings de- preciate through wear and tear, while land does not; 13 Gray (Mass.), 311, 312. 221 222 THE THEORY OF THE ASSET ACCOUNTS hence, if reserves are created for the depreciation of build- ings, and applied for balance sheet purposes to Land and Buildings account, it is not possible to ascertain the book value of the asset which the depreciation affects. These accounting differences in the nature of the two values, land and buildings, would seem to be sufficient to cause the creation of two distinct accounts with them, and are generally so regarded. Plant Land That part of the land which the buildings occupy, or which is necessary to the proper working of the plant, should be kept by itself in the account "Plant Land." As part of the plant, land may be charged at the time of acquisition, not only with the cost of purchase, but with all the expenses incident thereto, such as title search- ing and insuring, commissions to real estate agents, recording of deeds, etc. After it has been acquired, and until operations have begun, it can be charged with in- terest on the purchase-money mortgage (or on any other obligation incurred in its acquisition) and with the cost of fencing, erecting gates and approaches, filling in, draining, leveling, etc., incident to the erection of the plant. As soon, however, as the plant has begun opera- tions, the value of plant land can only be increased by the cost of such improvements as enhance the efficiency of the buildings erected thereon, or increase their useful life by remedying conditions which tend to make structures deteriorate faster than might reasonably be expected. The question of cost of improvements which tend to make plant land more valuable for any purpose other than the one for which it was acquired, while admittedly important in determining its cost if a sale is contemplated, should not be permitted to influence the appraisal of values for the purposes of a going concern. LAND AND BUILDINGS 223 Investment in Lands Any parcel of land owned and not at present neces- sary to, and not likely to be required for, the operations of the plant, is essentially an investment. The true rea- son for acquiring it may not have been a desire for profits. It may be that in order to obtain a desirable plot it was necessary to purchase adjoining land which had no special value for the purpose of the plant; or it may be that the purchase was made with a view of preventing the erec- tion in the immediate neighborhood of competing or light-obstructing plants; whatever the reason, a certain amount of capital has been used for the acquisition of a value not required for operating, and the cost of carrying it may properly include betterments, maintenance of fencing, taxes, interest on the purchase-money mortgage, etc., even after operations have begun. Buildings The Buildings account is capable of apparently har- monious action, even though elements which are really foreign to it are introduced in its make-up. Therein lie both its importance and its danger. If we were to attempt to inject into the account with customers, transactions which have no relation whatever with sales and settlements thereof, we would obtain re- sults which, by comparison with others, would carry on their face the evidence of inaccuracy. If, on the other hand, we were to include on either side of the account with merchandise, elements of cost and elements of deduc- tion from cost which have no relation whatever with mer- chandise, we would distort the truth about certain phases of the profits, but we would not change the net result of the operations of the period. In the case of buildings, however, the situation is quite different. The account offers the opportunity of 224 THE THEORY OF THE ASSET ACCOUNTS capitalizing expenditures in order that the profits of the period may be inflated, or of reducing the income by charging to revenue the cost of adding to, or enlarging, the structures, as well as the cost of extending their useful life, which should have been capitalized. That concerns have frequently taken advantage of that opportunity is not to be doubted; that it can be done successfully and, it may be said, without much danger, is due to the fact that the standards by which the components of the Buildings account (in common with all other so-called property ac- counts) are judged, may be stretched to accommodate any personal opinion not too grossly unreasonable. The original cost of the buildings is seldom a question at issue so far as the accountant is concerned. If the buildings have been acquired from another concern, he is not competent to pass judgment upon the price paid for them ; nor is he asked to do so. All he has to do is to record the transaction. If the buildings have been erected under a contract, the situation is precisely the same; if they have been constructed by the concern itself under a special contract calling for the payment to the builder of a certain percentage of the cost, the true cost of the build- ings will, of course, be whatever has been expended under the direction of the builder, plus the fees paid to him as per contract. In this latter case the interest on the money which the concern may have had to borrow pending con- struction, in order to meet the bills of the builder, will also be considered as a proper cost of the structures. Lastly, if the construction is attended to by the concern itself, upon plans submitted by an architect, the cost of the building will include his fees, the expenses incurred in connection with permits, licenses, etc., the cost of in- surance protection, the cost of all material used, the cost of the labor expended on the foundations as well as on the structures, the cost of any outside labor which may LAND AND BUILDINGS 225 have been required, the proportion of the overhead ex- penses which apply to the construction, the interest on any moneys which have been borrowed for construction purposes and used therefor, up to the time when the new buildings were opened for operation. In regard to what constitutes the cost of material, sup- plies, and labor consumed in construction, the rulings of the Public Service Commission are of interest to all con- cerns, whether or not they fall under the class of business organizations which the commission controls, for they embody the views which accountants generally hold on the subject. "Cost of labor (employed in construction) includes not only wages, salaries, and fees paid employees, but also such personal expenses of employees as are borne by the corporation. Cost of materials and supplies consumed in construction, is the cost at the places where they enter into construction, including cost of transportation and inspection when specifically assignable. If such materials and supplies are passed through storehouses, their cost as entered in the account may include a certain proportion of store expenses." It is an open question as to whether or not it is proper to add to the overhead expenses applicable to construc- tion, an extra amount representing the profit which a con- tractor would have added to the price quoted for the buildings. It is claimed by some that the cost of the buildings constructed by a concern for itself, presumably because it can erect them at better terms than would be possible if the work were given to contractors, shoulfl be such as to reflect the saving realized by the company. It is claimed by others that the cost to the company may be stated at a figure representing precisely what it would have had to pay if outsiders had attended to the con- struction. This latter theory may appeal to the statis- 22 6 THE THEORY OF THE ASSET ACCOUNTS tician and to the independent appraiser, but its 'effect upon the results of the operations is so marked as to be obnoxious to the accountant. Assuming, for instance, that a company were to build an additional plant during a certain operating period, and add to the cost of the build- ing an amount of overhead expenses calculated to cover not only the proper proportion which the work performed would naturally warrant, but, as well, the profits which a contractor would have realized on the work, it stands to reason that the results of the operations of that period may show improvements over past periods which disturb comparisons and lead to erroneous judgment of condi- tions in regard to carrying capacity. After the original cost of buildings has been recorded, all subsequent charges to the account raise the ever- present and delicate question of the proper separation of capital expenditures and revenue expenditures. Capital Expenditures When subjected to a theoretic analysis, this term sp- pears to apply to such expenses as, in the aggregate, rep- resent the cost of the increased earning capacity of the enterprise as a whole or of particular parts thereof, which has been secured over the earning capacity known to exist before the said expenses were incurred. Revenue Expenditures In contradistinction, these expenses are such as must be incurred in order that advantage may be taken of the earning capacity of the enterprise, or in order that such capacity may be maintained at the required standard. If the radius of action of a locomotive is 200 miles on a certain amount of fuel, water, and lubricants, and, if through the addition of, say, a steam condenser to the mechanical equipment of the engine, that radius is ex- LAND AND BUILDINGS 227 tended to 250 miles on the same consumption of fuel, water, and lubricants, it is obvious that the value of a capital asset has been enhanced as an income producer, and that the cost of the increased earning power may be capitalized. But if, on the other hand, the additional equipment of the machine has only resulted in maintain- ing an efficiency which would otherwise have been im- paired, there has been incurred an expense necessary to obtain revenue, that is to say, a revenue expenditure. Writing on the subject of "The Accounting of Indus- trial Enterprises,"* William M. Lybrand, C.P.A., says: "With respect to items which may properly be considered as capital expenditures, it has been suggested as a work- ing basis that no addition should be made to the property accounts unless it can be clearly shown that they have increased the earning capacity of the plant. A simple, positive rule such as this might be all that is required, if the changes in the plant and the resulting increase in earning capacity were occasioned only by actual exten- sions or additions of property which had never before ex- isted. But such is not the case. In every progressive manufacturing concern, alterations or additions to the plant are constantly being made for the purpose of sim- plifying the manufacturing processes and thereby increas- ing the output with the same expenditure for labor and materials, or in order to decrease those operating charges which are in the nature of overhead expenses required to be taken up in the cost of the product. As no alteration or addition to the plant is probably ever undertaken ex- cept for the purpose of increasing the earning capacity thereof, directly or indirectly, the literal application of the rule referred to is not possible, and it will be necessary to consider the nature of the various alterations, improve- ments, and additions, before an intelligent decision can be made as to their ultimate disposition." * Journal of Accountancy, December, 1908, 22 g THE THEORY OF THE ASSET ACCOUNTS In the Journal of Accountancy of November, 1906, John P. Herr says on the same subject: "One of the most difficult things with which the ac- countant has to deal is the question of capital expendi- tures * * * As capital expenditures are generally handled at the present time, a manager who has interest in the profits * * * may cover up shrinkages in the net earnings, losses by bad management, and defalcations, and make it practically impossible for the accountant * * * to determine whether the charges are for bona fide bet- terments or not * * * We find in one work on account- ing a statement that when in doubt as to whether an expenditure is a capital expenditure or chargeable against revenue, the amount should be charged against capital, the reason given being that if it is 'afterwards' determined that the expenditures were for repairs, it is easy to get them out of capital into revenue, while it is extremely difficult without much explanation and on proper author- ity to take items out of revenue and place them into capital. The adoption of such a policy by accountants will add to the already great laxity in this direction, and tend towards the lowering of professional standards." As bearing upon the subject of capital expenditures, the following quotations from a pamphlet issued by the Public Service Commission, First District, State of New York, may be of interest: Additions. "Additions include additional structures, facilities, or equipment not taking the place of anything previously existing." Betterments. "Betterments include the enlargement or improvement of existing structures, facilities, and equipment." Renewals. "Renewals include all extensions of terms of years in land and tangible fixed capital, and all exten- LAND AND BUILDINGS 229 sions of the life period of franchises and other intangible fixed capital." Replacements. "Replacements include all substitu- tions for capital exhausted or become inadequate in service, the substitutes having substantially no greater capacity than the things for which they were substituted. When a substitute has a substantially greater capacity than that for which it is substituted, the cost of substitu- tion of one of the same capacity as the thing replaced should be charged as a replacement, and the remaining portion of the cost of the actual substitute should be charged as a betterment." Repairs. "When through wear and tear or through casualty it becomes necessary to replace some part of any structure, facility, or unit of equipment, and the extent of such replacement does not amount to a substantial change of identity in such structure, facility, or unit of equipment, the replacement of such part is to be considered a repair, and the cost of such repair is to be treated as an operating expense, and must not be charged as a replacement in any capital account." In connection with land and buildings there often arises the question of increased valuation due to favorable conditions in the real estate market. Concerns desiring to make a good showing for a given period, are not un- likely to take advantage of upward fluctuations of land, in order to inflate their "profits." The accountant is very likely to have in connection with this kind of profits the same opinion as the average lawyer has about all kinds of gains. To the lawyer, nothing is profit which has not been realized in cash. To the accountant, nothing brings profits which has not been sold. He instinctively objects to all kinds of estimates and inflations of capital assets on the basis of market values. He is inclined to think that since business requires its capital assets in order to oper- THE THEORY OF THE ASSET ACCOUNTS ate, it cannot afford to sell them; hence, the taking of profits on values supposed to be invested permanently, might well be deferred until they are sold, either because operations have come to an end or because more favorable conditions elsewhere have made advisable the removal of the plant. CHAPTER XX BUILDING EQUIPMENT, FURNITURE AND FIXTURES, DELIVERY EQUIPMENT, PATTERNS, OTHER EQUIPMENT Realty Fixtures and Personalty Fixtures The question of the proper differentiation of realty fix- tures and personalty fixtures is of interest to accountants, since it involves the possibility of lawsuits in connection with the foreclosure of mortgages on buildings and on their equipment, the rights of the parties to a contract of sale of reaky, the rights of the landlord and of the tenant, and the important matter of accurate accounting in connection with bankruptcy proceedings and receiverships. Realty fixtures are part of the building to which they are annexed, and their value should either be added to the value of the building, or stated in a separate account with building equipment, or in a group of accounts representing that equipment. Personalty fixtures are neither part of the building nor of its equipment; they are not considered as part of the property pledged under a mortgage, and they can be sold, removed, changed, destroyed, or otherwise disposed of, without in any way affecting the value of the building or the rights of any one who has, or may have, an interest in the structure. Realty fixtures may, under certain conditions, include elements which accountants are sometimes satisfied to call '"machinery" or "machinery and tools." When such is the case, what is the worth of the information supplied by books 231 232 THE THEORY OF THE ASSET ACCOUNTS of account which state the value of the asset "buildings," in the narrow sense which the word may have, and oppose it to a liability account reflecting the mortgage which has been placed not only on the structure, but, as well, on all that it contains which falls under the meaning of the term "realty fixtures" as the law understands it ? Going a little further, what is the value of a statement of affairs which deducts from the amount expected to be realized on buildings, the amount of the mortgage placed thereon, if part of the value of the said building is to be found in the account "Machinery and Tools" ? The Law of Fixtures The Cyclopaedia of Law and Procedure states that "the law of fixtures deals with property whose status as realty or personalty is indeterminate until the proof of cer- tain facts and the application of certain rules of law. When the status is thus determined, tangible property must be either real or personal. Fixtures then may be defined as tangible property whose status as realty or personalty is indeterminate. According as certain facts shall appear, its status will become determinate, and it will fall into one or the other category * * * In the matter of "fixtures" so called, it is difficult to say with precision what degree of annexation is sufficient to work the change from personalty to realty. In some cases the courts have said as a matter of law, that certain articles, although fastened to the realty, are no part of it, while on the other hand articles may be so incorporated with realty that the court will say as a matter of law that they are fixtures ; but as physical annexation of a chattel alone is not always necessary to its becoming part of the realty, and as physical annexation alone does not necessarily make a chattel realty, but in either case other circumstances may combine to prevent the one or the other, it is believed that the true rule is that articles not otherwise BUILDING AND OTHER EQUIPMENT 233 attached to realty than by their own weight are prima facie personalty, and articles affixed to land in fact, although only slightly, are prima facie realty, and that the burden of proof is on the one contending that the former is realty and that the latter is personalty." It has been held by courts of law that a heavy statue, designed for permanent ornamentation of a building, is part of the building, and subject to a mortgage of that building; 1 that a machine which is attached to its base merely to give it stability, is not part of the building ; 2 that shelving attached to the walls merely to give it steadiness is part of the build- ing; 3 that a machine attached to the floor to give it steadi- ness, when it is attached otherwise than by cleats, is part of the building; 4 that platform-scales erected in the street, but with beams extending into an adjoining building, are part of the building; 5 on the other hand, belting, gas fix- tures, and radiators have, in some cases, been held to be realty, while in other cases they have been held to be personalty. Distinction Between Realty and Personalty Fixtures In view of the many differences of opinion which the decisions of the courts suggest in the matter of fixtures, it seems that the rule contained in the foregoing quotation from the Cyclopaedia of Law and Procedure may safely be accepted by accountants. Thus, everything permanently attached to the building and impossible of removal without cutting into walls, ceilings, and floors, or without impairing the fitness of the building for the purpose to which it was destined, may be properly included in the cost of the build- ing, or kept in a separate account with building equipment or with realty fixtures. Everything which is attached to the Decennial 745. THE THEORY OF THE ASSET ACCOUNTS building by its weight only, and can be easily removed with- out in any way interfering with the efficiency of the build- ing, or defacing it, may be called furniture and fixtures. In the former category we would then include: boilers and furnaces imbedded in the floors or walls, machines sunken in the floor or attached to it in such a manner as to be part of it, elevators and the machinery on which they depend for power, ventilating systems, water connections, piping, feeding wires, inside sewerage and drainage sys- tems, crane runners and supports, shafting and pulleys which are so encased in the walls and ceilings as to necessitate cut- ting in order to remove them, safes, closets, benches, and shelving built in the walls or permanently attached to them, etc. In the second category (furniture and fixtures) we would include chairs, tables, desks, pictures, and other re- movable decorative objects, files and cabinets, writing, copy- ing and computing machines, safes not attached to the walls, lamps and chandeliers, movable stoves and radiators, and generally all the appliances, implements, etc., acquired to facilitate the transaction of business, or add to the comfort of the officials, employees, and patrons of the concern. It is to be understood, of course, that the segregation of the building into its components, such, for instance, as general building equipment, power plant equipment, boiler plant equipment, heating plant, etc., is not condemned, pro- vided the sundry units are understood to be part of the whole, detached for purposes of recording analytically the original cost of the units and the subsequent transactions affecting them. Furniture and Fixtures The Furniture and Fixtures account has no well-defined theory : what it will contain depends upon the policy of the concern as to what it will capitalize and what it will charge BUILDING AND OTHER EQUIPMENT 235 to operations. Some firms carry their furniture and fixtures at their original cost, and charge all subsequent additions, re- newals, and repairs to the income of the period in which the transactions occurred ; others add to the original amount the cost of what they buy, and credit the account, periodically, with an amount representing the difference between the book value and the total inventory computed conservatively; others still, add the cost of additions to the original value, and set aside yearly out of profits an amount which is credited to a reserve account and is supposed to reflect the amount of depreciation suffered by the property during the period. Delivery Equipment The somewhat antiquated title of Horse, Wagon, and Harness, which was formerly applied to this account, is fre- quently replaced, in these modern days of motor trucks and light-power delivery wagons, by the name "Delivery Equip- ment." What the account will contain depends upon the policy of the concern. It is supposed to include the cost of such equipment as is necessary to cart the goods in and out of the plant. Like the asset "furniture and fixtures," it may be carried at its original cost, all replacements and additions being charged to expense; or the original value may be added to whenever transactions take place, the true value being obtained through periodical inventories figured conservatively. Or again, it may be carried at cost, a cer- tain amount being periodically set aside out of net profits to provide for such depreciation as it is estimated that the property may have suffered. If losses occur either through natural causes or through accidents, the account is credited with the original, or with the depreciated, cost of the unit lost (as the case may be) and is then debited with the cost of the unit which replaces it. 236 THE THEORY OF THE ASSET ACCOUNTS Patterns A pattern is "a piece of paper, card-board, sheet metal, or thin plank corresponding in outline to an object that is to be cut out or fabricated, and serving as a guide in determin- ing its exact shape and dimensions. Pattern pieces or gauges are largely used in making special machinery, in which all the parts are made separately by gauges, and then put together."* The value at which patterns should be carried on the books is, of course, their cost; that is to say, the amount of all the expenses which their fabrication has necessitated. But, as the value of the pattern is problematic after the object for which it was made is accomplished, the ques- tion of the ultimate disposition of the asset is important. The patterns made for a special machine, which will not be used elsewhere than in the plant of the concern which built it, have no value unless there is a probability that the apparatus will be duplicated at some future time. Hence, if the machine is to be the only one of its type, the cost of the patterns is an integral part of the cost of the machine. In the contrary case it may be retained as an asset, at cost. If, peradventure, the object for which a pattern is made becomes useless through obsolescence of the type, the pattern itself necessarily loses its value. Patterns made to standardize the object manufac- tured, and used constantly as models, may be retained as an asset at whatever cost they represent. If their useful- ness has expired, they should be written off gradually by periodical charges to the Profit and Loss account; or a reserve may be created for them pending final decision as to their ultimate disposition. Under no conditions, how- ever, should they be charged to cost of manufacture unless they were made for a special job and there is no possibility of their being used again. * Encyclopaedic Dictionary. BUILDING AND OTHER EQUIPMENT Other General Equipment The theory of other property accounts which, for the sake of financial statements, may be grouped under this title, such, for instance, as Fire Apparatus, Emergency Equipment, etc., is substantially the same as the theory of the account "Delivery Equipment." CHAPTER XXI MACHINERY AND TOOLS Classification of Machinery and Tools Although comparatively few concerns attempt to make their accounting differentiate the components of this ac- count, it may be better to subdivide the subject matter into its units which, for ordinary manufacturing businesses, may be substantially as follows : 1. Machines; that is to say, such machines as are at- tached to the floor or to benches or to their bases by their weight only, or in such a manner as not to make them part of the building. 2. Machine Tools. 3. Shop and Hand Tools. As opposed to the machine tool, the machine proper is that part of the whole apparatus which, by itself or through auxiliary devices, produces the required motion; the ma- chine tool, on the other hand, is the part of the machinery which performs the final function for which the apparatus as a whole was constructed. As to the hand and shop tool, it has nothing whatever to do with either. Taking as an example a milling machine, we find it defined in the "En- cyclopaedic Dictionary" as : "a machine for dressing metal work to shape, by passing it on a travelling-bed beneath a rotating serrated cylindrical cutter." In a machine of this type the part of the apparatus which produces the motion necessary to carry the object to be dressed in the proper position under the cutter, is the machine proper, whereas the cutter is the machine tool. 238 MACHINERY AND TOOLS 239 The distinction may not appear important at first, but becomes so when it is considered that while the cost of the original tool equipment (which may comprise several cut- ters) is proportionately greater than that of the machine, the life of the machine may extend over a period of twenty years or more, whereas the cutter may be destroyed the first time it is used, either owing to a flaw in the material of which it is made, or through careless or faulty adjusting. Machine and Tool Accounting If the value of the machine and of the machine tools is stated in one account, and one of the cutters is destroyed, the account must be credited at once with the loss sustained ; or the recording of the loss may be postponed until the tak- ing of the physical inventory at the end of the period; but in either case, the value of the machinery and tools asset must be reduced to the value of its remainder. This necessi- tates the keeping of a special machinery ledger containing an account with each machine. If, on the contrary, two accounts were created, one for machines and another for machine tools, a list of the ma- chines could be made once for all, stating the date at which they were acquired, their cost, their estimated life, their residual value, their factory number, their location on the floor of the plant, and the rate of depreciation which is ap- plied to each unit for purposes of reserves. This list would constitute a permanent inventory, subject only to additions and deductions due to the acquisition of new units or to the discarding of units whose life has expired. As to the machine tools, the fact that they are carried in a separate account makes it possible to place them in the custody of the storekeeper, to control their issue to the fac- tory, and to obtain a periodical book-inventory probably more valuable than a physical one, since it can be readily checked and priced. 240 THE THEORY OF THE ASSET ACCOUNTS Universal Machines In regard to machines, they may, if the occasion arises, be subdivided into two distinct accounts, one containing the value of the universal machines, the other the value of the special machines. Universal machines are those which are built according to a standard, and are used by all industries where the work to be performed calls for the application of familiar princi- ples of mechanics. Special machines, in contradistinction, are those which have to be constructed to meet the require- ments of special classes of industry, or of new manufacturing processes. Among the former may be mentioned drilling, cutting, milling, and grinding machines ; a good illustration of special machines is afforded by the hydraulic diamond- headed filter through which, prior to the discovery of the wire-pulling process, the metal composition used in the man- ufacture of carbons for electric bulb-lamps was passed. Universal machines are generally purchased from con- cerns who deal in them because they are standardized arti- cles ; they are the best product of industry at the time they are acquired, and are subject to uniform prices. The value at which they are carried on the books is their original pur- chase cost as given by invoices, to which may be added freight and cartage, and the cost of installation and adjust- ing. The cost of subsequent changes and alterations which increase the efficiency or extend the life of the machines, may be capitalized. The credits to the account are for losses due to accidents which impair the usefulness of individual units, either in part or in full, and, at the expiration of the life of the machine, for their depreciated value as contained in the reserve for depreciation, and their residual scrap value. Special Machines Special machines are built either by machine shops, in accordance with designs and specifications submitted by the MACHINERY AND TOOLS 241 concern for whose account the construction is undertaken, or by the concern itself. In the former case, the value at which the machine is stated is the contract price ; in the latter case it is the cost of material and labor, plus the freight and cartage on the material and a proper proportion of over- head expenses. In either case the cost of the experiments which were conducted before a desirable type was obtained, and the cost of the designs and patterns which were made, may be added to the value of the machine. The cost of all future improvements which make the machine more suitable to the requirements of the concern and increase its efficiency, may be added to the original cost. As to the question of increase of machine life, it is generally more than counter- balanced by the danger of obsolescence which is ever-present in this class of property. If a competitor develops a type which reduces the cost of manufacture, either by bringing about time-economy, or by making possible substantial changes in the process itself, the machine which is not capable of obtaining the same result must be discarded, irre- spective of its cost, and a more advantageous one built. Thus, we have in "special machines" an asset quite dif- ferent from the asset "universal machines." One is subject to obsolescence, and the other is not ; the cost of one is cer- tain and its components are well known ; the cost of the other is uncertain, and the proof of the accuracy of its stated value is not readily obtained. Barring accidents, one will be in service for a known number of years ; under the same condi- tions, the extent of the other's useful life is problematic. Depreciation Without attempting to go deeply at this point into the subject of depreciation, which will be considered in subse- quent chapters, it is evident that the irreparable wear and tear sustained by universal machines, either as a result of manufacturing, or through the mere efflux of the term of 242 THE THEORY OF THE ASSET ACCOUNTS their useful life, is quite different from the possibility of loss through obsolescence which is found in special machines. If, then, the 'asset which is to be depreciated is composed of the two distinct types, the reserve for depreciation will also contain two kinds of losses, i.e., one which is probable and one which is problematic. It seems, under the conditions, that the purpose of accounting would be better served if the two types of machines were kept separate. Shop and Hand Tools The nature of the asset "shop and hand tools" is so different from that of the two elements of machinery and tools already mentioned, that it should under all conditions be stated by itself. The tools contained in this account are sometimes referred to as "small equipment." They com- prise saws, files, hammers, screw-drivers, etc., which on ac- count of their fragility, their size, the manifold uses to which they are placed, and the facility with which they can be passed from hand to hand and from bench to bench, cannot be readily or accurately inventoried. They are generally kept under the custody of a storekeeper, and charged to cost of manufacture when issued to the factory. In some cases they are consigned to the workingmen, and submitted peri- odically to the inspection of the storekeeper ; at this time, the broken and worn-out tools are charged to the cost of manu- facture, and the cost of the tools lost is charged to the wages of the careless workmen; in either case, credit is given to the general ledger account containing their value. Which- ever way they are treated, they are not subject to depre- ciation. CHAPTER XXII GOOD-WILL, PATENTS, TRADE-MARKS, COPY- RIGHTS, FRANCHISES GOOD-WILL Definition One of the most commonly quoted definitions of good- will, so far at least as accountants are concerned, is the one given by Lisle in his book "Accounting in Theory and Prac- tice" : "Good-will is the monetary value placed upon the connection and reputation of a mercantile or manufacturing concern, and discounts the value of the turnover of a busi- ness in consequence of the probabilities of the old customers continuing." Another definition is the one appearing in the opinion of Lord Elton in the English case of Crutwell v. Lye, which is about one hundred years old : "The good-will which has been the subject of a sale, is nothing more than the prob- ability that the customers will resort to the old place." Lord Elton's definition gives the impression that good- will is a purely local matter, and that if a concern having acquired the business of another, subsequently transfers it to a different locality, it loses the right to expect that the old customers will continue. This is indeed the stand taken by a Pennsylvania court in the case of Elliot's appeal (60 Pa. St. 161) in which it was held that the good-will of an inn, or tavern, did not exist outside of the premises where the business was conducted at the time of the sale. Lord Elton's definition has, however, been the subject of 243 244 THE THEORY OF THE ASSET ACCOUNTS much criticism in and out of American courts, owing to its narrow conception of the valuable asset "good-will." Nor does it seem that English courts have shared his views. Vice-Chancellor, Sir W. Page Wood, says : "Good-will, I apprehend, must mean every advantage * * * that has been acquired by the old firm in carrying on its business, whether connected with the premises in which the business was previ- ously carried on, or with the name of the late firm, or with any other matter carrying with it the benefit of the business." Personal Character of Good- Will Purely local as the character of good-will is under cer- tain conditions (as for instance in the case of a hotel whose attractive and convenient location is primarily responsible for the vogue which it enjoys) it may be said to be more commonly personal. If Steinway and Sons were to sell their business and their name to a firm who found it advisable to transfer the plant and the selling agency from New York to Boston, it is certain that the good-will of the musical world would not be affected by the change. It is precisely that element of personality possessed by good-will which links it so naturally to types of organiza- tion in which the names of the supposed proprietors are known, that is to say, sole proprietorships and copartner- ships. It is also on this account that the courts have ruled that the good-will of a partnership does not inure to the benefit of the surviving partners, but belongs to the pur- chaser of the firm name,* and that the good-will of a market stand or stall the lessee of which has died, is independent of the stand itself and belongs to the estate of the deceased, t Good-will is very frequently referred to as an "intangible asset," that is to say, something the existence of which is spoken of, but is not palpable. Intangible as it may be by * Slater v. Slater, 175 N. Y. 143 (1903). t Journe s Succession, 21 La. Ann. 391. GOOD-WILL 245 itself, it must nevertheless rest upon something tangible; it is not conceivable, for instance, that a skilled surgeon whose fame is far-reaching could sell the good-will of his practice to an unknown confrere whose skill has yet to be demon- strated. There is nothing tangible in the assurance of the vendor surgeon that his patients will be willing to intrust their lives to his successor. Good-will in this case is non- existent as a marketable value, since it depends upon per- sonal skill which is not to be acquired through purchase. On the other hand, a physician practising without competition in a rural district could in all propriety place a value on the good-will of his practice, provided he were to agree to recommend the purchaser to his patients as fully capable of giving them equally skilled service, and agree to retire, or to move to another state or to another part of the same state. Good-will in this case would rest upon the monopo- listic prerogative of the vendee. This is so true that if the vendor subsequently performed an act which would tend to defeat the certainty of monopoly now possessed by the vendee, such, for instance, as announcing the resumption of his practice in the field of his former activities, the courts would invalidate the contract and relieve the aggrieved vendee of his obligations under the contract of sale.* The Good-Will of Corporations The nature of the good-will of corporations may be quite different from that of the good-will of sole proprietorships and of copartnerships. When corporations sell their assets it often happens that the identity of the vendor is lost in that of the vendee. In this case the purchaser does not acquire the right to expect that the customers of the vendor will resort to the old place. He acquires the earning power of an established business whose products will sell, no matter who offers them for sale ; he figures that, with more up-to- Townsend v. Hurst, 37 Missouri 679. 246 THE THEORY OF THE ASSET ACCOUNTS date methods of conducting the business, and through the application of scientific economy, and the union of forces hitherto antagonistic, larger profits will be obtained than were possible before the consolidation of interests took place. For this, he is willing to pay a sum of money which may be far in excess of the properties acquired. In the absence of a better term, accountants, as well as laymen, are generally satisfied to call this excess price good- will; but the frequency with which the excess of cost over the intrinsic value of the properties acquired is distributed by boards of directors over the value of the individual prop- erty units included in the purchase, no mention whatever being made of good-will, indicates that there is some deep- rooted objection to the term, at least from the point of view of corporations. There are, in fact, any number of instances of consolida- tions of corporations where the application of the word good-will to the excess price paid by the consolidating in- terests over the intrinsic value of the properties acquired, would be equivalent to an attempt to mislead, or to an ad- mission of ignorance of the conditions which brought about the combination. The earning power of, say, three corpora- tions to be consolidated may have been reduced to a negli- gible quantity by the keenness of the competition in which they have engaged. If that earning power were to be used as the basis for the computation of the value of good-will in accordance with the rules which are said to prevail in such cases, there would remain a minus quantity to express the good-will valuation. And, yet, the stockholders of the three competing companies may not feel disposed to combine un- less they receive a considerable amount over the intrinsic value of the properties which they control. Thus, so far as earning power is concerned, the bonus paid does not apply to past performances but to confidence in the future. If the word good-will applies to anything, under these conditions, GOOD-WILL 247 it must be to that harmony which the consolidation has brought about among forces which up to now were only desirous of destroying one another. Good- Will as an Asset It should be said, however, that while any reference to good-will may properly be eliminated from the books of a corporation which absorbs other interests in such a manner as to cause the identity of the vendor to be entirely lost, it should be retained as an asset of a corporation which takes over a copartnership or a sole proprietorship, particularly when the vendee concern retains enough of the name of the vendor to preserve the personal character of the good-will purchased. The importance of the asset "good-will" when it has been acquire'd by purchase, cannot be overestimated. There is no other asset of a concern the sale of which would be so effective in bringing operations to an end. In some instances it has been held by courts of law that under the terms of a contract for the sale of good-will, the vendor has no subse- quent right to solicit trade in the section of the country in which he previously operated, even among people who were not his customers at the time of the sale.* The sale of good- will may even prevent an individual from using his own name in connection with the line of business in which he has engaged prior to the sale. Judge Batesf quotes a case in which Beatty and Gage formed a partnership whose most valuable asset was a series of copy books, known as "Beatty's Head Line Copy Books." They dissolved, Gage buying out Beatty's interest for $20,000. It was shown that a large part of the price was for the right to sell the copy books. A publishing company, with Beatty's assistance, got out a new series called "Beatty's New and Improved Head Line * Munsey v. Butterfield, 133 Mass. 492. t "Law of Partnership* " 248 THE THEORY OF THE ASSET ACCOUNTS Copy Books." This was held to be an infringement of Gage's rights, the word Beatty as applied to the books being a valuable asset which passed to Gage.* Depreciation of Good- Will Why good-will, having been acquired at a cost which is sometimes considerable, and constituting in some instances the only truly valuable asset of a concern, should be out- lawed and sentenced to gradual expulsion from respectable books, is one of the perplexing puzzles which accounting offers to its students. Accountants who would never permit the reduction of a physical asset by the estimated amount of depreciation which it may or may not have suffered during a given period, have no scruples at all when it comes to good- will. Still, it seems that if a concern has paid a large sum to acquire the good-will of another, and has not only re- tained it but even increased it, there is no apparent reason why so-called conservatism should demand the writing off of the asset to the detriment of the very profits which its purchase gave the right to expect. One of the reasons frequently advanced in favor of this writing off policy, is that the valuation of good-will, being based on a given number of years' purchase of the average net profits of the vendor concern, less a fair return on capi- talization, its cost is consumed concurrently with the efflux of the period for which it has been purchased. This is, in- deed, an extreme view. It is unequivocally expressed in Clarence Munro Day's "Accounting Practice" : "Good-will is a legitimate asset in an industrial enterprise and the most accepted method of computing the amount of good-will is to take the total profits for the last five years and deduct from them five years' interest on the capitalization at seven per cent per annum ; the balance is good-will. The rate of interest is based on the assumption that no capitalist would * Gage v. Canada Publishing Co., n Ont. App. 402. GOOD-WILL 249 invest in an enterprise unless he was assured at least seven per cent annual return. Good-will should be written off the books during five subsequent years by charging off one-fifth against each succeeding year." As opposed to this view, which we have qualified as extreme, the following quotation from Dicksee's "Auditing" may be of interest: "Good-will does not depreciate. On the other hand, it will generally be conceded that it is liable to fluctuations, both continual and extreme * * * As a matter of fact, good-will is not written down because its value is supposed to have become reduced such a course is all but unknown. The amount at which good-will is stated in a balance sheet is never supposed to represent either its maximum or its minimum value; no one who thought of purchasing a business would be in the least influenced by the amount at which the good-will was stated in the accounts ; in short, the amount is absolutely meaning- less, except as an indication of what the good-will may have cost in the first instance. Inasmuch, therefore, as nobody can be deceived by its retention, there is no necessity for the amount of good-will account to be written down. On the other hand, the practice is not unusual, where sufficient profits are being made. The question is not, however, one upon which the auditor is required to express an opinion." Creation of Good- Will It is generally recognized that the question of the value of good- will does not arise until a sale is contemplated. Thus, it does not seem possible for a concern which has or- ganized otherwise than by purchase of an already established business, to create the asset "good-will" during the course of its operations as a going concern. Still, if it is considered proper to set aside the expenses of organization in an ac- count which will be reduced periodically during the years to which the benefit derived therefrom applies; if further, it 2 e THE THEORY OF THE ASSET ACCOUNTS is agreed that corporations have the right to spread the loss incurred through discounts on bonds over the life of the bonds, there does not seem to be a valid objection to the charging of the operating shortcomings of what might be called the "probation period" of a newly established business to an account which would record the cost of obtaining the good-will of the community. We often hear of concerns which expect to lose money during the first five years of operation, owing to the heavy advertising which they will have to do in order to call the public's attention to the value of their goods. If the cost of such advertising is charged to expense, together with other lavish expenditures which a newly established business is bound to make at the start to win the favor of those whom curiosity first attracts to the establishment, a considerable deficit may be shown. Would it not be better to raise an account with good-will, which would be made to reflect the extraordinary cost of establishing the business, and to dis- tribute that cost over the future periods which are to be benefited thereby? PATENTS Nature of Patents Black's Law Dictionary defines a patent : "A grant made by the Government to an inventor conveying and securing to him the exclusive right to make and sell his invention for a term of years." Thus, a patent is nothing short of a monopoly granted by the State, presumably as an induce- ment to the inventor to disclose the secret of his invention for the benefit of the public at large. The territory over which the monopoly extends is mentioned in both the letters patent issued to the inventor and in the statute authorizing the issue of patents. United States patents apply to all the states and organized territories, as well as to American ves- PATENTS 251 sels on the high seas. They do not, however, apply to foreign vessels in American ports. In certain foreign coun- tries England, for instance a patent which has not been operated for four years may be revoked, but in the United States the right of the patentee is not thus affected. In England, the Crown reserves the right to use the patented invention in return for fair compensation ; while the United States Government does not reserve that right to itself. However, no injunction can be obtained against the Govern- ment, and it is within its power to use the invention by pay- ing therefor reasonable fees to the inventor. In the United States the term of a mechanical patent is seventeen years from the date of grant ; the term of a design patent is three years and one-half, or seven years, or four- teen years, according to the application. In England the patent expires with any foreign patent granted before the English patent ; in Canada it expires with any foreign patent granted during its life. In the United States a patent can be extended by special act of Congress. Treatment of Patents The value at which the asset "patents" is carried on the books, depends upon whether the concern which owns it is the inventor, or has acquired it from the inventor. In the former case, its value is the cost of conducting the experi- ments which have led to the invention, and the fees paid in connection with the search as to the validity of the claim for the patent, and with the filing of the claim. In the latter case its value will, of necessity, be what the concern paid for it. Since patents grant what may be termed a legal monop- oly, it is clear that they convey a sort of a title to the good- will of the community in which the right to exclude every- body except the Government from the use of the invention is exercised. This is why so many corporations which ac- THE THEORY OF THE ASSET ACCOUNTS quire the business of other concerns where a patent is in- cluded among the assets, carry the excess price paid over the intrinsic value of the property acquired, under the term "Patents and Good- Will," or merely spread it over the value of the patents. If the monopoly granted by the patents lasts only for a term of years, it would seem that the asset should be written off during the life of the grant. This can be done in two ways: 1. Credit Patents and debit Profit and Loss with equal instalments corresponding in number to the number of years during which the patent continues to be operative. 2. Credit Patents, or Reserve for Amortization of Patents, and debit one of the components of the cost of goods sold, with periodical amounts repre- senting the probable royalty which would have to be paid on the sales if the patents were operated on a royalty instead of owned. If the reserve account has been created, debit it and credit Patents as soon as the two accounts are equal in amount. It will be noticed that the second method makes the cost of manufacture bear the loss sustained through the natural extinction of the very asset which made operations possible and created a legal monopoly; further, that it leads to the peculiar conclusion that the income from sales becomes larger as soon as the asset "Patents" has been eliminated. When speaking of the statement of income we shall have occasion to refer again to the oddity of accounting conclu- sions to which we are led by certain accounting theories and methods. It should be stated that, instead of being written off, patents have frequently been appraised on the basis of the saving in royalties which their possession affords, precisely TRADE-MARKS like water-power rights have been appraised on the basis of the saving in fuel and power-producing machinery effected by the use of natural forces. There exists another theory to the effect that while it is true that patents expire within a certain number of years, the benefit derived from them by the business does not ex- pire concurrently. It is pointed out that the species of monopoly granted by patents is bound to create a consider- able amount of good-will, the existence of which is appre- ciated by would-be competitors, and deters them from engaging in a line of business which has been for so many years the exclusive domain of an established concern. Un- der this theory, it would be possible to retain the asset value of a patent long after its legal termination, by transferring this value to the Good-will account. TRADE-MARKS Definition A trade-mark is nothing more than a conventional sign which, for commercial purposes, has the same effect as the signature has upon a written document; they both certify to the origin or authorship of the thing to which they are appended. Trade-marks make it possible for their owners so to earmark their goods as to make them easily recognizable by buyers ; in other words, they guarantee that whatever good- will attaches to the product, will be certain to revert to the proper party. In the case of Liedersdorf v. Flint,* it was said: "The court proceeds upon the ground, that the com- plainant has a valuable interest in the good-will of his trade or business, and that having appropriated to himself a par- * 15 Fed. Cues 219 (Note 8). THE THEORY OF THE ASSET ACCOUNTS ticular label, or sign, or trade-mark, indicating that the article is manufactured or sold by him or by his authority, or that he carries on his business at a particular place, he is entitled to protection against any other person who pirates upon the good-will of his customers or of the patrons of his trade or business, by sailing under^ his flag without his authority or consent." Since an unauthorized use of trade-marks constitutes an infringement of the owner's right to exclusiveness, it may be said of them that they confer a monopoly different from the one obtained under patents, in that its duration is not limited by statute, and can be exercised as long as one desires to use the marks for trade purposes. Thus, the main distinction between patents and trade-marks is that the former need not be used to remain in force, whereas the latter must be used or the owner's exclusive right to them is lost. While the cost of trade-marks may be insignificant when acquired otherwise than by purchase from former owners, their value may be considerable, because the very success of the goods which they protect means the acquisition of the good-will of the trade to which these goods are offered for sale. If trade-marks have been acquired from another con- cern their cost may be high, owing to the good-will which they convey. No matter what their cost may be, their in- fluence upon the prosperity of the business is so well defined that they are entitled to a place among the invested values of the enterprise. If kept in force, their value should not be written off. If abandoned, they may be closed by debit to profit and loss, precisely like all other assets which have outlived their usefulness ; or they may be written off gradu- ally during a period of years, upon the theory that although given up, they have brought good-will to the business of future years; or again, their original cost may be transferred to the good-will to be written down with that asset, if such is the policy of the concern. COPYRIGHTS 255 COPYRIGHTS Definition Bouvier's Law Dictionary defines copyrights as "the ex- clusive privilege, secured according to certain legal forms, of printing, or otherwise multiplying, publishing, and vend- ing, copies of certain literary or artistic productions." In the United States, to be entitled to a copyright one must make application therefor, remitting at the same time the required fee, and cause to be delivered to the Library of Congress two copies of the work. Like trade-marks and patents, copyrights give a monop- oly; but in their case the privileges is limited to a term of twenty-eight years from the time of recording. The term can be extended for twenty-eight years, upon request by the author, his widow, or his children, within one year after the termination of the original grant. This privilege does not extend to the assignee, unless so provided in the contract of assignment. Copyrights are personal property ; as such, they may be willed ; in the absence of a will, they descend to the natural heirs. The nature of the species of monopoly granted by copy- rights, consists in the privilege enjoyed by the owner or his assignee or full licensees, to prevent any unauthorized sale of the copyrighted works, and the publication of mutilated parts thereof. Copyrights as an Asset The question of the value of the asset "copyrights" is a complicated one. The original cost of obtaining the grant is insignificant unless the value of the time consumed in the preparation of the work be capitalized, together with the expenses incident thereto and with the cost of such prelim- inary advertising as may have been deemed necessary. 256 In the case of copyrights which are valuable only to the original grantee, such, for instance, as catalogues, price lists, and advertisements, the cost of plates, etchings, half- tones, etc., may be added to the value of the asset as stated above. But in the. case of assignable copyrights, the plates, etchings, and half-tones are so independent of the right it- self that they can be sold without giving the purchaser the slightest claim upon the copyright unless so provided in the contract. The probable value of assignable or salable copyrights depends, to a great extent, upon an estimate of the vogue which they will enjoy; their real value depends upon past performances so far as public favor is concerned, as well as upon an estimate of the continuation of their vogue. Copyrights, being a monopolistic grant, raise naturally the question of good-will. A copyrighted work may have been a financial failure and yet have obtained an artistic success such as to lift its author and its publishers to a very high plane in the favor of a certain class of readers. If the defects which made it commercially unprofitable can be remedied in future works of the same author, the good-will which the first production has acquired may enhance greatly the commercial success of subsequent copyrights. Hence, the losses sustained by the poor seller might be capitalized under the name of good-will, or added to the value of the copyright, at least until such time as the retroactive effect of subsequent successful works upon the unsuccessful one has been ascertained. FRANCHISES Definition Franchises have been defined as "a branch of the sov- ereign power of the State, subsisting in a person or in a corporation, by grant from the State." This definition has FRANCHISES 257 been assailed, upon the ground that it fails to establish a proper distinction between "primary franchises" and "sec- ondary franchises." Primary Franchises Primary franchises are special privileges, not generally possessed by individuals, which are granted by the State pursuant to a well-defined policy of government or of busi- ness control. They include : the right of perpetuity of pur- pose and of life, w r hich corporations obtain by virtue of their charter ; the privilege of limited liability which certain forms of organization receive from the State, as well as all the other special privileges which their legal status conveys, and the rights and prerogatives which all citizens enjoy under existing statutes, or in accordance with the spirit of the common law. Secondary Franchises Secondary franchises, at least under the American sys- tem of government, originate through a contract made upon valuable consideration, between the sovereign power and in- dividuals or corporations. The consideration for the con- tract may be monetary, or it may be only the public value of the services to be rendered by the party seeking the grant. They include, in the language of the Supreme Court : "rights and privileges which are essential to the operations of the corporation, and without which its road and works should be of little value ; such as the franchise to run cars, to take tolls, to appropriate earth and gravel for the bed of its road, or water for its engines, and the like."* The main distinction between the two classes of fran- chises, so far as organized business bodies are concerned, is that the former (primary) cannot be alienated, assigned, mortgaged, or otherwise disposed of, while the latter (sec- * Morgan v. Louisiana, 93 U. S. 217; 23 L. Ed. 860. 2 eg THE THEORY OF THE ASSET ACCOUNTS ondary) may be, if proper authorization is given by the sovereign power which made the grant. Generally speaking, secondary franchises are monopolis- tic and permanent rights "to do an act, or a series of acts of public concern." 1 They constitute a contract between the grantor and the grantee, which cannot be revoked unless the grantor specifically reserves to himself the right of revo- cation. The characteristic feature of franchises is that they must be granted by a sovereign power. Under this interpretation of the nature of the grant, it has been claimed that the privileges conferred by the municipalities are not franchises but merely licenses. 2 On the other hand, it has been held that if the grantee of the municipal licenses has given ade- quate consideration (such as a promise to pay to the munici- pality a certain proportion of its earnings or of its net profits), the grant ceases to be a license and becomes a fran- chise which is in the nature of a binding contract and cannot be revoked at the will of the grantor. 3 The legal doctrine which attempts to establish a differ- ence between the franchises granted by a state and those granted by municipalities, is generally thought to be un- sound, upon the ground that municipalities, being state cor- porations and part of the body politic, are mere subdivisions of the sovereign power. The question as to whether or not the grant of a franchise by a city is an infringement of the right of the state, appears to be one of legal proceedings, and not a question of fact. 4 Charges Against Franchises In connection with the components of the book value of the asset "Franchises," when possessed by public service cor- 1 Southampton v. Jessup, 162 N. Y. 122, 126; 56 N. E. 538. * Chicago City R.R. v . People, 73 111. 541. Chicago Municipal Gas Light, etc., Co. v. Lake. 130 111. 42; 22 N. E. 616. East Cleveland R.R. Co., 6 Ohio Cir. Ct. 318. FRANCHISES 259 porations, the Public Service Commission of the first district of the State of New York has ruled : "To this account shall be charged 'the amount (exclu- sive of any tax or annual charge) actually paid to the state or to a political subdivision thereof, as the consideration for the grant of such franchise or right' (Section 55 of the Public Service Commission Law) as is necessary to the conduct of the corporation. If any such franchise is ac- quired by assignment, the charge to this account in respect thereof must not exceed the amount actually paid therefor by the corporation to its assignor, nor shall it exceed the amount specified in the statute above quoted. Any excess of the amount actually paid by the corporation over the amount specified in the statute, shall be charged to the ac- count 'Other Intangible Street Railway Capital.' If any such franchise has a life of not more than one year after the date when it is placed in service, it shall not be charged to this account but to the appropriate accounts in 'Operating Expenses,' and in 'Prepayments' if extending beyond the fiscal year. "Payments made to the State or some political subdivision thereof as a consideration for granting an extension for more than one year of the life period of a franchise shall be classed as renewals. Those made as a consideration for franchises or extensions thereof covering additional territory to be operated as a part of an existing system shall be classi- fied as betterments. If the franchises cover separate and distinct new enterprises, the payments therefor shall be classed as original. "Note: Annual or more frequent payments in respect of franchise must not be charged to this account, but to the appropriate tax or operating expense account." This debars a public service corporation which falls un- der the commission's supervision, from charging to the 2 6o THE THEORY OF THE ASSET ACCOUNTS account "Franchise" the cost of obtaining the consent of the property owners, and the cost of the legal expenses incurred in connection with obtaining the grant. Generally speaking, however, such expenses are thought to be properly capital- ized under the heading "Franchises," by companies not con- trolled by the commission, together with the consideration for the contract between the grantor and the grantee, i.e., the amount paid to the state or political subdivision thereof. As to the propriety of capitalizing legal expenses, the ques- tion remains an open one ; some accountants claim that such capitalization is faulty whenever the company which is the beneficiary of a franchise, has a permanent legal department as part of its administrative organization. Any other cost incident to, or necessary for, the enjoy- ment of the franchise, such, for instance, as the cost of paving between tracks, may be capitalized in some other property account, such as Paving, Track and Roadway, etc. The payment to a municipality of a portion of the earn- ings from operations, in accordance with the terms of a franchise grant, is considered as a burden of the asset and cannot enter into its valuation. CHAPTER XXIII INVESTMENTS Surplus Capital That part of the capital of a business which is not re- quired for the operation of the enterprise, may be invested outside the business in such a manner as to provide an in- come at least equivalent to the returns which a private in- dividual may expect to receive from his wealth through ordinary investment channels ; also, profits which have come in the business and are not needed for additions and better- ments, for extension of the field of operations, or for dis- tribution to the interested parties, may be similarly used. This is done in order to obtain an income through sources which the legitimate pursuits of the enterprise do not afford. Finally, all available funds of the concern, whether capital or the result of operations, may be invested for the produc- tion of the income necessary to fulfill the purpose for which the concern was organized. Speculative Investments Investments may be temporary or permanent in nature. If temporary, they may have an undercurrent of speculation which should not be present in permanent investments. A business concern having unemployed funds, may afford to invest in securities selling below their acknowledged or sup- posed worth, hold them until market conditions improve, and sell them in order that the profits may be realized. But a life insurance company, whose duty it is to obtain for the 261 262 THE THEORY OF THE ASSET ACCOUNTS present and secure for the future an income of such magni- tude that it will not only exceed the cost of conducting the enterprise and provide for such losses as may be incurred, but provide as well for the largest possible refunds of pre- miums to the policy holders in the form of dividends, cannot afford to buy securities the fluctuations of which may be due to the uncertainty of the income to be derived from them, or to the problematic character of their value in the event of the dissolution of the companies issuing them. Temporary investments may include, among other things, securities owned, securities purchased on margin, and goods purchased owing to unusually favorable market conditions and held either to be used by the concern itself, if conditions make it advisable, or to be sold if prices rise to a figure which will guarantee a larger profit than could be had if the goods were to be used by the concern. Securities purchased for speculative purposes should be carried on the books at their original cost, that is to say, at their market value on the day of the purchase, plus fees re- quired by law or custom, and charges for services rendered by the agents who attended to the purchase. When pur- chased on margin, they should be carried at cost, that is to say, market value on the day of purchase, plus charges inci- dent thereto, plus subsequent charges made by brokers for interest on the proportion of the cost which the margin does not offset, less, if such accrue, any dividends or interest col- lected by the broker for the account of the legal owner of the securities. To offset the excess of the original cost over the amount of the margin and the subsequent additions to, and deductions from, that excess, the account with the broker is credited or debited, as the case may be. The account is also debited with all payments made to the broker subsequent to the purchase. Thus, the equity of the speculator is represented by the difference between the asset and liability accounts. 263 The theory which holds that securities carried for specu- lative purposes should be stated at cost, is often objected to on the ground that, since speculation is involved, it is well to make the Investments account reflect the fluctuations of the market. It cannot be forgotten, however, that nothing which has not been sold can bring profits, and that the Profit and Loss account is not intended to reflect what the profits or the losses would be if certain transactions had taken place, but what they are as a result of the transactions which have taken place. Goods acquired for speculation should be carried at cost of purchase, plus charges for brokerage, cartage, storage, etc., and plus the subsequent cost of holding them. Permanent Investments The word "permanent" when applied to investments, does not mean that the funds are invested forever in one particular thing, but that if the sum which has been invested is returned at the expiration of the term of the investment, it will be reinvested at once, or as soon as may conveniently be done. Permanent investments may be divided as follows : 1. Loans Secured by Bonds and Mortgages 2. Loans Secured by Collateral a. Time Loans b. Call Loans 3. Investments in Bonds of Other Companies 4. Investments in Stocks of Other Companies 5. Investments in Real Estate i. Loans Secured by Bonds and Mortgages The account representing this type of investments is frequently found under the name "Mortgages Receivable." In connection with the word "mortgage," as usually em- ployed, F. A. Cleveland says in "Funds and Their Uses" : "That which commonly goes in the security market as 264 THE THEORY OF THE ASSET ACCOUNTS 'mortgage/ is a misnomer ; it is in reality a credit obligation secured by a mortgage * * * in fact, if one held only the 'mortgage' or security contract, it would be of little value. The promise for the delivery of money is found in a 'promissory note' or other evidence of debt. The mortgage is only a collateral contract which gives to the creditor a contract of lien on the property named as security for the payment of the contract of credit." The Mortgage Contract The indenture pledging property to secure the loan re- ceived by the mortgagor may, or may not, mention the right of the mortgagee to pay delinquent taxes on the property pledged, or such assessments levied on the prop- erty as the mortgagor may fail to pay, or fire insurance premiums which he is in duty bound to pay and has not paid; nevertheless, the mortgagee has that right, and such payments made by him will be presumed to be for the benefit or protection of the pledge. The payments thus made will be added to the principal of the loan, and be covered by the pledge, precisely as if they had been part of the original sum loaned. This applies also to the necessary expenses of the mortgagee in connection with foreclosure proceedings. By necessary expenses is meant disbursements which cannot be construed as being incurred merely for the benefit and protection of the mortgagee. It has been held by courts of law that in the absence of stipulations in the pledge to the effect that the mortgagor is to bear cost, the recording fees cannot be charged against him.* This is due to the fact that the recording of a mortgage is principally for the protection of the mortgagee, since, while an unrecorded mortgage is valid as between the contracting parties, it is invalid as against innocent third parties. To insure the permanency of this kind of investment, * Simon v. Sewell, 64 Ala. 241. INVESTMENTS 265 the mortgagee has been given the right to refuse repayment of the sum loaned until the date mentioned in the promissory note. To secure the recovery by the leaner of the principal sum loaned, of the advances made by him for the protection of the property pledged, and of the interest accrued there- under, the states of the Union have enacted statutes con- cerning the steps which the mortgagee must take to enter the premises or to satisfy his claim through foreclosure proceedings. Mortgage Interest In regard to the income from mortgage loans, it should be noted that it does not accrue from the date of the mort- gage, but from the date at which the money was paid to the mortgagor; that if no rate of interest is mentioned, the legal rate prevails ; that if, peradventure, the bond or prom- issory note does not mention interest, while the mortgage does, interest will be allowed at the legal rate ; that interest after the maturity of the obligation and default thereon, is chargeable to the mortgagor if the instrument so stipulates or if it carries interest "until paid." The amount which will be loaned on bonds and mort- gages depends generally upon the margin considered to be safe. Some concerns will loan on first mortgages as much as 80% of the appraised value of the property to be pledged while others will loan only 60%. In the first instance the margin would be stated as 20% ; in the second, at 40%. Accounting Procedure and the Mortgage Register Accounting for this class of investments presents no difficulty so far as the general ledger is concerned, since it consists merely in recording the amount loaned, the ad- vances made for the account of the mortgagor, either at the time of the loan or subsequently, and the amount collected at maturity of the investment. But a subsidiary book which 2 66 THE THEORY OF THE ASSET ACCOUNTS will give all the information that may be required, is a more complex matter. For each individual mortgage there must be known, besides the name of the mortgagor and the amount of the loan : the date when the mortgage was given and its maturity ; the location and the general description of the premises mortgaged ; the state and county, and the book and page, in which the mortgage was recorded ; the interest rate and date; the number, the term, the amount, and the expiration of the policy of fire insurance which protects the buildings, the amount of the premium paid, the name of the company in which the property is insured, and the name of the party who is to pay the premiums ; the appraised value of the land and of the buildings ; the amount of principal repaid if the mortgage provides for gradual extinction, and the amount of interest accrued and due, as well as the amount paid. Figure 38 will show how the information required may be conveniently condensed without detracting from the lucidity of the record. Any other data which may be needed in regard to possible assignments of the mortgage, may be inserted on the left side of the folio. The Nature of Security "When a debtor delivers to his creditor an evidence of indebtedness with the intention that it become additional se- curity for his personal existing obligation, it becomes merely concurrent security, and is only designed to increase the means of the creditor to realize the principal debt which it is given to secure."* "There are three kinds of security: the first, a simple lien ; the second, a mortgage, passing the property out and out ; the third, a security intermediate between a lien and a mortgage, viz., a pledge."f The holder of a lien has no I sl ? I !? le v - Stringham, 44 S. D. 593, 598; 57 N. W. 776. t Halhday v. Holgate, L. R. 3 Exch. ^, 3 oa. INVESTMENTS 267 right to sell the property which he holds as security; he must be content to retain it until his claim is satisfied. "A mortgage is but a conveyance with a clause of de- feasance; it is something more than a lien; it is the grant of an estate as specific security for the money loaned."* The holder of a pledge has no title of any kind to the thing Date Recorc Intenz. IN5US Com "fern Ftolic Expi Amo Pren By w APPR Lan< Buik Nam Date / (^iven uoo Cit> 5ta Dta \TION ( ^> 5t MC Ml iDua {Stgfti Irourrry eaJt RW J gram and dimens ns of proper+y mortgaged. P*ry. i PaV. *\ o a ^ JANCE' laniy i y Mo. unt 4 Amoi. Mori ?em nFl -mimS gager. i srks 4ame Wlrr rvxn payW* AI5AL5 1 S |g linos * : of Appraiser of Appraisa s Prin ypal irrtenKSt l>- Cr Pair (bfleda Figure 38. Subsidiary Ledger for Secured Loans pledged, but has an implied right to sell it on the day of the default of the pledger. "The authorities show that the difference between a pledge or pawn of personal chattels and a mortgage of them is, that a mortgage passes the whole legal interest and property from the mortgagor to the * Dateman's Appeal, 127 Pa. St. 348; 17 AtL 1086, uoo. 2 68 THE THEORY OF THE ASSET ACCOUNTS mortgagee, and possession by the mortgagee is not essential to create his title, and, generally speaking, is inconsistent with such a title, while a pledge transfers only personal property in the thing pledged, the general property con- tinuing in the pledger. The pledgee's right is not complete until he has obtained possession, and his right or special property is to hold the pledge as security for the debt or engagement of the pledger, and on default on the day ap- pointed for payment or performance, to sell the pledge. Se- curities for money and negotiable instruments may be given in pledge, and the addition, as there is in the agreement here, of an express power to sell on default, will not change what would have been a pledge into a mortgage."* The foregoing describes fully the nature of the asset "loans on collateral," and differentiates between investments in which the title to the security pledged is in the leaner, although it carries a defeasance clause, and the investments in which the title to the pledge remains in the pledger. 2. Loans Secured by Collateral Time loans are made for a specified period of time, and cannot be repaid before maturity without the consent of the loaner; that consent may be given without consideration, or in consideration of the payment of a "bonus" calculated on the basis of equated time. Call loans are not made for any specific period, and are repayable at the option of the beneficiary or upon the de- mand of the loaner. The securities pledged under either class of loans may consist of bonds or stocks, or both, or even of goods de- posited in a warehouse, as evidenced by the pledge of the storage receipt. The pledge is, in any case, of a market value superior to the loan made thereunder. The amount of the margin depends upon the policy of the loaner as to Dateman's Appeal, 127 Pa. St. 348; 17 Atl. 1086, iioo. INVESTMENTS 269 what he considers safe. It is understood between the con- tracting parties that the securities pledged may be with- drawn at any time by the party who has title to them, and replaced by others equally acceptable to the pledger. It is also understood that if the market value of the pledge falls below the margin represented by the difference between the Namct Na Termsi A Hrlravk Amount t 1 nan $ Dates: Loan Margin % Maturity Interest i Remarks: &. % MVMt' Date Description Quan- tity Market Value Total Value Date Desription Quan- tity Market Vfclue Total Value Figure 39. Record of Collateral Pledged for Loans market value of the original securities on the day of the loan, and the amount loaned, the pledgee may call upon the pledger for additional security sufficient to make up the difference, or, if it is a call loan, for additional security or for repayment. In case of default the pledgee may sell the securities, apply the proceeds to liquidate the indebtedness 270 THE THEORY OF THE ASSET ACCOUNTS of the pledger, and, if any excess remains, return this to the pledger. The method of keeping account of the collateral pledged under either time or call loans, is illustrated by Figure 39. Exchanges of securities are recorded by merely crossing off the particular items which have been removed, and entering under the proper date the securities which have taken their place. 3. Investments in Bonds of Other Companies The accounting treatment here depends absolutely upon the purpose of the investment. If an "investment house" buys bonds, it is for the pur- pose of holding them until such time as they can be dis- posed of advantageously among customers of the house, or, if more profitable, resold in the open market. The only question at issue in either case is one of profit, and it is evident that, since par value is purchased and sold, with a variation in the amount of discount gained or premium suffered, the one important thing from the theoretical stand- point is to determine precisely that variation. Hence, so far as the general ledger is concerned, an ac- count with the par, and one with the premiums and dis- counts for every class of bonds acquired, will satisfy the requirements. The account with par is merely an inventory account reflecting at all times the unsold portion of the principal; the account with premiums and discounts is a complex account which, in order to show profits and losses, requires the application of the inventory of that part of the net amount of the account which applies to the principal unsold. The Interest Account Premiums and discounts must be carefully distinguished from the interest purchased, if any. Interest which has ac- INVESTMENTS 271 crued on the bonds at the time of their purchase is under no conditions to be considered as part of the cost of the investment. It must be evident to the student of accounting that the amount paid for interest accrued on bonds acquired does not represent either principal or income of the pur- chaser. It merely expresses the amount of the earnings of the vendor which the vendee will receive on the first interest date and must refund to the vendor in anticipation; or if the bonds are acquired from the company responsible for their issue, it represents only that part of the interest receivable at the first interest date, which the purchaser has not earned and which the issuing company has not incurred. As a consequence, interest accrued on bonds acquired, no matter what the purpose of the investment may be, is nothing more than interest purchased, for which a special account must be raised. This account will be closed, at the first interest date, by crediting to it that part of the interest receipts which was earned by the bonds before they were purchased, and which formed part of the purchase price. It is evident that this account does not reflect either a gain or a loss. The interest received on bonds by an investment house is, of necessity, income on the capital invested, and should under no conditions be considered as reduction of the cost of the investment. If a business concern buys bonds as temporary producers of income, the only logical way of treating the account is to express the bonds at cost. The question of amortization or of accumulation of cost to par cannot arise in this particular case, since it never was intended to hold the bonds until maturity. The receipts of interest will send to the earning account "Interest on Bonds," an amount which will bear the rate of income which the concern expected on the cost shown by the bond account. When the securities are sold, the account with principal will reflect the profit or the loss made on the sale of the ledger asset. 272 THE THEORY OF THE ASSET ACCOUNTS Relation of Cost to Income If, in accordance with the purpose for which it was created, a concern purchases long-term investments in order that the rate of income which they produce may be guaran- teed for an extended future, then, and then only, does the accountant face the question of amortization of that part of the cost which will not be repaid to the purchaser at ma- turity, or the question of accumulation of that excess of par over cost which will be received at maturity of the invest- ment. This class of investment cannot be recorded otherwise than at the cost at the time of acquisition. By cost is meant only par plus premium or less discount, as the case may be, and, for reasons which will become obvious as soon as the theory of amortization has been expressed, cannot be made to contain interest purchased, brokerage, stamp tax, etc., etc. If the value of the asset is stated at cost, and cost is less than par, it is evident that at maturity of the investment, the amount of the principal received being credited to the asset account, the credit will exceed the debit, unless in the interim steps have been taken to accumulate cost to par. Conversely, if cost is greater than par, and at maturity of the invest- ment the amount of principal received is credited to the asset account, the debit will exceed the credit, unless in the interim steps have been taken to amortize the portion of cost in excess of par value. Now, since bonds assure to their holders an interest an- nuity during the life of the instruments of credit, and a re- version of principal at maturity, if a bond with a nominal return of, say, 5% has been acquired at a price to produce 4%, and another bond with a nominal return of 4% has been acquired at a price to produce $%, it is plain that in the first instance the cash interest income received on the par reversion value has been greater than the expected income INVESTMENTS 273 on the outlay, while in the second instance it has been smaller. Submitting these facts to rigid analysis, we see that the excess of cash income produced by bonds acquired at a premium, represents in reality a periodical return of cost over par, that is to say, a reduction of cost, and that the excess of effective income produced by bonds acquired at a discount represents in reality a periodical accretion of cost to par. Proceeding further, if 5% on par has been received in cash as interest on a bond acquired at a price which would produce 4% on cost, the income on the investment will not be accurately stated until the earning account to which the cash return has been credited, is relieved of the difference. And if T)% on par has been received in cash as interest on a bond acquired at a price which would produce 4% on cost, the income on the investment will not be accurately stated until the earning account to which the cash return has been credited is increased by the difference. What that difference will be found to be in either case, depends upon whether we are satisfied with near-accuracy, or only with absolute accuracy. In the first instance, it will be sufficient to divide the total premium or the discount into as many equal units as there are interest periods during the remainder of the life of the bonds. In the second instance we shall have to compute the exact income on the book value of the investment as it stood at the beginning of each successive period, deduct that amount from the interest re- ceived, and apply the difference as a reduction from, or as an addition to, the cost. The following examples will serve to illustrate the dif- ferent results obtained under the two methods of treatment. In Example A the premium has been amortized in equal amounts during the life of the bonds, extending from the date on which they were purchased to the date of their tnaturity. 274 THE THEORY OF THE ASSET ACCOUNTS EXAMPLE A INVESTMENT 5% Bonds of the Millstone Co., payable May i, 1914. Interest pay- able May and November i. Acquired to produce 4%. Par, $50,000.00. Date Interest on Investment Principal Remarks Nominal Return Period- ical Amor- tization Income Dr. Cr. Balance May i, 1909 Nov. i, 1909 May 1, 1910 Nov. i, 1910 May i, 1911 Nov. i, 1911 May i, 1912 Nov. i, 1912 May i, 1913 Nov. i, 1913 May i, 1914 $52,245.64 Cash Interest Cash $ ,250.00 ,250.00 ,250.00 ,250.00 ,250.00 ,250.00 ,250.00 ,250.00 ,250.00 ,250.00 $224-57 224.56 224.57 224.56 224.56 224-57 224.56 224.56 224.57 224.56 $1,025.43 1,025.44 ,025.43 ,025.44 ,025.44 ,025.43 ,025.44 ,025.44 ,025.43 ,025.44 $224.57 224.56 224.57 224.56 224.56 224.57 224.56 224.56 224.57 224.56 50,000.00 $52,021.07 51,796.51 51,571-94 51,347-38 51,122.82 50,888.25 50,673.69 50,449.13 50,224.56 50,000.00 $12,500.00 $2,245.64 $10,254.36 $52,245.64 $52,245.64 In Example B which follows, the premium has been amortized in accordance with the theory of the accountancy of investments. EXAMPLE B INVESTMENT 5% Bonds of the Millstone Co., payable May i, 1914 Interest pay- able May and November I. Acquired to produce 4%. Par, $50,000.00. Date Interest Principal Remarks Nominal 5% on Par Effective 4% on Cost Amor- tization of Cost to Par Dr. Cr. Balance May i, 1909 Nov. , 1909 May , 1910 Nov. , 1910 May , ign Nov. ,1911 May , 1912 Nov. , 1912 May , 1913 Nov. , 1913 May , 1914 Cash Interest Cash $1,250.00 1,250.00 1,250.00 1,250.00 ,250.00 ,250.00 ,250.00 ,250.00 ,250.00 ,250.00 $ ,044.91 ,040.81 ,036.63 ,032.36 ,028.01 ,023.57 ,019.04 ,014.41 ,009.71 ,004.91 $205.09 209.19 213-37 217.64 221.99 226.43 230.96 235-59 240.29 245.09 $205.09 209.19 213-37 217.64 221.99 226.43 230.96 235-59 240.29 245.09 50,000.00 $52,040.55 51,831.36 51,617.99 51,400.35 51,178.36 5o,95i-93 50,720.97 50,485.38 50,245.09 50,000.00 $12,500.00 $10,254 36 $2,245.64 $52,245.64 $52,245.64 INVESTMENTS 275 When the figures given in Example B are analyzed carefully, it is seen that the periodical amortization result represents a uniform amount of $205.09 (which is the dif- ference between the nominal cash interest received, and the effective amount expected as income) set aside at every interest date, together with interest at 2% semiannually (4% annually) earned by the amounts previously set aside, and deducted from the cost of the investment at the end of the period. Hence, the theory of amortization of premiums on bonds bearing interest semiannually, rests upon the assumption that the amount of cash representing the difference between the nominal and the effective rate at the time of the first receipt of interest, is deposited twice a year at compound interest, in order that at maturity of the investment a fund equal to the premium may be obtained. To prove whether or not this is true, let us assume that, instead of periodically reducing the cost of the bonds, we allow the original cost to remain undisturbed until maturity, and that we deposit twice a year in a special fund earning compound interest at 2% semiannually, the amount of cash received for interest on the par value in excess of the expected income. We then obtain the table given on the following page, which reflects faithfully the entries made in the ledger accounts which will be affected by the transactions. The illustration given is all the more interesting be- cause it shows that the net result of the cash transactions incident to the purchase, the interest earnings, and the sale of the investment from May i, 1909, to May I, 1914, has been to increase the wealth of the investor, as repre- sented by cash, in the amount of $10,449.10, which is precisely the amount which he expected his investment to produce in five years. 276 THE THEORY OF THE ASSET ACCOUNTS ; ; o . d Id Id ! d ! d Id Id Id I d d in INVESTMENTS 277 On the other hand, an analysis of the cost transactions reflected by Examples "A" and "B," that is to say, the "nearly accurate" and the "absolutely accurate" methods, shows: Cash Disbursements: May i, 1909 Paid for investment in bonds $52,245.64 Cash Receipts: Nov. i, 1909, to May i, 1914 Received for interest $12,500.00 May i, 1914 Received P a r value of bonds . . .. 50,000.00 62,500.00 Net increase of cash as a result of the investment, as corroborated by the income accounts from Nov. i, 1909, to May i, I9H $10,254.36 So far as cash is concerned, the difference between the two sets of results, is nothing more than the interest earned by the premium redemption fund created under Example C, i.e., $194.74. As to the difference in the income, it is due to the fact that, in Example B, the in- terest supposedly earned by the amount of $205.09 is deducted from an asset, while in Example C it is added to an asset. Principles of accounting state that if an asset is deducted from another, the income which originates from the asset thus deducted, is compensated by the de- crease of the other asset, while, if the asset arising from the receipt of income is recorded, the income must also be shown. 27 g THE THEORY OF THE ASSET ACCOUNTS We will use the same examples in connection with dis- counts. In Example D the discount has been accumulated in equal amounts during the life of the bonds. EXAMPLE D 3% Bonds of the Millstone Co., payable May I, 1914. Interest pay- able May and November i. Acquired to produce 4%. Par, $50,000.00. Interest Principal Date Nominal Rate Cash Receipts Applied to Reduce Dis- counts Total Income Dr. Cr. Balance Remarks Cash $974-57 974.56 750.00 224 $7 974-57 224. S7 48 652 62 224.56 48 877 18 224-57 974-57 224. H 7 224.57 974-57 224.57 May i 1914 974.56 224.56 $50,000.00 Cash $7,500.00 $2,245-64 $9,745-64 $5O,OOO.OO $50,000.00 The phase of the theory of accounts known as "accoun- tancy of investments" is much more readily understood by the student when applied to premiums than when applied to discounts. And yet, the accounting principle is the same and is equally plain from either point of view. On the one hand, the periodical recovery, under the outward appearance of "income," of the portion of the "cost" of the asset "in- vestments" which exceeds "par," necessitates the periodical reduction of the asset and of the income. On the other hand, the periodically increasing- value of the asset in its evolution from "cost" to "par," can only be expressed by a corresponding increase of income. In Example E the discounts have been accumulated scientifically. INVESTMENTS 279 EXAMPLE E 3% Bonds of the Millstone Co., payable May i, 1914. Interest pay- able May and November i. Acquired to produce 4%. Par, $50,000.00. Interest Principal Date Nominal 3% on Par Effective 4% on Cost Accum- ulation to Par Dr. Cr. Balance Remarks May , IQOQ Cash ov. , 1909 $750.00 $955.09 $205.09 2O5.O9 $47,959-45 Interest May 1910 750.00 959.19 48 168 64 Nov. 1910 750.00 963.37 213.37 48 382.01 May igu 750.00 Nov. 1911 750.00 971.99 48 821 64 May 1912 Nov. 1912 750.00 980 96 May 1913 750.00 985.59 235.59 Nov. , 1913 750.00 May , 1914 Cash $7,500.00 $9,74S-64 $2,245.64 $5O,OOO.OO $50,000.00 Enough has been said on the subject of premiums and discounts to show that the differences developed by the sundry methods of treating discounts and premiums are not very important, in so far at least as small investors are concerned. As to large investors, it would seem that their policy being to invest in such a manner as to obtain a stated rate of income, nothing will satisfy their requirements but the method which will make the income account re- flect the effective (or expected) rate of income which they receive. Courts of law are not unlikely to frown at scientific methods of amortizing or accumulating bonds to par in connection with the interests of life-tenants and re- maindermen. The following quotation from the Cyclo- paedia of Law and Procedure will point out how divergent opinions are in respect to premiums and discounts: "It is very generally held that if a testator leaves bonds which he owns to trustees, with direction or 2 go THE THEORY OF THE ASSET ACCOUNTS authority to hold the same, paying the interest to certain persons for life, with remainder over, the fact that such bonds are worth a premium at and after his death, will not warrant the trustees in retaining any portion of the interest for the benefit of the remaindermen. 1 But in the case of bonds purchased at a premium by the trustees after the testator's death, the cases are in hopeless conflict. In some states it is held that such premiums are to be charged to principal, and not to income, and a trustee is not justified in withholding a part of the income to meet a diminution of principal which may not ever take place. 2 In other states the rule is laid down that where trust funds are invested in bonds running for a term of years and purchased at a premium, in the absence of a clear direction in the will to the contrary, such a proportionate deduction should be made from the nominal interest as will, at the maturity of the bonds, make good the premium paid, and preserve the principal of the fund intact at maturity. This is called the sinking fund rule. 3 " Investment Accounting A great deal has been said about the difficulty of the theory of the accountancy of investments. Still, if the principle is understood, nothing is simpler than to amortize bonds when the cost, the nominal rate on par, the effective rate on cost, the interest periods, and the life of the securities are known. INVESTMENTS 2 8l As to accounting problems based on this subject, which C. P. A. candidates are asked to solve at examina- tions, they uniformly state the par value of the bonds acquired, the nominal rate, the effective rate, the interest periods, and the life of the bonds, and require the finding of the cost. No candidate should fail to meet the test if he really understands the theory of amortization. He re- quires no algebraic formulae, and no more advanced knowledge of mathematics than familiarity with division, subtraction, and addition. Considering the meaning of the transactions which will take place at the maturity of the securities, he will see at once that there will be received by the investor: 1. The par value of his investment. 2. The last instalment of the premium annuity re- payable in as many periods as the bonds have to live between the date of the purchase and that of the maturity. 3. The effective (or expected) rate on cost. Items 2 and 3 are included in the receipt of the nominal rate on par receivable at the same time as the principal. Adding the proceeds of principal at the end of the last period, to the proceeds of interest received at maturity, at the nominal rate, a sum is obtained which is composed of the whole cost (i.e., 100%) at the beginning of the said last period, plus the effective interest on cost. Dividing the sum of the cost of the principal at the end of a period, inflated by the nominal interest return, by 100, plus the effective interest rate for the period, will give the cost at the beginning of the prior period. Example: One hundred bonds of the M. K. T. Co. were acquired on January i, 1913; they are due June 30, 1914, and bear interest at 5%, January and July. They were acquired to produce 3%. Required, cost of bonds. 282 THE THEORY OF THE ASSET ACCOUNTS O 9 ON u IO c ^O a ON Os a 0) PQ 8 o M 8 oS !. 3 : cs g ^ _ *>" : 01 ^j o\ ' ON U 8 M | ^j- IX. 04 H Q : 8 | w- w- 8 0> tx Jo ' tx. o .2 ^ ; 0) 6 13 o ' ON I ON of o" C aJ to rt ^ b! *- oo o\ \C to j w tx C^ *O IX, ^* S ) J-H t^ ^" O\ to * tx. *3 rt 3 >-" ^ -*-> c*5 o m IO " C rt JJ rt OH rjj . j I-H HH 1-1 ; i 7 rt 2 to 8 8 8 : 8 rt ,0 1-1 O< rt ON 8 8 8 i 8 "f Q. * ^ IH ji CJ 0< 0) tx. * g 1 W "I g ,_; -M c i ' rt oj V C7 PH m T3 M O* 4 I I o 2^ ji? O f-r 1 4 .2 h5, n -o *" ^ 2 ft '9 -w y O to CXi "o qj -r ^ o,^ "c ** S^ S3 * "0*^0 ** 'S "^ c 'c *< 'S o g *o '5b *o cue So *o 'So t) C D M PQ M PQ W M INVESTMENTS 283 It will be noticed that the example shows the periods in their reverse order. Besides the methods suggested above for recording the investment in bonds in accordance with the very purpose of the investment, there is another which is adopted by all concerns which wish to make their invest- ments reflect market values. It is as follows: As to Principal. Having stated the investments at cost, adjust them to the market value at the end of every period, debiting or crediting the difference to profit and loss. No premiums or discounts are considered. As to Income. Take it at the nominal rate of the bonds, and make no adjustment whatever. It may be said of the foregoing that while this method is not objectionable in the case of speculative investments, it should be obnoxious to the very purpose of permanent investments, since they are made for income, and not for speculative profit. The question of discounts and premiums suffered or received by corporations through the issue of certificates of indebtedness will be taken up in subsequent chapters. 4. Investments in Stocks of Other Companies Whether the reason for making the investment has been to obtain income, to control competing interests, or otherwise, permanent investments in stocks of other com- panies should be carried at cost. In so far at least as the investor is concerned, the question of discounts and premiums never arises in con- nection with capital stock. A certificate of stock conveys no promise, expressed or implied, that a certain sum of money will be paid to the holder at any time. Generally speaking, whatever is received on account of stocks is income, and is commonly referred to as "dividends on 2 g 4 THE THEORY OF THE ASSET ACCOUNTS stocks." It must be said, however, that dividends re- ceived on the stock of mining companies which do not set aside a certain proportion of their earnings to take care of the exhaustion of ore-bearing veins concurrently with operations, carry a certain return of the original invest- ment. It is seldom possible to estimate what that amount is, as it is not a positive and well-known quantity, like the difference between par and cost as in the case of bonds, but depends not only upon the accuracy of the estimate of ore which the veins will produce, but also upon the value of the other assets of the company when operations cease because this ore is exhausted. Hence, it is very difficult to set aside out of dividends, an amount which will truly offset, at the winding up of the company, the amount originally invested. The same thing is true of land improvement companies, and of similar enterprises where the capital assets waste concurrently with the progress of the business. The temptation to adjust the book value of invest- ments to their market value is admittedly greater in connection with stocks than with bonds, because the fluctuations of stocks are greater and more frequent than is the case with bonds. Still, the principles which apply to one class of securities apply also to the other. It is quite evident that before the New York State Insurance De- partment restricted the investments in stocks which life insurance companies were in the habit of making, unfavor- able conditions in the securities market at the end of a fiscal period would have had a considerable effect upon the dividends to policyholders paid by a company whose custom it was to adjust its investments periodically upon the basis of market values. Assuming that at the end of the year 1912 a "paper loss" of $20,000,000 had been sustained owing to panicky conditions, and that one year later a "paper gain" of an equal amount had been realized, INVESTMENTS 285 due to an unusually optimistic feeling prevalent in Wall Street, the financial status of the company at December 31, 1912, would not have depressed the directors of the company any more than the financial status at December 31, 1913, would have elated them. Their investments being made supposedly with a view to permanency, the fact that the value of their securities was boosted by "bulls" or dragged down by "bears" would not have affected them in the least, for in neither case was there any necessity of selling the investments. As a matter of fact, however high the value of the securities might have soared, the sudden appearance on the market of a con- siderable block of stocks offered for sale by life insurance companies would very probably have had the immediate effect of lowering prices. But leaving aside the natural indifference of the com- pany to "paper losses" and "paper gains" on market values, let us consider the case of two holders of "tontine" policies of equal amount, maturing, one at December 31, 1912, and the other at December 31, 1913. It is quite obvious that the year 1912 having sustained a supposed loss of $20,000,000, the dividends received by the holder of the policy maturing in that year would have been dis- proportionate to those received in the subsequent year by a similar policy whose good fortune it was to mature at a time when the "bulls" were the masters of the situation in Wall Street. 5. Investments in Real Estate In connection with investments in real estate, whether made by direct purchase, or as a result of the foreclosure of investments in bonds and mortgages, there arises the question of incumbrances. Incumbrances have been thus defined: "An interest in, or chargeable on, land, which may subsist in, or in 2 86 THE THEORY OF THE ASSET ACCOUNTS favor of, a third person, consistently with a transfer of the fee, but diminishes the value of the estate of the occupant." Incumbrances include: mortgages and the interest thereon (as well as the claims of the mortgagee for taxes, assessments, and fire insurance); assessments, taxes, mechanics' liens, landlords' liens, attachments, judgments, visible easements, pending suits, etc. Some of these liens, to be binding on third parties, must be duly recorded in accordance with statutory provisions, or be otherwise known to exist; others may be readily ascertained through the exercise of proper diligence and care. In no case is the purchaser of incumbered property permitted to plead ignorance. He must examine records or recorded liens, and must inquire in regard to the existence of other incumbrances. Generally speaking, the purchaser of real property takes only such title as the vendor had. It must be added, however, that a purchaser is supposed to be en- titled to a good title, free of incumbrances, and that, if any incumbrances are existing, it is the duty of the vendor to remove them. Nevertheless, the covenants of the deed of sale will, in the absence of fraud on the part of the vendor, be accepted as regulating the rights and the liabilities of the parties. Thus, if property acquired is subject to incumbrances, the purchaser either agrees to take it subject to these liens, which the vendor must satisfy, or he specifically agrees to assume all liabilities for liens. In the first instance he will pay the value of the property as if it were unincumbered ; in the second in- stance he will deduct from the purchase money the amount necessary to liquidate the liability for existing liens. In regard to taxes and assessments, the general rule is that, whenever the vendor agrees to liquidate, or to INVESTMENTS 287 provide for, the liabilities, no lien whatever attaches to the vendee for taxes and assessments which are liens at the time of the contract. As to whether or not accrued taxes and assessments the extent of which is not positively ascertained, are liens at the time of the sale, depends largely upon the statutes of the individual states. There are some states, for instance, where the law provides that persons who are the owners of real property at a certain date of the year, will be liable for the taxes of that year. In a Mississippi case, it was held that where the vendor agreed to liquidate, or provide for, all liabilities, he was liable for taxes fixed by statute as due on a date prior to the contract, even though the extent thereof was not ascertained for several months thereafter.* In the state of New York, it has been held and affirmed that if the vendor covenants to convey property free of all incum- brances, taxes, and assessments, the extent of which is determined in the manner prescribed by law only after the conveyance, are liabilities of the vendee, and not of the vendor, t In regard to all other incumbrances, it may be said that unless purchasers of real estate expressly bind them- selves in the deed of sale, they are not liable to creditors of the vendor. Accounting for Real Estate Investments So far as accounting is concerned, property acquired subject to existing liens which are not the purchaser's liability, is recorded by merely stating what it cost; if liabilities are assumed by the purchaser, the property is recorded at its purchase value, credit being given to cash for the amount paid, and to the liabilities for the amount * Vicksburg Waterworks Co. v. Vicksburg Water Supply Co., 80 Miss. 31, 68, 80. f Lathers v. Keog, 109 N. Y. 583 ; 17 N. E. 131 ; affirming 39 Hun 576. 2 gg THE THEORY OF THE ASSET ACCOUNTS assumed by the purchaser in taking over the property ; for example : 1. Investment in Real Estate. .$20,000.00 To Cash $20,000.00 For acquisition of a parcel of property located at as de- scribed in a deed of sale, reference to which is hereby made. The prop- erty was subject, at the time of the transfer of the fee, to a mortgage of $10,000 which the vendor has agreed to satisfy at maturity out of the pro- ceeds of the sale. 2. Investment in Real Estate. .$20,000.00 To Cash $10,000.00 " First Mortgage Pay- able 10,000.00 For acquisition of The property is incum- bered by a first mortgage (describe) which has been assumed by the pur- chaser. Whether purchased property is incumbered or not at the time of acquisition, the purchaser may incumber it by giving to the vendor a "purchase money mortgage" covering part of the purchase price. Under these con- ditions, the foregoing illustrations might read: INVESTMENTS 2 %9 1. Investment in Real Estate. .$20,000.00 To Cash $12,000.00 " Purchase Money Mortgage Pay- able 8,000.00 2. Investment in Real Estate .. $20,000.00 To Cash $ 4,000.00 " First Mortgage Payable 10,000.00 " Purchase Money Mortgage Payable 6,000.00 The components of the book value of investments in real estate may be: 1. The cost of the property, including: a. If the property has been acquired in the real estate market, the cost of acquiring title, whatever the amount may be in particular cases, as well as commissions and brokerage incident to the purchase. b. If the property has been acquired as a result of foreclosure, the cost of all advances made for the account of the mortgagor by the concern in its capacity as mortgagee, such as amounts expended for taxes, for insurance premiums, and for repairs and improvements prior to acquisition of the property upon default of the mortgagor. 2. The cost of such improvements as enhance the marketable value of the buildings, or make them more desirable to tenants, or increase the rate of rentals. If the policy of the concern is to carry its investments at market value, the fluctuations of the market are re- 290 THE THEORY OF THE ASSET ACCOUNTS ifi INVESTMENTS 291 corded periodically by means of debits or credits to the asset account, and corresponding credits and debits to the Profit and Loss account. If the amounts involved are considerable and a great many separate parcels of property are carried, a special ledger may be assigned to the detail of the asset account. This book may be made very thorough by means of sections which will record the original value and the fluctuations of the investment, the original incumbrances attaching to the property, and the gradual extinguish- ment thereof, and the total of the positive and negative factors affecting the income received on the investment. The foregoing form is adaptable to the requirements of large investors. CHAPTER XXIV SPECIFIC FUNDS, RESERVE FUNDS, AND FUNDED RESERVES Specific Funds In the course of business, it frequently becomes advis- able to set aside specific funds, in order that certain pur- poses may be fulfilled, or certain policies carried out. Thus, a social club may periodically set aside part of its receipts for the purpose of erecting a permanent home for the association; a life insurance company may set aside and intrust to influential persons, funds which are to be used to defeat proposed legislation which it considers fatal to principles of life insurance; a large concern may place considerable sums in the hands of its officers to be used for the benefit of the business at large and accounted for periodically. These specific funds, whether known as building, emergency, legislative, working, or experimental funds, or otherwise, need have no connection whatever with profits. They are, in reality, part of the available cash of the concern, whether that cash comes from operative re- sults or from capital contributions. Unless protected by resolutions of the directorate, they can be used for pur- poses other than that for which they were originally cre- ated, and whenever the amount provided is greater than the requirements, or the policy which caused their crea- tion is abandoned, the balance reverts to the general cash. They are current assets and are stated as such on the balance sheet. 292 SPECIFIC FUNDS AND RESERVES 293 Reserve Funds In contradistinction, reserve funds are accumulated out of realized profits; that is to say, they are brought into existence by being separated from the fund of liquid assets which have come in as a direct result of profitable operations. They are created for the express purpose of liquidating liabilities incurred in order that the earning power of the concern may be maintained or increased, or to replace physical assets when they have outlived their usefulness. They apply the principle of finance that capi- tal borrowed to obtain income should be paid out of the income which it makes possible, or that assets which have been consumed by operations must be replaced out of profits. They can be applied only to the purpose for which they were created, and if they ever revert to the general cash it can only be because they were larger than necessary. Their ultimate disposition is so well estab- lished that they cannot be considered as current, or liquid assets; the Interstate Commerce Commission includes them among deferred debit items, that is to say, it treats them as factors which can only fulfil their mission by be- ing debited to the particular liability which they are in- tended to extinguish, or to the particular asset the value of which they will eventually measure. Funded Reserves If corporations borrow capital in order that they may obtain therewith an income greater than the cost of bor- rowing, and if prudence requires that part of the excess income thus obtained be applied to the liquidation of the debt, there are two distinct ways of arriving at the re- quired result : i. Set aside periodically a proportion of the profits which have been realized, in cash, thereby cre- ating reserve funds. As indicated above, this is 2Q4 THE THEORY OF THE ASSET ACCOUNTS done by crediting cash, and debiting a fund so earmarked as to indicate the purpose of the special deposit; the cash reserved is usually in- vested in some manner deemed suitable or ad- vantageous, i.e., it may be left in a deposit account with a bank, or it may be exchanged for interest- bearing securities. 2. Set aside periodically a proportion of the net profits, by debiting "Profit and Loss" the summary account which measures them or "Surplus" the other summary account which contains them and crediting properly ear- marked "reserves" which will measure the aggregate amount of surplus appropriated for special purposes. It will be noticed that either method accomplishes its purpose properly; the reserve prevents the distribution of the reserved cash profits otherwise than for the liquida- tion of certain obligations; the fund is just as effective, since it sets aside and earmarks as reserved for special purposes, part of the cash obtained through profits. If a reserve has been created, and, in addition to this, cash is set aside in a special fund, it is only because of scrupulous conservatism. This operation, which is re- ferred to as "funding reserves," has been criticized as often as the wisdom of creating reserve funds has been challenged. Railroad economists claim that to invest the large amounts necessary to liquidate the bonded indebted- ness of common carriers, at a rate of interest infinitely inferior to the earnings which that money could secure if used for the requirements of the road, is equivalent to mis- management. They further assert that the greatest security which railroad bondholders can have is the pros- perity of the enterprise, and that anything that detracts SPECIFIC FUNDS AND RESERVES 295 from that prosperity is detrimental to their interests; that since reserve funds, by withdrawing cash from operation, reduce the income of railroads, they should not be created, the reserve alone being sufficient. It sometimes happens, however, that bond indentures compel the periodical payment to a trustee of certain sums which will accumulate at interest until sufficient to liquidate certain debts. When this is the case, nothing but the reserve fund will satisfy the bondholders, and the usefulness of a reserve carried in conjunction with the fund is more than problematic. The meaning of the term "reserve fund" as given in the foregoing, is far from being generally accepted. Many writers of accounting hold that there is no differ- ence whatever between "reserve funds" and "reserves," and that both are amounts set aside out of profits, to be used, if the occasion requires, to write down the book value of the assets to which they apply. It is true, of course, that a reserve for depreciation of machinery will be applied to the undepreciated book value of the assets when the machinery has outlived its usefulness; but that reserve is not a fund, although it could be funded. It is also evident that a reserve for redemption of bonded indebtedness could never be ap- plied to the reduction of any asset whatever, and that it is not a fund at all, although it is supposed to be repre- sented by funds which are not specifically invested. The Interstate Commerce Commission appears to have settled the controversy; it requires that reserves created out of income or surplus be shown as follows, on the balance sheet of common carriers: 1. Invested in Sinking and Redemption Funds 2. Invested in Other Reserve Funds 3. Not Specifically Invested 296 THE THEORY OF THE ASSET ACCOUNTS Sinking Funds The most common of all the "reserve funds" is the "sinking fund for the redemption of bonds." These sink- ing funds may be created in several ways: 1. Taking as a basis the life of the debt to be liqui- dated, deposit periodically amounts equivalent to 1/5, or i/io, or 1/20 of the original amount due, less whatever interest the fund as it stands has earned during the prior period, it being understood that the last deposit produces no interest. 2. Divide the amount of the debt to be liquidated, by the amount of the annuity of $i for the given term of the debt, at a given rate. The quo- tient will be the amount of dollars of each suc- cessive sinking fund instalment. The examples A and B show that the interest earned by the sinking fund is debited to the fund itself, and credited to the earning account "Interest on Sinking Fund." It has been claimed that it should be credited to the account which is debited with the interest paid on the bonds. The intrinsic worth of such a theory is to be appraised in the light of principles of finance. The in- terest earned by a fund created by setting aside assets obtained out of the reinvestment of profits made possible by the incurrence of long-term liabilities, is hardly a de- duction from the cost of carrying that liability. So far as their accounting treatment is concerned, re- demption funds are similar in every respect to sinking funds. The difference in terminology merely means that sinking funds are supposed to be created in compliance with what is known as the "sinking fund provision" of bond indentures, whereas redemption funds are created to retire any long-term liability which is not subject to sinking fund requirements. SPECIFIC FUNDS AND RESERVES 297 < s S w M > S i5 < ^ (t 8 :::::::::: 8 U o o" 3 CO o V* C a 1 1 u :::::::::: 8 8 V N Q o" V)- s *J be : : 8 8 8:8 8 c U OOO O O I O 8 U E : :<* " : M ^ .s II 6 u 1 I d c c/5 Q o" d\ d\ " oo w" oo" o" 1 o ^ j|, u rt Q : : : : ^ :..... -o Ov 8\ O\ O Ov O\ O\ ... . . . 3 ^Q Q Q Q Q A 298 THE THEORY OF THE ASSET ACCOUNTS in -r 18:::::::::: '8 *o u o o" o M 1 :::::::::: 8 8 o" o" hf If) fx *O C* CM 0* VO O o CM IS c B-a u CO l>. >-^ to 9 CO, || -^N "Of? o\ o\ o\ t - < ol >-^ ol o" IT) V 2 : : : ' j : ' : : : : j. 8\ 8\ O\ ON o\ O\ O\ *. . . coco" ^ " co" Co" 4S.Q Q Q Q Q 4S, CHAPTER XXV ACCRUED INCOME NOT DUE Income from Investments The income from: (i) investments in real estate, (2) bonds of other companies, loans on collateral (call or time), bonds and mortgages, and (3) stocks of other companies, is, in the order given: rent, interest, and dividends. Since the date at which rents and interest mature does not always coincide with the last day of the ac- counting period, it follows that an amount of income on investments may have been earned which does not appear on the books, because cash has not been received therefor. The Cash Basis It may be that the policy of a concern is to keep its books on the "cash basis," that is to say, to consider as income earned only that which has been received in cash, and that, correspondingly, only expenses paid in cash con- stitute income disbursed. This policy has the great disadvantage of not being consistent. It rests upon the possibility that the right to receive income may be lost by the failure of the debtor to pay what he owes, and upon the impossibility of enforcing payment when such contingency occurs. But if the basis is correct, it should apply also to accounts receivable recorded as a result of 299 300 THE THEORY OF THE ASSET ACCOUNTS sales on credit, since the amount charged to customers contains not only the cost of the goods sold to them, but, as well, the profit realized on the sales. It is obvious that if it is sound theory to ignore income until it is received, it is also sound theory to ignore the profit on sales until the customers have paid the indebtedness which contains those profits. Yet it is doubtful whether a single instance could be found where a business concern which claims to be on a cash basis is consistent enough to apply that basis to merchandise transactions. The Accrual Basis Many concerns keep their books on the "accrual basis." This method applies the accounting principle that the primary connection between the net assets and the net income derived therefrom, is a matter of earnings and of expense incurred, and not one of income received in cash and expenses paid in cash. It takes cognizance of the fact that unless income is recorded when earned, losses due to the failure to collect that income cannot appear on financial statements. It might be supposed that an accountant had earned, during a calendar year, say, $10,000, and had been un- able to collect more than half of that sum, the balance being bad debts. If his books were kept strictly on the cash basis his earning capacity would be shown to have been $5,000 during that year, and no loss would appear in his income account. If his books were kept on the accrual basis, that capacity would be shown to have been $10,000, and his financial statements would show the fact that, being unable to collect more than half of that sum, he had sustained a loss of $5,000, owing to the financial incapacity of his clients or their bad faith. Leaving expenses and liabilities out of the question for the time being, the adoption of the accrual basis ACCRUED INCOME NOT DUE means that at the end of every accounting period, all in- come which has been earned during that period must be recorded as an accrued asset which, while perhaps not collected at the time, because it is not due, may be col- lected at some future time. This, of course, necessitates the recording of an income which will be credited to the profit and loss of the period, whether or not the accrued asset which it represents fails of collection. Thus, if the last interest receivable on investments in bonds of other companies or in bonds and mortgages or in loans on collateral, was received December I, and the accounting period ends December 31, there has been earned interest for one month, which is an asset of the investor as well as it is his income for the month of December. Nature of Dividends Dividends differ materially from rentals and interest; they do not belong to the stockholders until they have been declared and the knowledge of the resolution of the board of directors has become known outside of the board room. Hence, it is not possible to take as an asset and as income, dividends which are expected on investments in stocks of other companies, since there is no certainty that the directors will deem it advisable to distribute part of the surplus. But if a dividend has been declared, its amount must be taken both as an asset and as income, even though it be made payable months later. The legitimacy of the asset cannot be denied, since, after a dividend has been declared, it cannot be rescinded unless it has been established that its declaration was illegal. Record of Earnings on Investments The journal entries giving expression to the earnings on investments and to the corresponding accrued assets which they represent, are as follows: 302 THE THEORY OF THE ASSET ACCOUNTS Accrued Rentals Real Estate. .$ Accrued Interest on Bonds of Other Companies Accrued Interest on Bonds and Mortgages Accrued Interest on Collateral Loans Dividends Receivable (de- clared) To Rentals on Real Es- tate $. . . " Interest on Bonds of Other Companies " Interest on Bonds and Mortgages . . " Interest on Collat- eral Loans " Dividends on Stocks o f Other Com- panies To set up both the asset and the income derived from investments. Whatever is collected on the asset should be credited to the asset account, in order that it may show at any time the balance accrued thereunder, and not as yet col- lected or collectable. The income account should contain no credits whatever on account of cash receipts, and the debit side of the accrued asset should at all times be equal to the credit side of. the earning account. This means that if an investment is sold or expires during an accounting period, the first care of the accountant should be to make both the asset account "Accrued Interest" and the income account "Interest" reflect, in anticipation, ACCRUED INCOME NOT DLE 303 that part of the proceeds of the sale or of the settlement at maturity, which will not represent principal. Unless this is done, the books will show that interest income was obtained partially through the accrual of an asset and partially through the receipt of cash. To illustrate: On January 15, 1914, A loaned B, against proper collateral, $10,000, at 6%, principal re- payable on July 15, 1914, interest payable at maturity. A closes his books on the last day of every month. At July 15, 1914, prior to the settlement made by B, A's books show, on the 36o-day basis: INVESTMENT IN LOANS ON COLLATERAL 1914 Jan. 15 Cash $10,000.00 ACCRUED INTEREST ON LOANS ON COLLATERAL 1914 Jan. 30 Interest on Loans on Collateral.. $ 25.00 50.00 " .. 50.00 " .. 50.00 " .. 50.00 " .. 50.00 Feb. 28 Mar. 31 Apr. 30 May 31 June 30 $275.00 INTEREST ON LOANS ON COLLATERAL 1914 1914 Jan. 30 Profit & Loss.. $ 25.00 Jan. 30 Accrued Interest Feb. 28 50.00 on Loans on Mar. 31 50.00 Collateral $ 25.00 Apr. 30 50.00 Feb. 28 50.00 May 31 50.00 Mar. 31 50.00 June 30 . . 50.00 Apr. 30 .... 50.00 May 31 .... 50.00 June 30 ' .... 5O.OO $275.00 $275-00 THE THEORY OF THE ASSET ACCOUNTS Now, if upon settlement by B, on July 15, 1914, A makes the following entry: Cash $10,300.00 To Investments in Loans on Collat- eral $10,000.00 " Accrued Interest on Loans on Collat- eral 275.00 " Interest on Loans on Collateral.... 25.00 it is evident that the asset account "Accrued Interest" will fail to reflect the whole amount of the earnings to which it owes its existence, and that the earning account will be composed of two distinct elements: 1. One, said to be an earning, due to the fact that an asset receivable was placed on the books. 2. The other, said to be income, due to the fact that cash came in, in settlement of interest earned. Would it not be more logical to carry the theory of ac- cruals throughout the accounting period, and on the day of settlement of the loan make the following journal entries? i. Accrued Interest on Loans on Collateral $ 25.00 To Interest on Loans on Collateral $ 25.00 For interest accrued to date of settlement of principal and of inter- est on loan of $10,000 secured by collateral, maturing this day. ACCRUED INCOME NOT DUE 2. Cash $10,300.00 To Loans on Collat- eral 10,000.00 " Accrued Interest on Loans on Collateral . . . 300.00 For settlement of loan and collection of assets receivable on account of interest from Janu- ary i, 1914, to July 15, 1914. Income from Bonds If reference is made to the discussion of investment in bonds of other companies,* it will be found that the nominal account representing the income derived there- from, may under certain conditions contain debits and credits for amortization and accumulation of cost of in- vestments to par. It must be said at this point, that even where investments are carried at par, and separate accounts are kept for discounts and premiums, the nature of these latter accounts is such that they should be written down by means of periodical credits and debits to the nominal account representing interest on investments in bonds, and not, as is so often the custom, by credits and debits to the Profit and Loss account. When the conditions just described prevail, the asset account "Accrued Interest on Investments" should con- tain the nominal rate receivable on the face of the bonds, since in case of default the amount claimed by the in- vestor will be the principal, i.e., par, plus the interest on par at the rate stated on the instrument of credit. As to the earning account, it should reflect the true income Chapter XXIII. 306 THE THEORY OF THE ASSET ACCOUNTS which the bonds were to produce at the price at which they were acquired. This is the only case where the debit side of the asset account "Accrued Interest on Invest- ments" should not duplicate exactly, and, at all times, the credit side of the earning account "Interest on Invest- ments." CHAPTER XXVI ACCOUNTS PARTIALLY REAL AND PARTIALLY NOMINAL DEFERRED DEBIT ITEMS Allocation of Periodical Expenses When a concern has adopted the policy of charging against the income of a period, all the expenditures made and all the obligations incurred during that period for the protection of the physical assets, as well as for the acqui- sition of minor supplies intended to be consumed through the operation of the business as a whole, the question of accounts partially real and partially nominal arises only in connection with trading or manufacturing goods.* The policy referred to above is often qualified as "conservative" by those who have adopted it. Usually, however, it is objectionable to accountants because, by making the profits of certain periods suffer a detriment for the benefit of other periods, it destroys utterly the value of comparisons. When profits are ascertained yearly, it may be said with a semblance of truth that the law of averages is likely to make all periods very nearly alike, since the same ex- penses are bound to occur year in and year out, unless changes of policy have taken place in the interim. Still, this is not always true. Let us assume, for instance, that on January 2, 1912, a building was insured against fire, the policy covering a period of three years; it is obvious that because the year 1912 has been made to bear the Discussed in Chapter XVI. 307 -, g THE THEORY OF THE ASSET ACCOUNTS burden of the whole insurance premium paid during that year, the profits will suffer by comparison with the future profits of the years 1913 and 1914. And, if in the year 1913 a large amount of stationery is acquired in order to take advantage of the considerable saving which large orders afford when type has to be set up, it is evident that unless the cost of these supplies is spread over the periods in which they are consumed, the year 1913 will sustain a burden which the law of averages will not relieve in the least. It is for this reason that accountants recommend that, at the end of every accounting period, a sharp line be drawn between the expenses applicable to the period which has just expired, and the expenses applicable to subsequent periods. Common Accounts Partially Real and Partially Nominal The individual accounts which may be considered as partially real and partially nominal, vary according to the particularities of business. The most commonly found are : 1. Fire Insurance Premiums 2. Advertising Contracts 3. Stable Supplies 4. Stationery and Printing 5. Advertising Matter These accounts are subject to periodical inventories. This statement applies even to fire insurance premiums, since, to ascertain the amount applicable to subsequent periods, it is necessary to marshal the policies, and con- sider their terms. It is precisely because the values which they represent are susceptible of being inventoried, that they are to be found stated under the balance sheet group "Working and Trading Assets," together with the in- ventories of trading goods, manufacturing materials, goods in process, and finished goods. DEFERRED DEBIT ITEMS 309 Fire Insurance Premiums The advisability of carrying as an asset the portion of the fire insurance premiums which applies to periods subsequent to the one at issue, results not only from the requirements of proper accounting, but, as well, from the very nature of the contract of insurance for which the premium paid is the consideration. The law provides that whenever an insured party sur- renders his policy, orders it canceled, and demands the refund of the unconsumed proportion of premium paid thereunder, his right to the refund shall be absolute, pro- vided the policy contract contemplates the eventuality of cancellation. The amount of premium to be refunded will not, however, be the proportion of the whole which applies to the unexpired period covered by the original contract. It will be the amount of the premium, less what the cost of insurance would have been if the policy had been issued for the time during which the insurer was in the risk.* The insurer may, besides, deduct from the amount of the premium to be returned, his "reasonable" expenses in writing the policy. Hence, the amount of fire insurance premiums which going concerns carry as an asset at the end of an account- ing period, is never the exact amount which would be received if the policy were to be canceled on what is called the "short rate" basis. Still, for the purpose of statements purporting to show the financial status of such concerns, it is evident that the only expense incurred on account of fire protection, is the proportion of it which applies to the period covered by the statement, since there is no intention of surrendering the policy. For the purposes of statements purporting to exhibit the financial status of a concern facing liquidation through financial distress or otherwise, it is better to carry the asset * Matter of Independence Insurance Co., 13 Fed. Cas. No. 7015. -, IO THE THEORY OF THE ASSET ACCOUNTS "Fire Insurance Premiums, Unexpired Proportion," at the probable value to be received upon cancellation of the policy. What that value will be, is indicated by what is known as "Union Short Rate Tables." Advertising Contracts When advertising contracts have been paid in ad- vance, it is customary to apportion their cost over the periods during which they run. The word "paid" does not necessarily mean paid in cash. If a going concern has placed an advertising contract for a year, agreed to pay monthly a sum of $100 therefor, and recorded its rights and duties under the contract in the following manner: Advertising Contract $1,200.00 To Creditor's Account. . . $1,200.00 it has, so far as accounting is concerned, paid $1,200 in advance, since it has recorded a lien of that amount against the assets held. Hence, unless it treats the un- consumed portion of the consideration for the liability as an asset, it will not state its true financial status. What the value of an unexpired advertising contract is to a concern about to liquidate, depends naturally upon the terms of the contract itself. If it has been paid for in cash in advance of the performance by the advertising concern, a compromise agreement may be reached whereby the client will receive back a portion of his pay- ments, in consideration of the cancellation of the contract. The recording of such a transaction would consist in debiting cash with the amount received, debiting profit and loss with the loss (if any) represented by the excess paid in advance, under the contract, over the amount re- turned, and crediting the asset account "Advertising Contracts, Unexpired Portion." DEFERRED DEBIT ITEMS ,11 If the business concern makes monthly payments, but has recorded the whole contract as suggested in the fore- going entry, and, upon a plea of impossibility to perform, has obtained a cancellation of the contract, the only ac- counting necessary will be to debit the liability account reflecting the amount still due under the contract, and to credit the asset account supposed to represent the right of the concern under the contract now canceled. This, of course, is true only if the two amounts are equal. If the contract is assignable, that is to say, if no pro- vision thereof opposes its being assigned, and if there is no liability to be incurred thereunder by the assignee, the concern assigning its rights will merely debit cash with the amount of the consideration received from the assignee. Any difference between the book value of the contract and the consideration for its assignment will be debited or credited (as the case may be) to profit and loss. Stable Supplies, Stationery and Printing, Advertising Matter The individual inventorial value of these assets may or may not be deemed important enough to be included in the balance sheet; still, the amount of an account should have no bearing whatever upon its treatment at the end of a period. Unless this principle is carefully applied at all times, the cost of operations of any given period may be incorrectly stated, to say nothing of the financial status of the concern. Stable supplies are obviously a valuable asset of a going concern as well as of a concern about to liquidate. In the latter case, they are subject to market fluctuations, and to the hazards of an auction sale; but they are at all events a legitimate asset. The value of stationery and printing is so problematic 3I2 THE THEORY OF THE ASSET ACCOUNTS to a going concern that the Insurance Department of the State of New York does not permit of its being shown in the balance sheet of insurance companies; the application of the unexpired portion of the account to any given period, involves the consideration of the proper time to charge to expense, books of account, records, and memoranda, which may outlive considerably the period in which they are put in use; furthermore, the question of obsolescence of type is forever present in the consideration of the inventorial value of the asset. As to concerns about to liquidate, the value of the asset to them is, of necessity, its scrap price. The value of advertising material remaining on hand at the end of a period, from the point of view of a going concern, is its cost. This, of course, is true only provided the advertising policy of the concern has undergone no radical change during the period. In the contrary case, the cost of the now obsolete material must be charged to profit and loss. To a concern about to liquidate, advertis- ing material is mere scrap. Clearing Partially Real and Partially Nominal Accounts Accounts partially real and partially nominal must be relieved periodically of their nominal portion, or of their real portion. In the first instance, they are considered as inventory accounts, the consumed portion of which is to be charged to profit and loss; in the second instance, they are considered as nominal accounts, which may or may not be entirely consumed for the purpose intended. If not entirely consumed, the real portion must be carried forward as an asset. In either case, the treatment is the same. It is not, however, necessary to wait until in- ventory time to determine the nominal portion of these accounts. If treated as inventory accounts they may be credited whenever part of the material which they contain is DEFERRED DEBIT ITEMS 313 issued to the stable, or to the different departments and offices of the organization as a whole. First Method The Stable Supplies account of a concern opens on January i, 1914, with an inventory of $150; during the subsequent accounting period, there is purchased on credit, $500 worth of supplies. At the end of the period the inventory shows an asset of $75. The accounts affected by the transaction stated would show: STABLE SUPPLIES Account considered as inventory account or as a nominal account with a possible residual value. 1914 Jan. i Stable Supplies (Old Account) .$150.00 June 30 Creditors 500.00 $650.00 July i Stable Supplies (Old Account) . $75-00 1914 June 30 Profit and Loss. .$575.00 Stable Supplies (New Account) . 75.00 $650.00 PROFIT AND Loss 1914 June 30 Stable Supplies.. .$575.00 Second Method The Stationery and Printing account of a concern opens January 2, 1914, with an inventory of $300; during the period there is purchased on credit $250. In Febru- ary, $175 worth of material was issued to the adminis- trative department; in March, $50 worth was issued to the factory office. In May, $80 worth was issued to the 314 THE THEORY OF THE ASSET ACCOUNTS selling department. At the end of the period the status of the accounts affected by the above transactions is as follows: STATIONERY AND PRINTING 1914 Jan. 2 Balance . June 30 Creditors .$300.00 . 250.00 July i Balance $550.00 .$245.00 1914 Feb. 28 Stationery and Printing E x - pended Ad- ministration . .$175.00 Mar. 31 Stationery and Printing E x - pended Fac- tory Office ... 50.00 May 30 Stationery and Printing E x - pended Sell- ing 80.00 June 30 Balance 245.00 $5So.oo STATIONERY AND PRINTING EXPENDED ADMINISTRATION 1914 June 30 Stationery and Printing $175.00 STATIONERY AND PRINTING EXPENDED FACTORY OFFICE 1914 June 30 Stationery and Printing $50.00 STATIONERY AND PRINTING EXPENDED SELLING 1914 June 30 Stationery and Printing $80.00 DEFERRED DEBIT ITEMS Deferred Debit Items The expenses and losses incurred and sustained during a given period, may not apply to that particular period; if, for instance, an accounting period comes to a close on June 30, and during that month there has been paid $150 for rent of June and July, it is obvious that the applica- tion of $75 to the rent expense must be deferred until the subsequent period. Similarly, if a note maturing three months from June 15 has been discounted on that day, the loss of the discount cannot be made to fall upon the month of June, but must be spread over the three months ending September 15. The items which may be properly included among the deferred debits, are not assets in the strict sense of the word, since the question of their availability never arises. So far as the average business is concerned, they represent expenses which have no residual value other than the benefits for which they have paid but which will be en- joyed only in subsequent periods, or losses which respect for the accounting truth requires to be apportioned to the periods to which they legitimately belong. The Interstate Commerce Commission has greatly extended the generally accepted meaning of the word "deferred" when applied to accounts; and this will be re- ferred to again when speaking of the effect of the com- mission's rulings upon accounting theories and methods. Generally speaking, deferred debit items include: 1. Rent paid in advance 2. Taxes paid in advance 3. Interest and discount, proportion applicable to subsequent periods 4. Premiums paid on investments 5. Discounts suffered on issues of long-term obliga- tions 3 i6 THE THEORY OF THE ASSET ACCOUNTS The treatment of these accounts at the end of the ac- counting period, consists merely in crediting them in- dividually with the portion applicable to the operations the result of which it is intended to ascertain, and debiting profit and loss, or group accounts raised to be apportioned to other general classes of facts. Desire for analytical expression of financial facts has often led accountants to classify deferred debits in ac- cordance with the effect which they will have upon the financial statements of future periods. They have at times been stated as follows: 1. Deferred debits to Operating Expenses 2. Deferred debits to Deductions from Income 3. Deferred debits to Profit and Loss Organization Expense What the components of each group of deferred debits will be, depends naturally upon the peculiarities of the business. To illustrate, as to group 3, one of the most familiar of the factors which it may contain, is organiza- tion expense. At the birth of a corporation, a multitude of expenses are incurred which are necessary to fulfill statutory re- quirements, and to set in motion the mechanism of the corporate body and the operations of its business. The first group of such expenses includes the fees paid for incorporation, and for the filing and acknowledging of papers. The second group includes the fees paid to the pro- moter for his services, and to the lawyer for conducting the organization in a legal manner; also the cost of print- ing and circulating prospectuses, and of soliciting sub- scriptions; the cost of acquiring the necessary corporate equipment, such as corporate records, seal, etc.; the cost DEFERRED DEBIT ITEMS 317 of printing and issuing certificates of stock, and the cost of conducting the temporary office of the company pend- ing organization. The third group includes perhaps the cost of inducing skilled superintendents, foremen, and workingmen to abandon their present occupation, and to enter the em- ploy of the company. There is no doubt that the benefits derived by the corporation from these expenditures will be felt so long as it remains actively engaged in business. This is so true that the Italian law does not permit corporations to write off their organization expenses otherwise than pro- portionally during their official life, which extends for fifty years. In America, where perpetuity of corporate life is usually granted, it would not be possible to apply such a rule. On the other hand, unless the expenses of organization are written off during a certain number of periods, the balance sheet will forever contain an asset which has no salable value and which does not in any way tend towards the proper presentation of the financial status. Hence, it is customary to arbitrarily fix a number of years for the amortization of organization expenses. This is done by periodically crediting the account with the desired proportion, and charging profit and loss. The Public Service Commission for the first district of the State of New York prescribes that the corpora- tions organizing under its jurisdiction, keep an account with "Organization," to which shall be charged "all fees paid to governments for the privilege of incorporation, and all office and other expenditures incident to organ- izing the corporation or other enterprise and putting it in readiness to do business." On the other hand, the Interstate Commerce Commission requires that these ex- penses be included in the cost of construction and equipment. In Austria and Hungary the corporation is THE THEORY OF THE ASSET ACCOUNTS permitted to assess stockholders in the amount necessary to wipe off the expenses incident to the organization of the company, while in Germany the same purpose is ob- tained by selling stock at a premium calculated to defray the cost of organizing. Part IV The Theory of the Liability Accounts CHAPTER XXVII CAPITAL STOCK The Share and Its Functions In America a corporation may exist without issuing, under the form of shares, evidences of the contribution of capital by its members; it is understood, however, that in order that such corporations which are known as "corporations aggregate" may enjoy a perpetuity of life, the rights of the original members to the capital con- tributed by them, shall pass to their successors together with the property acquired out of capita 1 and with the corporate privileges. Generally speaking, corporations issue shares of stock to their stockholders, which, at the time of such issue, indicate the extent of the contributions of the stock- holders, and, thereafter, the proportion in which the holders whose names are registered on the corporate books will participate in the distribution of profits while the company continues as a going concern, and in the remainder of the assets and surplus after liquidation of the liabilities at winding up. Lindley, in his work on "Partnerships," refers to capital stock as follows: "When a company is formed, a sum of money is fixed upon, and is called its capital; this sum is divided into a number of equal portions; each 319 THE THEORY OF THE LIABILITY ACCOUNTS of these portions is a share, and whether the sum fixed upon is ever all subscribed or not, and whether what is subscribed is employed profitably or to the contrary, a share retains its original meaning." If a share of stock has a meaning when issued, that meaning must be that the legal entity which issues the document intends it as an evidence of its indebtedness to the original holder, his heirs, or assigns, for the net assets acquired out of the capital originally contributed and out of the reinvestment of undivided profits. If this were not true, the legal doctrine which holds that the title to the assets of a corporation rests in the corporation, would be meaningless, and the stockholders would be tenants in common, precisely like partners. Capital Stock as a Liability The fact that capital stock is truly a liability, is in- sisted upon, because of the spread in recent years of an academic theory which attempts to establish a distinction between "liabilities" and "accountabilities." It main- tains that capital stock, surplus, and reserves are "ac- countabilities" which merely measure the extent of the stockholder's "proprietorship" in the assets of the corporation. It makes the corporate balance sheet sub- servient to the following formula of double-entry book- keeping, which is only expressive of the nature of the proprietor's equity : "Assets less liabilities, equal proprietor- ship." So far as sole traders are concerned, they are un- questionably the owners of that part of the assets which will not be consumed for the liquidation of liabilities. Hence, for these two classes of business organization, the balance sheet is nothing more than the classified and detailed expression of the above-mentioned bookkeeping formula. CAPITAL STOCK 32* The proprietors have invested in the business the whole or part of their wealth, consisting of real or personal property, or both; their business is not an entity which the law recognizes; it is not a "person" in any sense oi the word, not even in contemplation of law; it owns nothing, owes nothing, and is nothing. The expression "My business is prosperous" means nothing more than "I am prosperous in business." The invested assets of a sole trader may be seized, upon due process of law, by anybody who has a valid claim against the owners of the equity in the investment, as measured by the result of the subtraction of the liabilities from the assets. As to copartnerships the same rules apply, with this exception: they are entities which the law recognizes only to the extent of permitting the individual creditors of the partners to share only in the assets which have not been used to liquidate the debts of the copartnership. The corporation, on the other hand, is an entity, none the less real because it is invisible and intangible. It ii a legal being invested with a written permit to exist, to possess, to contract, to sue, to be sued, and, generally speaking, to conduct the particular business for which it is created. To fulfill its purpose a corporation requires capital Since it has nothing at birth but the power to act as * human being for a far longer period and with a greatei continuity of purpose than is the lot of mortals, it must obtain capital through the contributions of those who believe in its ultimate fortunes and in the adequacy of its special organism for the fulfillment of its particular purpose; or if this is not sufficient, it must finance itselt as best it can, by pledging as security the assets obtained through the investment of moneys contributed by it? sponsors. It goes without saying that if it were true that the stockholders own the corporate assets, the cor THE THEORY OF THE LIABILITY ACCOUNTS poration could not violate the law and pledge that which it does not own. Indeed, the peculiarity of the status of the legal being known as the corporation, is that it owes everything which it owns. To show to what extent the anonymous sponsors of the corporation have equipped it with its original capital, there is issued to them shares of capital stock which be- come the personal property of the stockholders, precisely as the assets acquired by means of that capital become the real or the personal property of the corporation. The issue of stock measures the extent of the cor- poration's liability for original capital, or for subsequent increases thereof. The stockholders hold that evidence of the corporate liability to them, but they have absolutely no title to the assets. They cannot re-enter into posses- sion of them otherwise than by causing the death of the legal being whose birth they have brought about. Their individual creditors cannot seize any asset of the corpora- tion to satisfy their claims against the stockholders. They can, however, by due process of law, secure for themselves the stockholdings of their debtors. These stockholdings measure their owner's evidence of the cor- poration's liability: 1. At winding up, for money, property, or services originally contributed, as represented by the capital stock outstanding, expressed at par. 2. Also at winding up, or at any time deemed ad- visable by the corporation speaking through its directorate, for increments arising from the re- investment of undivided profits, as measured by: a. The surplus b. Such reserves as do not contain : (i) Losses temporarily withheld from the asset which they would otherwise reduce (reserves charged to cost) CAPITAL STOCK ^, 3 Z 3 (2) Losses incurred but not as yet paid through the outgo of an asset (operating reserves such as, "For In- juries") i.e., all the reserves appropriated out of surplus. Capital Stock Records The rights of the stockholders to the benefits accruing from the profitable employment of the capital represented by their shares, is closely safeguarded by statutes. The total amount of the capital stock indebtedness which the corporation may incur, is well known, since the charter states it, and it cannot be increased in violation of the rights of the original contributors. Indeed, if the authorized amount of capital stock is overissued, the pur- chasers of the excess do not acquire any rights whatever as stockholders, although they may have a cause of action for damages against the corporation for any harm done to them. Thus, so far as accounting is concerned, the financial books of a corporation must be so kept as to reflect at all times the authorized issue of capital stock, the amount actually issued, and the balance unissued, otherwise known as "potential stock." This can be done in two ways: i. At the time of opening the books, make a pro forma journal entry stating fully the authorized issue, divided into as many classes of stock as the charter con- templates, and, thereafter, frame an explicit pro forma entry whenever an authorization to increase the issue is obtained. When this is done, a reference to the journal will give the total authorized issue, even though the minute book is not available. As to the portion of that authorized issue which is actually outstanding, it will be 3 2 4 THE THEORY OF THE LIABILITY ACCOUNTS given by the sundry accounts with the sundry classes of capital stock, which will be credited at the time of issuing. Expressed in journal form, the requirements of this method might appear as follows: k THE A. B. C. COMPANY GENERAL JOURNAL January 2, 1914 The A. B. C. Company, incorporated under the laws of the State of New York, with an authorized capital stock of five hundred thou- sand dollars ($500,000) divided into five thou- sand (5,000) shares of common stock, of the par value of one hundred dollars ($100) per share, with express and implied power to con- duct a general manufacturing business. Cash $ 75,000.00 Property, Plant, and Sundry Assets 325,000.00 To Capital Stock. $400,000.00 For issue of capital stock in consideration of cash subscriptions to 750 shares and of property, plant, and sundry assets acquired from John Harrison, as per contract on file. The balance sheet of the company would show : BALANCE SHEET Assets Cash $ 75,000.00 Property, Plant, and Sundry Assets 325,000.00 $400,000.00 Liabilities Capital Stock Authorized . $500,000.00 Less Unis- sued 100,000.00 Issued and Outstanding.$4OO,ooo.oo $400,000.00 CAPITAL STOCK 3 2 5 2. When opening the books, state the "potential stock" as a debit representing the right of the company to issue the stock, and as a credit representing the extent of the stock liability which the corporation has been authorized to incur. The names to be borne by the two classes of statistical accounts may be : Debits: Unissued Capital Stock Common Unissued Capital Stock Preferred Credits: Capital Stock Authorized Common Capital Stock Authorized Preferred Subsequently, when capital stock is issued, debit the particular asset obtained as a consideration for the issue, and credit the "unissued" account. By itself, the balance of the unissued account represents the extent of the poten- tial stock, and when deducted from the "authorized" ac- count, it measures the actual capital stock liability of the corporation. AUTHORIZED CAPITAL STOCK COMMON Unissued Capital Stock Common $500,000.00 UNISSUED CAPITAL STOCK COMMON Authorized Capital Stock Common ... $500,000.00 Cash $ 75,000.00 Property, Plant, and Sundry Assets 325,000.00 CASH Unissued Capital Stock Common $75,000.00 PROPERTY, PLANT, AND SUNDRY ASSETS Unissued Capital Stock Common $325,000.00 326 THE THEORY OF THE LIABILITY ACCOUNTS If all the authorized issue of capital stock has been subscribed, partially paid for, and issued subject to subse- quent calls, the whole authorized issue constitutes a lia- bili'-y of the corporation and must be so stated. The rea- son for this accounting treatment is to be found in the spirit of the law regulating corporate bodies. A sub- scriber to capital stock who has received the stock upon partial payment of its price, has no power to surrender his shares. Corporations may, indeed, exercise the power to make bona fide compromises with subscribers when their doing so does not jeopardize the interest of third parties; they may also forfeit the shares issued to individual stock- holders who have defaulted on the payment of calls legally made; but generally speaking, the doctrine prevails that corporations have not power to release a subscriber from the obligations incurred under his subscription contract. The reason for the denial of that right is that the unre- strained exercise thereof would work to the prejudice of other subscribers and creditors. If all the stock has been subscribed, partially paid for, and issued subject to subsequent calls, the application of the requirements of the second method described above will give: CAPITAL STOCK AUTHORIZED (One account for each class of stock) Unissued Capital Stock $500,000.00 Capital Stock Author- ized $500,000.00 Capital Stock Sub- scribed $500,000.00 CAPITAL STOCK 327 SUBSCRIPTIONS TO CAPITAL STOCK (One account for each call) Capital Stock Sub- scribed $500,000.00 $500,000.00 Calls i and 2 $250,000.00 Balance (Uncalled subscriptions) 250,000.00 $500,000.00 Balance $250,000.00 CAPITAL STOCK SUBSCRIBED (One account for each class of stock) Unissued Capital Stock $500,000.00 Subscriptions to Capi- tal Stock $500,000.00 CASH Subscriptions to Capi- tal Stock, Calls I and 2 $250,000.00 and the balance sheet expressing the above facts will be : BALANCE SHEET Assets Cash $250,000.00 Uncalled Subscriptions 250,000.00 $500,000.00 Liabilities Capital Stock Author- ized, issued and out- standing $500,000.00 $500,000.00 If all the authorized issue of capital stock has been sub- scribed, and partially paid for, and the stock remains un- issued until all the subscriptions have been paid, the facts will be expressed as follows: CAPITAL STOCK AUTHORIZED Unissued Capital Stock.$soo,ooo.oo 328 THE THEORY OF THE LIABILITY ACCOUNTS Unissued Capital Stock Capital Stock Author- ized $500,000.00 SUBSCRIPTIONS TO CAPITAL STOCK Capital Stock Sub- scribed $500,000.00 Cash $250,000.00 CAPITAL STOCK SUBSCRIBED Subscriptions to Capi- tal Stock $500.000.00 CASH Subscriptions to Capi- tal Stock $250,000.00 and the balance sheet will show: BALANCE SHEET Assets Cash $250,000.00 Uncalled Subscriptions 250,000.00 $500,000.00 Liabilities Capital Stock Authorized . $500,000.00 Less : Unis- sued 500,000.00 Capital Stock Sub- scribed $500,000.00 $500,000.00 This, it will be noticed, is equivalent to stating that the corporation is not as yet liable to stockholders for stock issued, but that it will become so liable to them as soon as they have performed their share of the subscrip- tion contract. CAPITAL STOCK 329 The Status of Unissued Stock Teachers of accounting maintain that unissued capital stock is expressive of nothing but a corporation's right of issue under its charter; that it is not an asset any more than the admitted capability of an individual to earn $10,000 a year is an asset of his until he has actually earned the amount; that it is not a liability any more than the possibility of mortgaging a parcel of real estate is a liability until a sum of money has been borrowed and the property has actually been mortgaged. If their conten- tion is based upon the status of the certificates still at- tached to the stubs in the stock certificate book, it is undoubtedly true. If, however, the certificates have been detached from the stubs, signed, sealed, assigned in blank, and placed with transfer agents or other financial officers, ready for sale and delivery, there is at least one excellent reason for considering the shares they represent both as an asset and as a liability; it is that the Interstate Com- merce Commission requires that they be so treated for balance sheet purposes. On page 26 of its pamphlet "Form of General Balance Sheet Statement for Steam Roads," and under the subheading "Capital Stock" of the general heading "Liabilities," it says: "The amounts included in this account should be divided so as to show: (i) The par value of certificates (pledged or unpledged) held in the company's treasury, by its agents or trustees, or otherwise subject to its con- trol." On the same page, there is a footnote to the effect that, "for the purposes of the balance sheet statements, stock is considered as 'issued' when certificates are signed and sealed, and placed with the proper officer for sale and delivery." Premiums on Capital Stock Generally speaking, statutes do not permit capital 330 THE THEORY OF THE LIABILITY ACCOUNTS stock to be issued for less than par; hence, so far as the issue of stock to subscribers is concerned, it is unusual for a corporation to incur a capital stock liability greater than the consideration therefor. It is, however, quite fre- quent that subscriptions realize more than the par value of the stock. How are the premiums on stock to be con- sidered, in the light of the principle that the capital stock liability is to be carried at par ? Premiums realized on capital stock are neither income nor profits, since the word income means, that which has come in as a result of the investment of capital in any form whatever; while the word profit means that which has come in, in excess of the cost of the capital which has been sold. Premiums do not represent the excess of cap- ital obtained in exchange for a liability, but the excess ob- tained over the par value of the shares of stock expressive of that liability. This is true in any event; it does not matter whether the premiums were obtained at the time of the original subscription, or subsequently upon the sale of the unsubscribed portion of the original authorized issue, or again upon sale of a properly authorized in- creased issue. The treatment of premiums on capital stock as a profit, places the corporation in the position of admitting that it has been guilty of sharp practices upon its stockholders. As a consequence, it will have to return to the stockholders that which it has exacted from them in excess of the par value of the liability which it has incurred towards them. If dividends are declared out of premiums on capital stock, and the cash which the premiums placed at the disposal of the corporation is returned to the stockholders, where is the advantage of such financing? Premiums on capital stock should no more be sent to the credit of the Profit and Loss account than they should be sent to the surplus available for dividends. It has been CAPITAL STOCK 33! suggested that they be credited to a special account so ear- marked as to indicate that it is not available for distribu- tion. But is not this an admission that these premiums con- stitute a liability of the corporation? As a matter of fact, premiums obtained on the issue of stock which has a par value are a capital stock liability precisely as they would be if the stock had no par value, and there was no account- ing objection to stating the capital stock at the amount of its proceeds. And is it not because the fact that premiums on capital stock constitute a liability, cannot be denied, that the Interstate Commerce Commission requires that they be treated as such by the public service corporations which come under its jurisdiction? The commission has ruled as follows: "When any issue of capital stock is sold or ex- changed by or for the respondent company for a considera- tion the actual value of which exceeds the par value of the stock at the time of such sale or exchange, the premium so realized should be credited to a ledger account provided for discounts and premiums on all classes of stock sold. If the net balances in the accounts for discounts and premi- ums on all classes of stock sold is a credit balance, the amount should be included in this account. This balance should be carried permanently on the balance sheet unless extinguished by discounts suffered on subsequent sales of stock, or by retiring stock. When any stock is retired, the proper discounts and premiums account should be adjusted by debiting it with an amount equal to the extinguished premium on such stock." Discount and Premium Accounts If premiums are to be carried permanently on the credit side of the balance sheet, it follows that, for the sake of con- sistency, discounts should be carried permanently on the asset side as a partial offset to the liability expressed at the par of the shares, instead of being debited to profit and 332 THE THEORY OF THE LIABILITY ACCOUNTS loss, in either a lump sum or throughout a period of years. The net amount paid by the stockholders for their stock is indeed that which they may expect to receive at winding up, irrespective of the dividends declared in the past. This is true whether or not the company has legally or illegally ac- cepted as payment in full the consideration for the stock paid by the stockholder. In regard to discounts on capital stock, the Interstate Commerce Commission has ruled that "if the net of the balances in the discounts and premiums accounts for all classes of capital stock sold is a debit balance, the amount should be stated in this account (Unextinguished Discount of Capital Stock). This balance should be carried on the balance sheet (asset side) until extinguished by premiums realized on subsequent sales of stock, by assessments levied on the stockholders, by appropriations of income or free sur- plus for the purpose, or by retiring the stock. When any stock is retired, the proper discount and premium account should be adjusted by crediting to it an amount equal to the unextinguished discount on such stock." Treasury Stock Capital stock which has been legally issued is looked upon by the law as a liability of the corporation issuing it, until it has been liquidated, on the winding up of the cor- poration, through the distribution to the stockholders of the remainder of the assets after liquidation of all liabilities to outsiders, or until it has been legally canceled after author- ization given by the stockholders assembled at a meeting legally called to consider the cancellation. It follows that if stock has been acquired in the open market by the company responsible for its issue, in pursuance of some financing scheme, or donated to the company by the stockholders to be resold for the purpose of obtaining additional capital, such stock must be an asset. It is not "potential stock," since CAPITAL STOCK it has been issued; it is "actual stock" held in the treasury pending disposition. It is usually carried as "treasury stock," but the term does not seem to be satisfactory, be- cause it conveys to many the idea that it represents stock held in the treasury, whether or not it was once issued. It might be more in keeping with the efforts of modern accountancy to make financial statements intelligible both to the layman and to the professional accountant, if stock acquired by, or donated to, the issuing company were to be called "stock issued, acquired (or donated), and held in the treasury," or "actual stock held in the treasury." If stock which has been legally issued and has come back into the treasury is subsequently canceled upon due author- ization of an assembly of stockholders, it ceases to be treas- ury stock ; it reduces the liability for outstanding stock, and becomes potential stock precisely like the previous balance (if any) of the unissued authorized capital stock. Accounting for Treasury Stock A business concern acquiring its own stock in the open market, either to sell it later at a higher price than was originally obtained therefor, or to avoid the payment of large dividends earned and about to be declared, will in all probability carry treasury stock at par, since its par value is the exact counterpart of the liability therefor, expressed at par. If the price paid has been greater or smaller than par, it may debit or credit the "loss" or the "gain" to the Profit and Loss account, or carry it in a special account, "Premiums and Discounts on Treasury Stock," subject to periodical amortization. The result of such an accounting will be an additional profit or loss for the period during which the stock was purchased, or for a certain number of periods thereafter. But if that additional profit or loss means anything, it means that by "dabbling" in its own capital obligations the company has been benefited or in- THE THEORY OF THE LIABILITY ACCOUNTS jured to a certain extent. No matter what the financing scheme may have been which suggested the purchase of stock, its purpose should have been accomplished without affecting the income, since the question of reducing the capital stock liability was never at issue. It would undoubt- edly be better accounting to accept the view that premiums on capital stock constitute liabilities, while discounts con- stitute assets, or, at all events, that they represent facts which should be permitted to remain on the books until offset by subsequent transactions. Nor can it be said that such a treatment would not be good financing, since it would compel the supposed gains on discounts to remain in the business, while it would prevent the supposed losses on premiums from being charged to the present stockholders to the possible advantage of future stockholders. Donation Account A business concern coming into possession of its own stock through a donation, should carry the stock at par under the term "Treasury Stock," and create a credit account bear- ing an appropriate name, as, for instance, "Treasury Stock Donation Account," which will remain open so long as all the treasury stock is not disposed of. As sales occur, the treasury stock account should be credited with the par value of the shares sold, and the donation account debited with the discounts and credited with the premiums, if any. If treasury stock is given as a bonus to syndicates under- writing issues of bonds, or to purchasers of bonds or other classes of stock, the par value of the shares so given should be credited to the treasury stock account and debited to the donation account. Thus, when all the treasury stock is disposed of, the balance of the donation account will reflect the exact amount of working capital obtained by the com- pany as a result of the gift, and the question of what to do with the donation account will arise. CAPITAL STOCK 335 If the balance of the donation account is sent to the free surplus, dividends will be declared therefrom and the pur- pose of the donors will be defeated. If the balance is sent to a separate surplus account so earmarked as to indicate that it is not available for dividends, what will be the nature of that account ? It has been suggested that it practically con- stitutes a reserve susceptible of being transferred to surplus, if required to offset extraordinary losses of a given period or of a succession of periods. This may be "sentimental accounting" but it has no other quality. It fails to respect the purpose of the donation; it jeopardizes the benefits ob- tained thereby in so far as it makes it possible to declare dividends which will have to be paid out of the additional working capital obtained as a result of a gift made for the welfare of the corporation. In reality, the donation account measures the extent of the benefit derived by the stockholders present and to come from the benevolent action of one or several of them, and constitutes a capital liability of the corporation similar in every respect to the liability for unextinguished premiums obtained through the sale of stock. General Considerations Taken in its broadest sense, the word "debt" means a fixed and certain sum of money due, or owing, by virtue of express agreement. The distinction between "due" and "owing" has been established by a California judge* as follows : "Standing alone, the word 'debt' is as applicable as well to a sum of money which has been promised at a future day, as to a sum of money now due and payable. If we wish to distinguish between the two, we say of the former that it is a debt owing, and of the latter that it is a debt due. In other words, debts are of two kinds : solvendum in praesenti, and solvendum in futuro." The same judge, speaking of the nature of debts, says in the same case : "Whether a claim or demand is a debt or not, is in no respect determined by a reference to the time of payment. A sum of money which is certainly and in all events payable, is a debt, without regard to the fact whether it be payable now, or at a future time. A sum payable upon a contingency, however, is not a debt, or does not become a debt until the contingency has happened." All debts which are evidenced by securities of a permanent nature and for the payment of which certain property has been pledged, are generally referred to as "funded debt," even though it be true that the term appears * Jn People v. Arguello, 37 Cal. 524, 525. 336 BONDED DEBT to suggest that the payment of the debt is secured beyond peradventure by the periodical appropriation of money. Such an appropriation may or may not exist ; if it does not, the term "funded debt" applies just as surely to treasury bonds and stocks, mortgage bonds, collateral trust bonds, equipment certificates, etc., etc., since the debt is to all intents and purposes, funded through the pledge of a particular property which may be converted by sale into cash funds. In this book, however, it has been deemed advisable to subdivide funded debt as follows : 1. Bonded Debt, i.e., all debts evidenced by bonds. 2. Mortgaged Debt, i.e., all debts evidenced by bonds secured by mortgages on real estate or on chattels. Bond Issues Every corporation not restricted by constitutional pro- visions of its own making or by statute, has the implied power to issue bonds as evidence of indebtedness incurred for money borrowed, property acquired, labor performed, or financial services rendered by others for its benefit. This corporate privilege is exercised through the vote of the stockholders, or, if the latter have vested part of their rights in the directorate, through proper resolutions by the board of directors. Bonds are authorized to be issued in denominations best suited to the conditions of the market in which they will be offered for sale. Issues of bonds may be composed of units all maturing at the same date, or of a series of units each series maturing at a different date; in the latter case, the security pledged under the issue as a whole is all the more attractive because the retirement of a particular series usually causes the part of the pledge securing it to revert to other unmatured series. The mortgage securing the bonds is frequently issued to one or several trustees who hold it for the common good 338 THE THEORY OF THE LIABILITY ACCOUNTS of the bond purchasers; in many instances the indenture states conditions which must be fulfilled before the trustees are allowed to certify bonds for sale to the public. These provisions are common in modern railroad bonds issued for construction purposes where the trustee can only certify such instalments as cover the completion to date of a stated part of the construction. Accounting Theories of Bond Issues The accounting record of the liability incurred under an issue of bonds, depends upon the point of view of the accountant : I Considering the potential value of bonds as secured evidences of the indebtedness, and accepting them individually as pro rata representatives of a valu- able mortgage, he may give to the unsold part of the issue an asset value derived from its potential pledge value, and, for financial purposes, treat it as an asset. 2. He may hold the opinion that, being executed to the trustee, whether or not subject to his certification, the unsold portion of the proposed issue differs from the sold portion only in the fact that in the latter instance the cash value of the mortgage has been realized, whereas in the former case it has not. 3. Ignoring the borrowing power inherent in the un- sold instruments of credit, and refusing to be swayed in his opinion by the argument that whether or not the whole issue is sold the same amount of assets remain pledged, he may rigidly enforce the rule that potentiality does not mean actuality. Under the first and second hypotheses, the accounting 1 treatment will be the same ; the whole authorized issue will BONDED DEBT 339 be carried as treasury bonds, and at the same time as a liability. The liability will remain immutable until its maturity, or until premature cancellation of part of the evidence of indebtedness; as to the asset, its nature will change with every successive sale. Under the third hypothesis, the asset and the liability will be recorded only at such time as the former has been received in cash through sales. It is evident that either of the above treatments would produce the same impression upon the reader of a balance sheet were it not that, thanks to theorists and philosophizers, the general public has come to give to the term "treasury bonds" the same meaning as is commonly given to "treasury stock." The layman understands treasury bonds to be bonds issued and subsequently reacquired by the issuing company. The objection is only a trivial one, however, since for balance sheet purposes it is always possible to record the status of bonded indebtedness as follows : First Mortgage 5 per cent Bonds of 1925 : Authorized $100,000.00 Less held in Treasury 40,000.00 Issued and Outstanding. . . $60,000.00 Bonds Acquired by Issuing Company The question of the status of bonds purchased by the issuing company, for sinking fund purposes or for any other purpose, has usually found the accountant quite in- different. Instinctively, he has felt that it is of bonds as it is of stocks, i.e., neither uncanceled bonds nor uncanceled stocks reduce the liability of the issuing company. Unquestionably, if the purpose in acquiring the bonds is to hold them for speculative purposes, the liability of the company remains unaffected. But when we come to consider the status of bonds ac- 340 THE THEORY OF THE LIABILITY ACCOUNTS quired by the issuing company for the purpose of the sink- ing fund, we face a much more complicated situation. It is plain that at maturity of the bonds the liability will auto- matically be reduced by the amount of the par value of bonds held by the trustee of the sinking fund. But it is just as plain that if the par value of the bonds acquired under the sinking fund provisions of the indenture is de- ducted from the liability, the accounting correlation which should exist between the sinking fund and the expired por- tion of the life of the bond liability representing the whole issue, will be lost. And yet the bondholders who read the .balance sheet have the right to know the status of the sinking fund. C S. Ludlam, C P. A. (N. Y.), writing in the March, 1914 number of the Journal of Accountancy, makes a plea for the acceptance of the theory that sinking funds composed of uncanceled bonds of the company responsible for their issue are to be shown as deductions from the liability. Mr. Ludlam says : "It is appreciated that some of our legal friends will claim that bonds of a mortgagor, of the issue covered by a sinking fund, purchased by the sinking fund trustee and not retired and canceled, will not reduce the obligation of the mortgagor, and that such bonds should be treated as a part of the sinking fund and shown on the balance sheet of a corporation as an asset, and that, contra thereto, the full amount of the bonds, both outstanding and in the sinking fund, should be shown as a liability. It is admitted that there are some legal reasons for this, the chief of which is perhaps the question of legal practice in regard to the burden of proof, but it seems to me that ques- tions of this nature could arise only in cases of receivership or liquidation and would have to be dealt with only under court orders; consequently they would not apply to the ordinary accounting of a going concern. Further, while accountants must be mindful of any and all legal obligations, BONDED DEBT 341 and of any legal situation affecting the accounts of the clients, it will be apparent at once to anyone who gives the matter thought, that as an actual fact an individual cannot owe money to himself." Many people have given thought to bond accounting, and, judging from the rulings of the Interstate Commerce Commission, the commissioners have given to the particular subject of sinking funds all the respectful attention which it deserves. A sinking fund is, after all, an account to which nothing else can happen but to be eventually debited to the liability for the redemption of which it is created. Hence, it is essentially and wholly an item the ultimate disposition of which is deferred until such time as its contra will mature. For this reason public utility corporations must show sink- ing funds as deferred debit items. Nobody reading a balance sheet would be led to shrug his shoulders contemptuously at the anomaly presented by a sinking fund which, if examined under a sophistical micro- scope, would elucidate the fact that it contains evidence of indebtedness of the company to itself. One would simply understand that, no matter what particular asset the sinking fund may contain, it represents an accumulation of future debits to a liability account. As to the accountant, he would naturally, knowing the date of issue and the maturity of the bonds, divide the total liability by the sum of its life in years or in interest periods, or in accounting periods, multi- ply the result by the number of periods of expired life of the liability, and judge the sinking fund in the light of the ratio that it bears to the liability which it will redeem. Premiums and Discounts on Bond Sales When bonds have been sold at par, the recording of the liability therefor consists in expressing it at the same figure as the asset which represents the proceeds of the sale. But when bonds are sold at more, or at less, than par, there has 342 THE THEORY OF THE LIABILITY ACCOUNTS been obtained an asset greater or smaller than the liability, and we must record the extent of the excess or of the shortage under the name of premiums or discounts on bonds. What to do with these discounts or premiums is one of the most interesting of the problems which the ac- countant has to solve. Let us state at once that the universal custom is to credit the premiums and debit the discounts to profit and loss, periodically, during the life of the bonds. But is this correct from a financing as well as from an accounting point of view? When treating of investments in bonds, we have seen that, according to the tenets of the accountancy of invest- ment, bonds assure to their owners the return of the prin- cipal invested, and a periodical effective return of interest which, in the case of bonds purchased at a premium, is smaller than the nominal return ; while in the case of bonds purchased at a discount it is greater. We have also seen that, in the case of premiums on bonds the theory which holds that the nominal return is income, is a fallacy, as evidenced by the disastrous effect that it has upon the estate of a remainderman under the provisions of a will directing the executor to invest the principal of the estate in bonds, to pay the interest to a life-tenant and, at his or her death, the principal to the remainderman. We have demonstrated that if the investor must make his income reflect the rate of interest that he expected on his investment, he must amor- tize or accumulate the cost of the investment to par through the Interest account. If the purchaser of bonds above par must reduce the cost of his investment by charging his income with the periodical amount to be amortized, why should not the vendor of the bonds amortize trte premium which he has received, by crediting, not his Profit and Loss account, but his Interest account ? Is it not true that the effect of the premium is to BONDED DEBT 343 reduce his interest charges, whereas the effect of the discount which he sustains when the investor obtains a dis- count, is to increase his interest charges? To make this plain through an example : If the accounts of the investor show: INVESTMENT IN BONDS 5% First Mortgage Bonds Date Interest Principal Nominal 5% Effective 4% Amor- tization Dr. Cr. Balance May i, 1914.. . . Nov. i, 1914.. . . $1,250.00 $1,044.91 $205.09 $52,245.64 $205.09 $52,040.55 why should not the accounts o* the company show : FIRST MORTGAGE 5% BONDS, 1914-1928 1914 May i Cash $50,000.00 PREMIUM ON FIRST MORTGAGE $%. BONDS, 1914-1928 1914 Nov. i Interest on Bonds..$2O5.O9 1914 May i Cash $2,245.64 INTEREST ON BONDS 1914 Nov. i Cash .$1,250.00 1914 Nov. i Discount .$205.09 Premiums as Deductions from Principal There are two more theories to be considered in con- nection with the treatment of premiums on bonds: One is to the effect that premiums obtained on bond issues should 344 be set aside to serve as the nucleus of the sinking fund for the redemption of the principal at maturity ; the other states that "the premium must follow the principal," that is to say, must be deducted from the authorized issue. It will be noted that these two theories are similar in principle ; both attempt to provide for the partial redemption of the debt. Logical as both may appear to their advocates, they fail to take into consideration the intimate relation which should exist at all times between the bonded debt and its interest cost. The careful student of accounting must be impressed with the fact that, whatever the methods of treating pre- miums and discounts may be, their ultimate result is the same no matter what their intent may have been. The theory which applies premiums and discounts as additions to, or deductions from, income, allows them to contribute to, or to reduce, the amount of net profits out of which a fund will be created for the redemption of the debt, either through the accumulation of a reserve, a fund out of profits, or both. The theory which applies premiums and discounts as de- ductions from, or additions to interest cost, has precisely the same effect, and the same is true of the theories which use premiums either as a sinking fund nucleus or as a partial re- demption of the debt. The great question at issue in all accounting matters is not, however, a question of results, but it is one of illumina- tive sub- results. It is evident that if we ignore the nominal accounts, and are satisfied to deduct the liabilities from the assets at the end of a period, and compare the result with that of the prior period as elucidated by a similar treatment of the balance sheet, we shall obtain the net profit or loss of the period ; and nothing that we could do would change the result. But we have failed to show the causes which have brought about the result; we have also failed to show the BONDED DEBT 345 exact status of, and the relation between, the different causes. Lastly, we have failed to mention facts which, if known, and known to be true, would make it possible to pass a com- prehensive and accurate judgment upon the operations and the financing of the enterprise. Hence, throughout our accounting we must remember that figures which are not capable of making any statement of their own, and can only vouch for the accuracy of the final result, are meaningless and worthless. CHAPTER XXIX SECURED DEBT UNSECURED DEBT SECURED DEBT Real Estate Mortgages "In equity, whatever property, real or personal, is cap- able of an absolute sale, may be the subject of a mortgage."* "A mortgage may be made to cover both real and personal property; and the validity of a mortgage on real estate is not affected by the fact that it also pledges personal prop- erty and is recorded in the records of chattel mortgages."! In fact, unless statutes prohibit, a mortgage may be made to cover not only land and buildings, but machinery, and even profits to arise from the operation of the said real and personal properties. In the state of Louisiana, where the Code Napoleon prevails, only "immovable" property can be mortgaged. Generally speaking, in order that a mortgage given by a going concern may be valid and its provisions enforced, it must have been given for a consideration which, in point of time, may be : 1. Received at the time of the execution of the instru- ment 2. Receivable at some future time 3. Received at some previous time, subject to condi- tions which, being unfulfilled, are canceled in con- sideration of the mortgage Wright v. Shumway, 30 Fed. Cases, No. 18,093; i Biat. t Long v. Cockern, 29 111. App. 304. 346 SECURED DEBT 347 The consideration itself may be: 1. The receipt of property or of money or its equivalent 2. The granting to the mortgagor of the right to en- force the mortgagee's performance of a contract for future delivery of money when certain condi- tions are fulfilled by the mortgagor 3. The extension of the time of settlement of claims and accounts outstanding against the mortgagor 4. The surrender by the mortgagee of securities previ- ously pledged to him as a security for a debt of the mortgagor which is to be extended 1. Receipt of Property or Money. If the consideration has been the receipt of property, money, or its equivalent, the accounting procedure necessary to express the transac- tion on the books of the mortgagor, is to record the asset obtained as well as the liability incurred therefor. No entry of any kind is made in the account recording the value of the asset mortgaged, since the conveyance of it is subject to a claim which defeats it if certain conditions are satisfied. 2. Mortgagor's Right to Enforce Contract. If the con- sideration has been the granting to the mortgagor of a financial right to be exercised at some future time, upon the fulfilment by him of certain conditions (such as is the case with building loans), the mortgagor may : a. Record his financial right and, correspondingly, the long-term liability which he has incurred and se- cured ; subsequently, when exercising his right, debit the asset received and correspondingly de- crease the right. b. Omit the recording of the right, and record the asset and the liability only at the time the asset is actually received. Of course, in this case, the amount of the liability recorded is precisely that of the asset received. 348 THE THEORY OF THE LIABILITY" ACCOUNTS 3. Extension of Time. If the consideration has been the extension of the time of settlement of claims and ac- counts outstanding against the mortgagor, it is necessary to make the books reflect the fact that the old debt has been canceled and that a new one, having a longer maturity, has been incurred. 4. Surrender of Securities. If the consideration has been the surrender, by the creditor, of securities pledged to him in exchange for the security of the mortgage, the change in the nature of the liability must be recorded by canceling the pre-existing debt and recording the new one. Chattel Mortgages Real estate mortgages convey title to real property; chattel mortgages transfer title to personal property; both do so with a clause of defeasance, that is to say, with a clause to the effect that, if the giver of the security per- forms his share of the contract, the title reverts to him. It has been repeatedly held by courts of law that the passing of the title under both kinds of mortgages is merely a legal fiction, and that what the mortgagee really receives, is a lien pure and simple. As to the consideration for chattel mortgages, it has been claimed that any consideration which will support an or- dinary contract will also support a chattel mortgage. The covenants of both the real estate mortgage and the chattel mortgage, if legally enforceable, might accumulate the value of the asset of the mortgagee, or the extent of the debt of the mortgagor. If, for instance, one of the covenants is to the effect that the mortgagor is to pay all legal fees and all other costs, trouble, and expenses, the notice by the mortgagee of the amount expended by him mast be recorded by the mortgagor as an increment of the debt, and by the mortgagee as an increase of the asset. The main accounting difference between real estate and SECURED DEBT 249 chattel mortgages is found in the fact that the terms of the former are usually of such duration as to make the debt a capital liability, whereas the terms of the latter, if stated, are usually short, and, if not stated, make the instrument pay- able on demand. Interest on Mortgaged Debt From the point of view of accounting, there is nothing particularly interesting in the debt incurred for interest on mortgages, except that, if not paid when due, it may in all propriety be added to the principal debt. Secured Debt The term "secured debt" is used by accountants to denote all liabilities, to secure which an asset has been pledged by transfer to the creditor. The word "pledge" is used here in its strictly legal sense, as indicating the physical transfer to the creditor of valuable property of the debtor, to be held until settlement by the pledger, who retains title in the thing pledged. Debts may be secured by the pledge of bonds, stocks, mortgages receivable, warehouse receipts, or by the pledge of any personal property or evidence of the possession and ownership of such property. The pledging of bonds, stocks, or other personal prop- erty as security for debt, leaves the borrower in legal posses- sion of the pledge, but places the creditor in physical posses- sion thereof. True to the principles of law, the theory of accounts requires that the pledger record his liability under the loan, in the amount of the asset received, and make no record whatsoever in the account containing the asset pledged by him to secure a more liquid one. We have already discussed at length the nature of bonds and stocks as assets or as liabilities. Nothing further need be said about them in their capacity as pledges. It may, how- 350 THE THEORY OF THE LIABILITY ACCOUNTS ever, be interesting to touch upon warehouse receipts, which are so often used by business houses as security for advances from financial institutions. Warehouse Receipts A warehouse receipt is an acknowledgment by a ware- houseman that he has received and holds in store for the bailor the amount and description of goods named in the receipt. At common law, warehouse receipts were not negotiable, although they were assignable ; but since certain states have enacted statutes concerning these instruments, it must be said that they are governed by the laws of the particular states in which issued. The Uniform Warehouse Receipts Act (Par. 516) has this to say about this type of commercial paper : "A receipt in which it is stated that the goods received will be delivered to the depositor or to any other specified person is a non- negotiable receipt. A receipt in which it is stated that the goods received will be delivered to the bearer, or to the order of any person named in such receipt, is a negotiable receipt." The pledging of a warehouse receipt as security for a loan is made valid by the mere delivery of the receipt with the intention to create a pledge. If the pledger fails to pay his indebtedness at the appointed time, the pledgee may sell the property represented by the receipt, after having notified the pledger of his intention to do so. UNSECURED DEBT Notes and Bills Payable The status of promissory notes payable cannot be ascer- tained without a thorough knowledge of the law of com- mercial paper ; the same is true of the liability account "Bills Payable." UNSECURED DEBT 351 It is unquestionably true that the average keeper of ac- counts, after drawing a postdated check, will generally credit cash and debit the creditor's account, precisely as if the check bore the date when drawn. Still, under the doctrine of the laws of commercial paper, a postdated check is a negotiable bill of exchange, payable on demand after the day of its date; and further, the acceptor of the check ac- cepts it precisely as he would a bill of exchange; hence, the recording of a postdated check for the payment of a liability fails to cancel the liability ; it merely transforms it into an- other, and the entry should be : Creditor To Bills Payable As has been said before when treating of assets, the gen- eral term "notes and bills" should be kept in separate accounts. Bills Payable The signature of the drawer of a bill of exchange is of itself a guarantee to the payee that the drawee has sufficient funds to meet the bill; it is also an implied guarantee that the drawee will accept the instrument and pay it at its maturity, or that, in the case of default by the drawee, the drawer will pay the bill. If, then, the drawee has funds of the drawer, the former must, upon acceptance of the instrument, debit the drawer and credit the account "Accepted Bills Payable" ; the drawer, on the other hand, must credit the drawee and debit the payee. If, in contradistinction, the drawee has no funds of the drawer, the latter must debit the payee and credit the drawee, whereas the drawee must debit the drawer and record the liability incurred by him for the account of his correspondent If the drawee refuses to accept the bill, the drawer be- comes liable; that is to say, instead of having realized an 352 THE THEORY OF THE LIABILITY ACCOUNTS asset and applied it to the liquidation of a debt, he* has merely changed the nature of his indebtedness towards the payee. Hence, he must reverse the entry previously made and record the change in the nature of the liability. The liability of the drawee, under the terms of a bill of exchange, begins only upon his acceptance of the instru- ment, and should be recorded only at that time, whereas the liability of the drawer, or maker, ceases upon acceptance by the drawee, and should be canceled at that time, there re- maining only a contingent liability. Memorandum Checks Germane to the subject of bills of exchange, is that of memorandum checks. When it is desired to acknowledge a debt in a formal financial way, a check is sometimes drawn in the amount of the debt, bearing the date of maturity of the liability, and the word "Memorandum" written across its face. Such a check is not intended for immediate presenta- tion, and is in fact a bill of exchange payable on demand after its maturity. Of course, if the check is not postdated, the fact that it bears the word "Memorandum" does not prejudice the right of the payee to present it immediately. The execution of a postdated memorandum check calls for no special accounting record if the original debt has been recorded in the usual manner through the creditor's account. In the contrary case, the credit may be given to the account "Bills Payable." Promissory Notes Payable While the liability of the drawer of a bill of exchange is secondary, that of the maker of a promissory note remains primary; or, what is more to the point, if the note is not negotiable, the nature of the liability of the maker towards the payee has not changed in the slightest degree. Conse- quently, the transaction in virtue of which a non-negotiable UNSECURED DEBT 353 promissory note has been issued to a creditor, requires no recording if the maker of the instrument considers only its legal status. In the case of a negotiable instrument it is customary to cancel the original debt for which the note is issued, and to record the new debt in the account "Notes Payable." CHAPTER XXX ACCOUNTS PAYABLE/ DIVIDENDS PAYABLE Accounts Payable Records Theoretically, the term "accounts payable" is a balance sheet term. When found in that financial statement, it may include : 1. The credit balances of the accounts of creditors 2. The amount of expense bills received at the end of a period, and not paid as at the date of the balance sheet 3. The balances due to officers or employees of the con- cern on credit accounts which they were permitted to accumulate for any purpose whatsoever 4. Unsettled claims against the concern from whatever sources they may originate 5. Taxes, rentals, interest, due and unpaid at the time of the statement, etc., etc. Inasmuch as the purpose of a balance sheet is to show the financial status of an enterprise at some given date, it does not particularly matter whether or not unsecured in- debtedness is so analyzed as to show its sundry elements. But while the balance sheet may be permitted to speak in general terms, the books of account must be in a position to supply at all times the most minute information concerning financial facts. Hence, the general ledger should not be satisfied to gather in one account all the possibilities of un- secured accounts or claims to be paid ; it should express every 354 DIVIDENDS PAYABLE 355 component individually. It ought to be possible to obtain from the ledger the exact significance of the classes of in- debtedness which have been incurred during the accounting period and remain unpaid at the end. That this principle of ever-ready analysis constitutes one of the vital desiderata of business, is evidenced by the care with which accountants have built up the voucher register, which supports in admirable detail the one ledger account expressive of all outstanding claims and accounts, i.e., "Audited Vouchers Unpaid." The voucher register, it must be remembered, does not intend to supplant any par- ticular book, or to merge two or more books into one; it merely intends to analyze for the general ledger, and to present in ever-ready and concise form the analysis of, the liability account "Accounts Payable," or "Audited Vouchers Unpaid." The ledger account "Audited Vouchers Unpaid" is not intended to contain the liability for salaries and wages ac- crued and unpaid because not yet payable ; it has nothing to do with accruals. It may, however, properly contain the un- settled claims for salaries and wages which, having been properly audited and recorded in the pay-roll book or on the departmental salary voucher sheets, have, for some reason or another, remained unpaid. The account "Audited Vouchers Unpaid" is made to reflect these facts by a periodical journal entry debiting the account "Salaries and Wages Accrued/'' and crediting the matured liability account. Dividends Declared and Unpaid "A dividend is that portion of the profits and surplus funds of the corporation which has been actually set apart by a resolution of the board of directors, or by the shareholders at a corporate meeting, for distribution among the share- holders according to their respective interests, in such a sense as to become segregated from the property of the cor- 356 THE THEORY OF THE LIABILITY ACCOUNTS poration, and to become the property of the stockholders dis- tributively." 1 It must be carefully noted that only dividends declared make the stockholders individual creditors of the corpora- tion, and that holders of preferred and guaranteed shares of stock are not de facto creditors in the event that dividends which they had the right to expect, were not declared by the directors. It has been stated repeatedly that dividends declared and unpaid constitute a trust fund in the hands of the directors for the benefit of the stockholders, and cannot be disposed of otherwise than as intended, without the absolute and formal consent of those entitled thereto. On the other hand, it is true that in a famous Alabama case 2 it was held that, in the event of insolvency of a corporation, dividends unpaid became an asset of the corporation to be applied for the benefit of outside creditors; but such a legal doctrine is so entirely subversive of the care with which laws in general have guarded the interests of stockholders, that it may be challenged without fear or scruples. Indeed, in the State of New York it has been held that the receiver of a corpora- tion whose books show dividends declared and unpaid, can- not regard these dividends as a common debt, but must con- sider them as trust funds vested with a lien in favor of the stockholders. 3 The sanctity of the dividend as a true, just, and uncan- celable debt of the corporation has been proclaimed em- phatically in North Carolina where the State attempted in vain to appropriate unpaid dividends of the North Carolina Railroad Company for the benefit of the State University. When dividends have been declared, and made payable at some future time, they can be rescinded only in the event that no knowledge of the declaration has transpired outside 1 Cyclopedia of Law and Procedure, Vol. X, 546. 2 Curry v. Woodward, 44 Ala. 305. * Matter of Le Blanc, 4 Abb. N. C. (.N.Y.) 221. DIVIDENDS PAYABLE 357 of the board room. This, however, does not hold good if it is found that, instead of being declared out of the profits, dividends have actually been declared out of capital. If the dividends have been declared and paid illegally, it is also possible for the corporation to recover them from the stockholders if the latter knew that they were actually re- ceiving part of their capital to the prejudice of creditors of the corporation ; but it is not possible to recover such divi- dends in the case where the stockholders were ignorant of conditions and received the dividends in good faith. 1 What has been said in the foregoing applies only to the dividends declared by a going concern. The dividends of a liquidating concern are nothing more than the pro rata divi- sion of whatever is left of the assets after all the claims have been paid. The law of New York, which in this respect is typical of the laws of the other states, provides that dividends can only be declared out of surplus profits earned. In a Califor- nia case it was held that dividends cannot be declared out of earnings which represent interest accrued and not as yet receivable, even though it is certain that such interest will be received. 2 But it would seem that such a ruling is at loggerheads with the principles of accounting and with the rulings of the Internal Revenue Department of the Federal Government as to what constitutes income. Profits Available for Dividends What constitutes "profits and surplus" available for the declaration of dividends, will always remain one of the in- teresting topics of the science of accounting. Courts of law have ruled that it is perfectly proper to declare dividends out of profits inflated by the increase of the market value of assets unsold. In a decision by Justice Greenbaum 3 the 1 McDonald v. Williams, 174 U. S. 397; 19 S. Ct. 7435 43 L. Ed. 1002. 3 People v. San Francisco Sav. Union, 72 Cal. 199; 13 Pac. 498. 3 N. Y. Supreme Ct. ; Reported in N. Y. Law Journal, April 2, 1914. 358 THE THEORY OF THE LIABILITY ACCOUNTS court said: "A corporation has a very wide discretion in determining when a dividend shall be made. There might be a difference of opinion in a given case as to the wisdom of accumulating a large surplus which otherwise would be applicable to the payment of dividends, but that would not be a subject for legal interference where the discretion is fairly exercised. If the defendant corporation has the right to accumulate a surplus, it has the right to invest the surplus in securities, and if the securities appreciate in value, there is no reason why the profits arising from the investment should not be regarded as the profits of the business of the corpora- tion." The language of the courts is quite clear as to the ulti- mate disposition of increased value of securities acquired out of surplus. It remains to be seen, however, whether or not it is proper to pay dividends out of "profits" obtained by adding to capital assets of a physical nature, acquired to be used for the operating purposes of the business, favorable market fluctuations which cannot be realized in cash, since the assets are not for sale, nay, cannot be sold without bring- ing operations to a stop or to an end. It is quite conceivable that, in order to swell the surplus to a figure which will secure for it a respectable appearance after the declaration of dividends out of profits actually realized, favorable fluctuations in the market value of fixed assets acquired out of capital contributions, may be con- sidered. We say that it is conceivable, because of the well- known tendency of investors to consider the surplus of cor- porations as the most attractive item on their balance sheet, irrespective of the actuality and accuracy of the assets, the supposed value of which is exhibited by the financial state- ment. But to declare and pay a cash dividend out of such fluctuations when it is possible that at the time the assets are sold their value will be considerably less than is shown by the books, appears to be nothing more than paying dividends DIVIDENDS PAYABLE 359 out of anticipated profits. This is said with full knowledge of the fact that decisions may be found upholding the legality of such dividends. If it is really desired to give to the stockholders the benefit of increased market value of capital assets, it would be infinitely better to declare and pay a stock dividend. In that case, if profits eventually turned out to be losses, the deficiency in assets to be distributed could be charged to the capital stock issued under the form of dividends. Dividends from Income from Increased Valuations That there is a marked distinction between dividends de- clared out of income and profits obtained from the actual financial transactions of a concern examined from the view- point of operations, and dividends declared out of profits obtained from the increment of invested values, is evidenced by the fact that in differentiating between "corpus" and "income," in matters affecting life-tenants and remainder- men, courts have generally decided that: 1. Dividends, whether paid in cash or in stock, declared out of income and profits, are income and belong to the life-tenant. 2. Dividends, whether rjaid in cash or in stock, declared out of profits due to increased valuations, are principal and belong to the remaindermen. As an accounting proposition, proper differentiation should be had between the components of the surplus before declaration of dividends, in every instance where the capital stock of the concern is composed of preferred stock receiving a stated amount of dividends, and of common stock receiv- ing, if advisable, the balance of the profits. If the profits are made up of operating profits on the one hand, and of profits due to the sale of invested capital on the other hand, accounting principles would seem to require that, when about 360 THE THEORY OF THE LIABILITY ACCOUNTS to pay dividends, the surplus be divided into two distinct parts : 1. The portion which represents operating earnings 2. The portion which represents increments of capital and that, the preferred stock having received its portion of the operating profits, and the common stock the balance, the surplus component representing increments of capital be dis- tributed pro rata to both classes of stock in the ratio that the preferred stock bears to the common stock. This is precisely the view taken by the legal and account- ing advisers of the Equitable Life Assurance Society of the United States in the matter of an extra dividend of $80,- 000,000 declared in January, 1914, by the Union Pacific Railroad Company, whose preferred stock was held in part by the Life Assurance Society. The surplus out of which this dividend was declared, was made up in part of approxi- mately $59,000,000 representing profits on sales of securi- ties of affiliated and controlled companies, and approximately $15,000,000 gained in the conversion of convertible bonds into common stock on the basis of $175 of bonds for each $100 of stock. In deciding against the Assurance Society, Justice Greenbaum of the Supreme Court appears to have been influenced : 1. By the terms of the preferred stock issue which stated : "Such preferred stock shall be entitled in preference and priority over the common stock to dividends in each and every fiscal year, at such rate, not exceeding 4% per annum, payable out of net profits, as shall be declared by the board of directors. Such dividends are to be non-cumula- tive and the preferred stock is entitled to no other or further share of its profits." 2. By the decision in the case of William v. Western Union Tel. Co. (93 N. Y. 162, 168) to the effect DIVIDENDS PAYABLE 361 that the capital stock of a corporation is the capital or property contributed by the stockholders to the extent required by its charter, and that "whatever property it has up to that limit must be regarded as its capital stock" and that any amount of property over that limit is surplus profits. Of course the ruling of the learned justice is the law in the case and will remain the law until reversed; but ac- countants may still be found who believe that the contention of the Equitable Life Assurance Society was remarkably true to principles of accounting, and exhibited the shortcomings of preferred stock for the benefit of future investors. Dividends declared on capital stock belong to the stock- holders of record on the day the corporate books are closed, and the right to them passes to subsequent purchasers of the stock only upon mutual agreement between the interested parties. This is particularly interesting because it is not in- frequent to find among business men the belief that "option" sales of shares of stock convey to the buyer of the option the right to dividends declared on the shares between the initial and the closing date of the option. Stock Dividends Stock dividends may be declared in lieu of cash dividends, or as a result of the receipt of property by donation, gift, etc., or under the form of increments in value over the amount paid therefor. In the first instance the term "stock dividend" is a misnomer; it should be "dividends paid in stock." Accounting Treatment of Dividends In many European countries dividends are declared by the stockholders at their annual meeting. Having accepted the financial statements as submitted by the directors, they 362 THE THEORY OF THE LIABILITY ACCOUNTS vote that a certain portion of the annual profits be set aside for reserves, that another portion be distributed to those en- titled thereto, and that the remainder, if any, be transferred to surplus. If there are not sufficient profits from the year's operations for the declaration of the desired dividend, the surplus is drawn upon, the required amount being sent to the profit and loss, out of which all regular dividends are paid. Extra dividends are paid out of surplus. It is safe to say that in America the majority of the corporations send the annual or the semiannual balance of net unappropriated profits to the surplus, and declare divi- dends out of that account. The journal entry giving ex- pression on the financial books to the declaration of divi- dends is: Surplus (or Profit and Loss, if the occasion arises) $. . To Dividends Payable No.. . . $ It is customary to number the dividends, giving a differ- ent series of numbers to the different classes of stock. Unpaid portions of dividends declared must remain a liability of the corporation until claimed; and if it has be- come certain that they never will be claimed, they can onlv return to surplus by decision of the board of directors. CHAPTER XXXI ACCRUED LIABILITIES DEFERRED CREDIT ITEMS Accrued Liabilities Liabilities accrued, but not due, are recorded in order that the income charges which they represent may be made to apply to the period in which they originated. The ad- visability of entering such charges at the end of a period is largely dependent on the requirements of the financial state- ments to be obtained at the time. If a true financial condi- tion is to be exhibited, all accrued income charges must be included in the statements, as well as all accrued income benefits, or credits What the accrued liabilities will contain, depends es- sentially upon the business conducted and upon the type of organization. The inclusion of taxes in this group of liabilities is due to the fact that, unless the theory of ac- cruals is accepted and applied to the accounting of an en- terprise, taxes are recorded when paid, and do not appear as a liability at any time. The date at which the liability for taxes arises, depends of necessity upon the provisions of the statutes regulating the imposition of taxes by the different subdivisions of the body politic. Generally speaking, however, an individual is liable for taxes on whatever taxable property he pos- sesses on the day fixed for the completion of the tax list, and, while agreements between parties transferring the lia- bility for taxes from one to the other may be valid as be- 363 364 THE THEORY OF THE LIABILITY ACCOUNTS tween them, such agreements do not relieve the original party of his liability for its payment. Taxes, Licenses, Assessments, and Fees Taxes are contributions imposed by the body politic upon its citizens, for its support and their protection. License fees are taxes imposed on the right to conduct a certain business. In most states they are imposed on such businesses as require special inspection, control, or regulation. Assessments are charges made against property owners benefited by improvements made to public property, to defray the cost of the said improvements. Thus assess- ments partake of the nature of a consideration for the en- hanced value of the property by reason of the impro\e- ments made. Fees include all amounts paid to public officers for services rendered. Classification of Taxes Taxes are divided into direct and indirect. Direct taxes are imposed upon the individual with the intention that he shall pay them and bear the burden of them himself. In- direct taxes are those imposed upon property in such wise that they can be added to the price and so passed on to somebody else. More specifically, taxes may be classified as: 1. Federal Taxes 2. State Taxes 3. Municipal Taxes Taxes are further subdivided as: 1. Business and Occupation Taxes 2. Property Taxes 3. Excise Taxes 4. Inheritance Taxes ACCRUED LIABILITIES 365 1. Business Taxes The term "business taxes" includes all taxes which can- not be strictly construed as taxes on property, excise taxes, or inheritance taxes; they are, for instance: a. Taxes upon the premium receipts of insurance companies b. Taxes upon the gross receipts of railroad companies c. Taxes on savings banks according to their deposits "Occupation taxes" are in the nature of licenses to con- duct business, rather than taxation in a strict sense of the term. 2. Property Taxes Property taxes are subdivided into : a. Taxes on real property and interest thereon b. Taxes on personal property a. Taxable real property includes, generally speaking, whatever the individual state laws have classified as real, such as land and buildings and their appurtenances and im- provements; machinery and fixtures which are attached to the buildings in such a manner as to be part of them under the meaning of the law ; mines, minerals, and even mining rights; riparian and water rights; bridges and wharves. b. Taxable personal property includes: money in the possession of the individual, or receivable by him at the time of the assessment; traders' and manufacturers' stock in trade ; boats and vessels ; loans and investments of money ; debts due to residents by non-residents; annuities; fran- chises, etc. 3. Excise Taxes These taxes are levied on particular classes of goods, or commodities; the term commodities has been said by eminent jurists to include corporate franchises, transfers 366 THE THEORY OF THE LIABILITY ACCOUNTS of shares of stock, and the giving of trading stamps in connection with a sale of merchandise, giving right to goods other than the goods sold. 4. Inheritance Taxes These taxes are imposed upon the privilege of acquiring property by inheritance, legacy, or succession; they are levied in accordance with the provisions of the laws of the individual states. The rate of the tax and the particular properties which will be deemed taxable, are also matters of state legislation. Deferred Credit Items To the average concern, the items included in this class of financial facts are not liabilities; they are merely (i) benefits received during a certain period and applicable to a subsequent one, as for instance : a. Unextinguished discounts on securities acquired b. Unextinguished premiums on securities issued c. Unearned portion of fees received in advance of the rendering of services or (2) aggregations of credits measuring the amount of cash receipts for the distribution of which sufficient in- formation is lacking. It requires no great effort of imagination to realize that: i. Discounts obtained on securities purchased or pre- miums realized on securities issued could have been applied to the profits of the period in which the purchase took place, and that it is only the desire to make a series of periods receive the benefit of the gain, which indicates the deferring of the application. DEFERRED CREDIT ITEMS 367 2. Unearned portions of fees received in advance of the rendering of services, while, no doubt, giving rise to a liability for work which may, or may not, entail expense, do not represent a financial liability as we understand the term. Here, again, it is only the desire of being conservative and true to accounting principles which has demanded that the application of the fees to the income be deferred until such time as the work is done. 3. The lack of sufficient knowledge to properly credit the account which brought in cash, does not give rise to a liability, but merely defers the time when the name of the outgoing value will be known. The rulings of the Interstate Commerce Commission have greatly extended the meaning of the term "deferred credit items" so far, at least, as public service corporations are concerned. This class of facts has been made to in- clude, not only benefits applicable to subsequent periods, unearned portions of income, and credit balances of sus- pense accounts, but, as well, operating reserves, and lia- bilities on account of provident, pension, savings, relief, and hospital funds, whether contributed by employees, or by the company, or by both, wherever such funds are managed by trustees for the company. While, at first glance, it may appear odd to include operating reserves among deferred credit items, it will be seen, when the nature of such reserves is investigated, that the only thing which may happen to them is to be paid out when the loss for which they provide has materialized. And since the entry giving expression to the payment of the reserve will be: Dr. Reserve Cr. Cash it must be readily seen that what is actually deferred is the time when cash will actually go out to pay the loss. 368 THE THEORY OF THE LIABILITY ACCOUNTS Operating reserves are created by charging operations for overcharges to passengers or shippers, and for injuries and claims of similar nature, which, while as yet not posi- tively determinable, are bound to occur in an amount which experience has established, within a series of periods. The reason for spreading the losses with some sort of equality over a series of periods instead of taking cognizance of them only when they materialize, is to be found in the ac- counting conviction that unless this is done, comparisons between the individual periods of a series will be unfair. It is for the very same reason that all accruals are so often recorded monthly. The reason for the inclusion of the liability for pension, hospital benefit, and other similar funds is to be found else- where. The Interstate Commerce Commission has so classi- fied the balance sheet of public service corporations engaged in the interstate traffic that it is possible to oppose : Capital Assets to Capital Liabilities Working Assets to Working Liabilities Accrued Assets to Accrued Liabilities Any asset or liability which does not fit this classifica- tion is of practically no importance so far as the operations of the property are concerned ; the assets represent nothing available for current purposes ; the liabilities represent noth- ing which has to be met for current purposes. On the other hand, there is an item, "Hospital Fund," the application of which is deferred, while opposed to it there is a liability the payment of which, out of a fund with a deferred applica- tion, is postponed until the claim is made. CHAPTER XXXII RESERVES AND SURPLUS PROPRIETORSHIP ACCOUNTS RESERVES AND SURPLUS Distinction Between Reserves and Surplus Reserves and surplus not appropriated, together measure the profits made by the corporate enterprise and as yet undistributed. As such they constitute the increments of its capital not represented by shares of stock, and not ex- pressible in shares of stock except through the declaration of a stock dividend. The only real difference between reserves and surplus is that the former are that part of the surplus earnings which has been set aside to provide for losses which may or may not materialize; whereas the latter is that part of the sur- plus earnings which has been allowed to accumulate for dis- tribution among the stockholders in the form of dividends, or for such other disposition as may seem desirable. The foregoing applies neither to operating reserves nor to reserves for depreciation created by charges to cost of operations or to cost of goods manufactured ; nor again, to secret reserves. Still, it might be, and has been argued that by reducing the profit through charges to income, these re- serves come out of surplus just as effectively as if they had been appropriated out of it. The truth or fallacy of this argument will become apparent when we have classified re- serves and analyzed the different classes. 369 THE THEORY OF THE LIABILITY ACCOUNTS Classification of Reserves Reserves are classified as follows: 1. Reserves for Depreciation. Reserves representing actual losses of capital through operations, charged to opera- tions or to manufacturing cost of goods, and temporarily withheld from the asset account which they would reduce if applied to it. 2. Operating Reserves. Reserves representing charges to operations for losses which have not yet materialized but will positively materialize. 3. Reserves for Surplus Contingencies. Reserves repre- senting appropriations of surplus for losses that may or may not materialize ; such reserves are : a. Invested in a special fund, or b. Not specifically invested, but contained in the general fund constituting the gross assets. 4. Reserves for Redemption of Debt. Reserves repre- senting appropriations of profits, intended to reduce the amount of profits available for distribution, in order that the amount so appropriated may be compelled to remain in- vested in the business until it is time to apply it to the re- demption of debts. These reserves may be : a. Specifically invested in properly earmarked redemp- tion funds, or b. Not specifically invested. 5. Secret Reserves. Created by: a. Reducing the cost or book value of certain assets beyond the limits of the probable or the possible, or b. Reducing both assets and profits by deducting from the cost of investments the income which they produce, or RESERVES AND SURPLUS 371 c. Applying specific or general contingency reserves to the reduction of assets with which they are not related. 6. Reserves for Exhaustion of Physical Assets. Before proceeding further, it must be understood that the fact that an account is called "Reserve" does not necessarily give it the right to masquerade under that title. The lia- bility recorded for taxes accrued can no more be called a "reserve for taxes" than the credit offsetting a debit to an asset for increase of market value can be called a "reserve for appreciation" of that asset. Nor can the term be ap- plied to a deferred credit item such as "unearned consulting fees" or "unearned title fees." Having classified reserves, each class must be analyzed, and both its purpose and the principles which is applies be ascertained. i. Reserves for Depreciation Depreciation is composed of two distinct elements : a. The irreparable loss suffered by the physical unit through : 1 i ) Wear and tear caused by operations (2) Accidents (3) Efflux of time (4) Mere exposure to the elements b. Obsolescence of the type Whenever, through operation or accidental causes, a physical unit has sustained a loss of efficiency incapable of being restored by adequate repairs, there is supposed to re- main an element of loss which, intangible as it may be, has partially consumed the capital invested in the unit; and as years go by, the succession of injuries to the unit reduce it to a level of efficiency so low as to make the asset of very little value from a practical standpoint. Thus, elements i, 372 THE THEORY OF THE LIABILITY ACCOUNTS 2, and 3 are so closely related, and so undeniably associated with operations, that it has been deemed quite proper to charge the depreciation loss which they indicate, to the cost of the goods manufactured, or, if the concern is not manu- facturing, to the cost of conducting the enterprise. As to the loss due to exposure to the elements, it may properly be argued that it has little, if anything, to do with operations. It is, besides, so difficult to estimate properly the loss sustained, that it would seem impossible to provide for it otherwise than by application of surplus, subject to adjust- ments whenever the exact truth becomes known. Obsolescence of type represents a loss only when known. Provision for this loss far ahead of its materialization is one of the many precautions dictated by conservatism, which must be reckoned with. But it is a complete denial of its purpose, to treat it indifferently, and sink it, merged with other elements of depreciation, in the cost of operations. If there is ever a good reason for creating a specific re- serve out of net profits, that reason is presented by the possible obsolescence of physical units. It may be feared that a specially made machine will be rendered useless within a year or two or five years, by the invention of a better and more economical machine ; but the expected loss may never come, or may be postponed for many years. Hence, logic would indicate a special treatment for a special condition. It has, unhappily, become the usual practice to consider the term "depreciation" as a convenient invention for as- similating antagonistic factors ; charges made to operations under the title of "depreciation" often contain, if the truth were known, provisions for unknown quantities, the ulti- mate result being the perversion of accounting truth. The main trouble with such unscientific accounting is that it works at cross purposes with the legitimate, although idealis- tic, aspirations of cost finding. It denies that an accounting statement of facts should be truly analytical, and should at RESERVES AND SURPLUS 373 all times "split hairs," if necessary, in order that conclusions to be made from figures submitted, may be minutely ac- curate instead of superficially just. Coming back to accounting principles, if depreciation, in the accepted sense of the term today, is charged to cost of operations, it cannot be denied that it represents a genuine loss through such operations. Hence, the creation of a re- serve for this loss is tantamount to merely deferring the time when the loss will be credited to the asset which has sustained it. As a consequence, a reserve for depreciation created in this fashion is not, and cannot be said to be, ap- propriated surplus; it cannot be shown on the liability side of the balance sheet, but must be deducted from the asset in order that the true remainder value of the asset may be stated. We will discuss later the different methods of pro- viding for depreciation. 2. Operating Reserves Operating reserves are not appropriations of surplus; they measure the amount of all additional cost of operations which, while not necessarily incurred at the present time, will positively be incurred if past experience counts for any- thing; they represent cost incurred and unpaid, and the only connection that they can possibly have with surplus is that, if unnecessarily high, they will be sent in part to the credit of that account, in order to remove any prejudice that it has suffered through over-conservatism. But, until they are found untrue they are supposed to represent true cost, and cannot be stated otherwise than as items the ultimate disposition of which is deferred. 3. Reserves for Surplus Contingencies When closing the books for the purpose of ascertaining the surplus profits of a period, it is customary to take as profits the net fluctuations of assets, representing the amount 374 THE THEORY OF THE LIABILITY ACCOUNTS by which incoming values have exceeded the outgoing values. Thus, the increase of incoming claims upon customers, over the cost of outgoing merchandise, is taken as the gross profit. But it may happen that in the following period, ac- counts receivable may be lost through the failure, the lack of good faith, or the financial embarrassment of one or more customers. The account being lost, it remains to charge it to accumulated profits, under the form of surplus adjust- ment, in the amount of : a. The capital lost b. Profit taken as such during the prior period, and lost during the present one But, since losses of accounts receivable are likely to be sustained, it is advisable at the end of any given period to provide for them by appropriating enough of the very profits which the account brought about ; which reserve must con- tain not only its quota of the profits which may be lost, but, as well, its quota of the capital which is likely to vanish. All reserves for surplus contingencies, to be truly re- serves, must provide either for possible losses of capital, or for possible losses of accumulated surplus. If they are for contingencies of an unknown nature, as, for instance, a sort of insurance against problematic financial happenings, they are not truly reserves ; they are surplus temporarily debarred from dividend distribution. 4. Reserves for Redemption of Debt It is a well-established principle of finance that debts in- curred to obtain at once a large amount of capital required for improvements or additions which will increase earning power, should be repaid out of profits. If, for instance, an individual borrows $20,000 to estab- RESERVES AND SURPLUS 375 lish a stage line between two towns, it must be that he has in view : a. To obtain the necessary equipment out of money which he does not own, and which represents the wealth of somebody else b. To obtain out of that equipment an income which his business acumen tells him will be large enough to : (1) Meet the charges for interest which the lender of the capital will make. (2) Give him, the borrower, enough of a re- mainder to : (a) Live from the fruit of his industry (b) Maintain the property acquired out of the money borrowed (c) Provide for the natural exhaustion of the property (d) Repay the original debt If he has, perhaps, been able to persuade the lender to accept the equipment in payment of the debt at maturity, he must have in mind to set aside annually out of his income, enough money to either pay the loan or supply him with the capital necessary to acquire new equipment. If neither of these two propositions fits in with his purpose, he will, at maturity of the debt, lose both the equipment and the income. If a railroad company possessing a one-track line, and believing that a two-track line will double its income, bor- rows enough money to proceed immediately with the im- provement, instead of proceeding gradually by reinvesting in property the profits obtained from the original investment, it must be that it intends to repay the debt out of profits. If this is not the case, how will the debt be repaid? Through the sacrifice of the assets originally obtained out of contri- butions of capital ? By giving back that part of the capital 376 THE THEORY OF THE LIABILITY ACCOUNTS assets obtained out of the debt incurred? If the former method is adopted, what sense was there in the exchange? If the latter, what sense was there in borrowing? The bond- holders must expect their bonds to be paid out of profits and not out of the very capital which their money has pur- chased, since that capital is pledged to them as security; they cannot expect to be paid out of the capital acquired through antecedent liabilities incurred, since that capital is pledged to others. Hence, reserves for the redemption of debts must be created out of profits. It is evident, however, that if suffi- cient profits are not reserved and so earmarked that it will be at all times possible to identify them, their purpose may fail; if they remain in the free surplus they may be dis- tributed as dividends, and there will be left to pay the debt nothing but the pledge more or less depreciated, the sale of which will deprive the borrower of the very asset for the acquisition of which he contracted a liability. Since reserves for redemption of debts must be created out of profits, it is possible : a. To appropriate surplus earnings as measured by the Surplus account, or by the periodical profit and loss. This appropriation prevents the distribu- tion, under the form of dividends, of assets repre- senting reinvested profits. b. To set aside the assets themselves by taking them out of the general fund of assets, and assigning them to a sinking or redemption fund. In the former case we have a reserve for the redemption of a debt ; in the latter case we have a sinking or a redemp- tion fund. Either of these two methods is adequate of itself; if the two are used in conjunction, no particular purpose is accomplished, but scrupulous conservatism is satisfied. RESERVES AND SURPLUS 377 5. Secret Reserves This accounting term has been made to cover a multitude of sins; whenever objection is taken to pessimistic writing off of invested values, or to disproportionate charges for depreciation, or again to charges to operations or revenue, for capital expenditures which should have been applied to the increase of assets, the answer is, "Secret Reserves." A manufacturer of prominence in the City of New York once stated to the writer, in a tone indicative of deep-rooted pride, that his capital assets had been "bodily knocked down into the pit of secret reserves," and that their book value, as it stood at the time, was preposterous. Since the said manu- facturer was the president of a corporation, the questions at issue were : Did he want to deceive the stockholders, the government, the public, or himself? Did he wish to sub- mit to the directors, the stockholders, the banks, and the public, financial statements with a mental footnote to the effect that things were not in truth what they showed on their face ? And if he took the ground that it is well to hide your wealth from some people, did he believe that anyone capable of reading balance sheets is not in a position to follow accounting facts from year to year, and to point out fluctuations in wealth not supported by the statement of in- come submitted, and thus unearth secret reserves ? 6. Reserves for Exhaustion of Physical Assets Certain physical assets contribute directly to the produc- tion of wealth, and others, indirectly. In the former group we find, mines, timber lands, etc., and in the latter group, plant, machinery, tools, etc. The second group depreciates in value through wear and tear; while the first becomes gradually exhausted as it yields its wealth. Since it is undeniable that the extraction of a ton of ore has exhausted the mine in the amount of the cost of that ton, it is evident that the investors must be made to realize 378 THE THEORY OF THE LIABILITY ACCOUNTS that all returns to them in the form of dividends contain, besides a share of profits, a partial repayment of capital; unless there has been appropriated out of the profits realized on the sale of the ore, enough to provide for the repayment of the capital when the physical assets are exhausted. The foregoing principles apply equally as well to the exhaustion of timber lands and of any other wealth-pro- ducing physical asset the life of which is dependent upon its exploitation. Creation of Reserves As suggested in the foregoing, reserves taken as a class of items, are created by charges to cost of operations, to net profits of the present period, or to accumulated profits of prior periods, and by corresponding credits to individual re- serve accounts, or to classes of reserves; but the provision which they attempt to make for losses of assets is just as effectively made by crediting the physical assets, whenever the loss is so positive as to be taken as cost of operations. In such cases, if a reserve is set up, it is only because of a de- sire to leave the original cost of the asset undistributed on one side of the scale, and to place on the other side a counter- weight, establishing the difference between the two. Provision for Depreciation To provide for depreciation of physical assets so that they may be gradually brought down to zero, or to their residual value, several methods are available : i. If the credit is to be given to the asset: a. Divide the amount to be written down into equal sums, each representing the loss sustained in each successive period of the life of the asset, and pro- vide for each such sum in due time. RESERVES AND SURPLUS b. Write off periodically a sum representing a fixed per cent of the residual value of the asset at the be- ginning of that period. c. Debit the asset periodically (and credit income) with the interest, at an agreed rate, on the amount of the capital invested in the asset at the begin- ning of the period, and write off periodically the proper instalment of an annuity so calculated as to decrease the asset to zero, or to its residual value at the end of its effective life. d. Revalue the asset at the end of each period, and write off the periodic decrease in value. 2. If the credit is to be given to a reserve account, the methods are precisely the same with the exception that method "b" can be operated only by obtaining the residual cost by means of periodically comparing the amount of the reserve with the original cost of the asset. The comparative value of the above methods need not be discussed at length. They all aim at the equalization of profits by making each successive operating period bear its share of the loss of capital assets. It must be stated, how- ever, that under the requirements of the Interstate Com- merce Commission the corporations subject to its accounting control use the first, that is to say, the simplest, method. Mr. Hatfield* states that the second method "involves a com- plicated mathematical calculation, and the annual rate of de- preciation gives little indication to the ordinary man of the period required to write off the asset. Furthermore, it in- creases the depreciation charge in the earlier years, and in the case of a new concern this may be distasteful as being an additional charge against profits at a time when business has not come into full swing, and profits are low." The third method must be especially distasteful to ac- * "Modern Accounting," page 130. 3 8o THE THEORY OF THE LIABILITY ACCOUNTS countants who do not believe that interest on invested capital can ever be a charge either to operations or to assets, or a credit to income or profits. The fourth method would appear to offer the ideal solu- tion of a difficult problem if it were not that it is im- practicable so far as the average enterprise of any size is concerned. Also, this method is open to the objection that, while an appraisement at the end of, say, the twentieth year might show the asset to have a relatively large salable value, its real value to the enterprise, so far as efficiency is con- cerned, might be insignificant. Provision for Exhaustion The method of estimating the provision to be made for the exhaustion of mines, is a little simpler in theory than the creation of reserves, but a great deal more complicated in actual practice. Theoretically, it is plain that, while the lifting to the surface of a ton of ore has exhausted the vein to the benefit of the storeroom or the ore pile, it is only the sale of that ton which depletes the wealth of the mine. Hence, it seems that, if provision is made for the exhaustion of the property, it should be made only on the basis of the tonnage sold. As to the amount to be set aside out of the profits on each ton, it should be such as to amount eventually, together with the residual value of such other assets as were acquired out of capital contributions, to the amount of the paid-up capital. PROPRIETORSHIP ACCOUNTS Positive and Negative Components The sum of the assets, less the sum of the liabilities, gives the amount of the proprietor's equity in his assets. It fol- lows that every account which appears on the books after the closing of the nominal accounts reflecting the causes of the fluctuation of values, and which can be called neither an asset PROPRIETORSHIP ACCOUNTS 381 nor a liability, must be either a positive or a negative com- ponent of the equity. It also follows that, when speaking of the proprietor's equity in such terms as "positive" and "neg- ative," we must apply the former term to credit components, and the latter to debit components ; whereas, when speaking of assets and liabilities, we apply the term "positive values" to debits, and the term "negative values" to credits. The components of the equity of the sole proprietor of a business, are: NEGATIVE POSITIVE Deferred Debit Items Deferred Credit Items Drawing Account Undivided Profits Capital Account The components of the equity of the copartners are : NEGATIVE POSITIVE Deferred Debit Items Deferred Credit Items Drawing Account (Debit Drawing Account (Credit Balance ) Balance ) Undivided Profits Drawing Accounts The theory of the drawing account of the sole proprietor is as follows : It must contain, on the credit side, the profits realized during the period, and, on the debit side, the drawings in anticipation of such profits; if capital is withdrawn, the amount of the withdrawal should be charged to the capital account. The balance of the drawing account should repre- sent the amount by which the profits have exceeded the drawings thereof, or the amount by which the drawings have exceeded the anticipated profits ; when established, the balance should be closed to the credit or to the debit of the proprietor's capital account. 382 THE THEORY OF THE LIABILITY ACCOUNTS The theory of the drawing account of copartners is as follows : Partners may draw, according to their articles of co- partnership : 1. In anticipation of profits 2. For bonuses, salaries, emoluments, etc., accruing to them periodically 3. Capital Drawings of capital should be charged to the capita! ac- count; drawings of bonuses, salaries, and so forth, should be charged to special credit accounts bearing appropriate names and created when the right to draw has matured. These special accounts, when created or increased by subse- quent credits, constitute liabilities of the copartnership, and should not be credited to the drawing account, which is to reflect only the extent of the drawings in anticipation of profits. The drawing account proper is credited with the profits when ascertained, and debited with drawings when made. The balance of the account, if a credit balance, should, according to the spirit of the articles of copartner- ship, be sent to the credit of the capital account, or to a "Loan Payable" account ; or they should remain in the draw- ing account itself, subject to the pleasure of the partner. These credit balances are not to be treated as loans to the copartnership unless it is so understood among the partners. "Unapplied profits" are nothing more than the balance of the profit and loss, the ultimate disposition of which is un- certain. It may be withdrawn by the proprietor or he may reinvest it. In the latter case it will, in due course, be sent to his capital account. "Undivided profits" when found in the accounts of co- partners, indicate that while the profits are to be ascertained monthly, quarterly, or semiannually, they are to be divided among the partners at certain stated periods only. PROPRIETORSHIP ACCOUNTS 383 The capital account, when analyzed, must give the fol- lowing components : NEGATIVE 1. Original Liabilities 2. Net periodical excess of decreases of assets, plus increases of liabilities over increases of assets, plus decreases of lia- bilities, after addition thereto of drawings of anticipated profits POSITIVE 1. Original Assets 2. Net periodical excess of increases of assets, plus decreases of liabilities over decreases of as- sets, plus increases of liabilities, after deduc- tion of drawings of an- ticipated profits in an amount smaller than the profits Part V Financial Statements CHAPTER XXXIII FINANCIAL STATEMENTS BASED ON SINGLE ENTRY The Statement of Assets and Liabilities The theory and the mechanism of this statement have been treated in detail in the discussion of single entry.* No further comments are at present necessary, except to point out that the statement has a twofold purpose, in that it attempts to show the financial status by means of inven- tories, and to marshal fluctuations of invested values in order that their meaning may be clearly expressed by the state- ment of resources and of their application. The Statement of Resources and of Their Application This statement is based not only upon accounting prin- ciples but, as well, upon a principle of economics. For every- thing which one receives, one has to give up something already in possession, either in the line of wealth or in the line of credit. If this is not the case, the recipient must have been the beneficiary of a gift, a legacy, a bequest, or a devise. Recognizing this principle, and applying it to the busi- ness concern, the statement of resources claims that re- sources include, assets once held but now consumed; credit See Chapter V. 384 STATEMENTS BASED ON SINGLE ENTRY 3 g- once enjoyed but now partially exhausted through usage; and increases of wealth reinvested. If an individual has $100 in the bank, he has an asset; if he draws $25 for a suit of clothes, he turns part of his asset into a resource which he applies to the acquisition of an asset of a different nature. If, instead of consuming his asset, he acquires the suit of clothes upon a promise to pay in the future, he has turned his credit into a resource which he has applied to the acquisition of an asset which he did not possess at the beginning of the period ; but he has partially consumed his credit, and to reestablish it, he will have to consume his asset "cash." If a business concern has obtained, at the end of a period : 1. New assets that it did not have at the beginning 2. Increases of assets held at the beginning 3. Decreases of liabilities liening the assets at the beginning it must have consumed : 1. Certain assets held at the beginning 2. A certain amount of its credit And if the aggregate of the things obtained has been greater than the aggregate of the consumption of assets and credit owned and enjoyed at the beginning of the period, there must have been received during the period, profits which have also been applied to the acquisition of wealth. To illustrate the foregoing, there will be demonstrated one of the practical problems of the New York C. P. A examination of January, 1912. PROBLEM The following is a comparative balance sheet at Decem- ber 31, 1910, and at December 31, 1911, presented to the directors of the Western Company at their meeting of Jan- uary 5, 1912: 386 12/31/1910 12/31/1911 Land $20,000 $25,000* Buildings 45,ooo 45,ooo Machinery and Tools 86,000 9,ooo Horse, Wagon, and Harness 10,500 10,500 Patents 6,000 6,000 Good- Will 25,000 25,000 Cash 28,300 10,300 Accounts Receivable 29,600 26,550 Investments Bonds 15. Inventory of Goods in Process 10,800 14.69 Inventory of Materials and Supplies 6,750 10,300 Agency Investment 3.68o $267,950 $281,020 Liabilities 12/31/1910 12/31/1911 Bond and Mortgage Payable, 1915 $20,000 Notes Payable $35,ooo 2,000 Accounts Payable 16,400 19,35 Reserves for Depreciation 2,500 6,750 Discount on Bonds 1,000 Capital Stock: Preferred 150,000 150,000 Common 50,000 50,000 Surplus 14,050 31,920 $267,950 $281,020 * Increase due to appraisal based on rise in values of factory sites in the immediate vicinity. Together with the above balance sheet, there was sub- mitted to the board of directors a statement of income and profit and loss showing the profits of the year 1911 to have been $22,120. The directors state to the auditor that, in view of the decrease of cash and of the increase of capital liabilities, they are unable to ascertain what has become of the increased profits of the year. The auditor prepares and STATEMENTS BASED ON SINGLE ENTRY 387 submits to the directors, before the meeting is adjourned, an account properly named, which is so arranged as to show clearly how the Western Company has applied such re- sources of the year 1910 as have been lost in 1911, and the resources and profits of the year 1911. Prepare the account rendered by the auditor. SOLUTION It is presumed that, for the enlightenment of the direc- tors, the comparative balance sheet submitted to them ex- hibited the increases and decreases of the present period over the last period. At all events, they must be obtained before the statement of resources can be established. This done, the factors which have contributed to the increase of wealth (i.e., increases of assets and decreases of liabilities) and the factors which have contributed to the decrease of wealth (i.e., decreases of assets and increases of liabilities) are op- posed as shown on page 388. It will be noted that the $15,000 increase of assets rep- resented by the account "Investments in Bonds," has only consumed $14,000 of other assets, since it has been acquired at a discount of $1,000, and that only the actual cost can be employed to represent an asset consumed to acquire another ; that the profits reinvested are not the amount shown by the statement of income, but are only part of the total profits which were actually received; in other words, since only $21,050 of the assets of the prior period and $22,950 of credit of the prior period have been consumed to acquire $28,120 of new assets and to rehabilitate the concern's credit in the amount of $33,000, the excess of applications over the consumption of resources must have been produced by such profits as were actually received in cash. If the consumption of resources represented by decreases of assets and increases of liabilities is greater than the ap- 3 88 FINANCIAL STATEMENTS * . 88 o c C/) 1 s " a 3 ! 3 s> . /. ^* t-i o n) ^ 3 ,0 15 : H *> l S DH rt H o 1 ^ ..S-3 t-3 rt ! <-5 O tfl rr oJ5 In c Decrease Liabiliti Period : Notes Payable. "rt O H Pi! u. o 8 O M 8 \r> 8 88 ^" ^^ ^O t * ^ ^ 8 8 8 8 8 8 S 8 H g g o C 6 o c Q *y Q C > o C X 10 1 O " ^ C O fc oq_ w S -s; oc C^ C p lO 8 ^ < N M 1 < ^ % "*"* QJ Wn iS "* ..00 if 3 'onsumption of the Cur sets of the Prior Peri PaeV. Accounts Receivable. "n -*- H S . i i % I C Total ~he Reinvestment of as follows: Profits transferred to Profits appropriated serve purposes *CT 4- h Less profits obtained appraisal of properl Remainder Total Resources. STATEMENTS BASED ON SINGLE ENTRY 389 plication, the statement will end on the credit side as follows : "To pay for the cost of conducting the business, over and above the return thereof in the line of profits," or some such appropriate explanation. Proof of Ledger Assets The Insurance Department of the State of New York re- quires insurance companies to submit a statement calling for: 1. Amount of ledger assets at beginning of the year $. 2. Income of the year Total $. 3. Disbursements of the year Balance representing assets at the end of the year $ Recognizing the principles of accounting supporting the insurance statement, the New York Board of C. P. A. Ex- aminers applied these same principles to a mercantile busi- ness, and built up an examination problem in June, 1912, which was severely criticized by accountants who claimed that it was impossible to start with the amount of assets at the beginning of the period, add the income, deduct cash disbursements, and arrive at the assets at the end. The criticism is based on sandy foundations. In account- ing parlance, the word "disbursements" applies to cash, only if it is qualified as "cash disbursements." Speaking from the broad point of view of principles of accounting, an asset consumed is an asset disbursed, while cash disbursed to acquire another asset is not a disbursement of an asset, but 2QO FINANCIAL STATEMENTS merely reflects an exchange. To illustrate the foregoing, there is submitted a problem which is modeled upon the lines of the New York C. P. A. problem referred to ; it appears to have, over its predecessor, the advantage of presenting the problematic requirements in a more lucid manner. PROBLEM The ledger of the Secaucus Supply Company shows at January I, 1914: Debits : Land and Buildings, $30,500; Delivery Equipment, $5,000; Investment Bonds, $9,500; Inventory Mer- chandise, $12,000; Stable Supplies, $150; Cash, $16,500; Accounts Receivable, $14,800. Credits : Accounts Payable, $9,000; Surplus, $17,450; Mortgage Payable, $12,000; Capital Stock, $50,000. The books show at June 30, 1914 : Cash Book: Capital Stock, $5,000; Customers, $35,000; Interest on Investments, $400; Interest on Bank Balances, $80; Mortgage Payable reduced, $3,500; Creditors, $20,000; Delivery Equipment, $300; Freight, $425; Stable Supplies, $200; Salaries of Salesmen, $1,500; Advertising, $50; Administrative Expense, $6,500; Interest on Mortgage, $150. Profit and Loss Account : Debits : Purchases, $20,000; Freight outward and inward, $425 ; Stable Supplies, $235 ; Salaries of Sales- men, $1,575; Advertising, $50; Administrative Expense, $6,500; Interest on Mortgage, $210. STATEMENTS BASED ON SINGLE ENTRY 391 Credits : Interest on Investments, $490 ; Interest on Bank Bal- ance, $80; Sales, $38,500; Increase of Merchan- dise Inventory, $500. Required : 1. A statement which will give full expression to the following formula : "Initial Assets" plus "Income of the Period" less "Disbursements of the Period" equal "Assets at the Close of the Period." 2. The balance sheet of the company at June 30, 1914, supporting the total of the assets shown by state- ment i. NOTE: The accounting period extends from January i, 1914, to June 30, 1914. In connection with the solution of this problem which appears on the pages immediately following it is pointed out: 1. That the sale of the capital stock in the amount of $5,000 has increased the asset "cash," not through the channel of income, but through the incurrence of a liability to stockholders. 2. That adding the amount received from capital con- tributions to the original assets, we obtain the total amount of assets with which the concern started, and the addition thereto through sources not directly connected with income. 3. That if we add to this total of assets, all the income of the period, whether received or accrued, we have taken cognizance of all the positive fluctua- tions of the assets, and that the result of the addi- 392 FINANCIAL STATEMENTS 1 PL, rtf SI bo 3 I .. w 2*^ *1 - 8 2 rt O H i V > b O 'la PL, |< V > V m rt u H u C 1 >^s > c 6 > c 1 1 4-* C 1 , I a .. >-. < i 3 cnJ: S c 1 ^ C c ;2 S i -"c r; U3 rt 11 ^-t rt STATEMENTS BASED ON SINGLE ENTRY 88 88S| 88 8 Qv8 e? 8 8 V O. O i " IS IS > ; C ) c ) C ' u 5 C " t u -i - t VC r /~\ o V JS 3 13 4-> s ft> o U w 1 u C E H JS *C8 t/i 1 o< Q CO n4 > u h CO CO 1 bo G PH n V tn H ^ p. E a u \^^f J C & 8 c t m s Ov c u n .- J X bi ) O -*_i . pj* t. t c u C 1| 5 1 ) .2 . A U 3 n Q V ;a .. o '8*3 M f" 1 - 5 w 2'sfc o-o c C o o , H rt 393 8 8 3 1 TT 3 O) CJ U 888 88 888 8S O ""> o o M i ro "2 o IH ' to cK of 10 o ' 10 o < f^ r5 8 | vo 8 : S.2 <"2 FINANCIAL STATEMENTS tion would be the amount of the concern's assets if it had cost nothing to obtain the income. 4. That the cost of obtaining income can only be that which has consumed assets, and must exclude that which has brought about the recording of an ac- crued liability. To make this still clearer : Stable supplies show at the beginning of the period a value of $150.00 During the period there have been purchased for cash. . 200.00 Total $350.00 There has been charged to profit and loss, as expended 235.00 Leaving a remainder of $i 15.00 Hence, the disbursement of the asset has been not $200 disbursed in cash, but that amount plus $35 of the original asset held at the beginning of the period, and now consumed. An essential principle to be borne in mind when pre- paring this statement, is that all the accruals of income credits must be considered, since they affect the assets; whereas all the accruals of income debits must be ignored, since they only affect liabilities. Consider, for instance, the salaries of the salesmen: $1,500 was paid in cash, while $1,575 was charged to profit and loss; the only part of the expense which affected assets is the part paid in cash ; hence, it is the only one of which the statement takes cognizance. The first and second statements discussed above are said to be based on single entry, because they can be established from books kept in accordance with the principles of that method of bookkeeping which recognizes only inventories STATEMENTS BASED ON SINGLE ENTRY 395 of assets and liabilities revealing increases and decreases, without regard to the causes which brought about the fluctu- ations. As to the third, it is based on the same principles, since it considers only increases and decreases of assets with- out regard to the nature of the bookkeeping entries which gave expression to their counterpart. CHAPTER XXXIV TRIAL BALANCE WORKING BALANCE SHEET Trial Balance The trial balance is not a financial statement; it is merely a list of the balances of the accounts remaining- open on a double-entry ledger at sundry times, i.e. : 1. After the posting of the transactions of the month, as reflected by the books of original entry. 2. After the posting of the accruals and of the in- ventories, and the possible adjustment of accounts, due to a desire for more accurate or more exten- sive distribution. 3. After the posting of the closing entries which estab- lish the profit and loss account and either leave it as it then stands, until the directors have passed upon its disposition, or send it to the credit of the accounts entitled thereto. The trial balance, in fact, is nothing more than a surface indication that the books are in balance, and that the trans- actions have been accurately recorded. Classified Trial Balance, or Working Balance Sheet Here again we have a statement which cannot be called financial; it leads to the establishment of the balance sheet and of the statement of income and profit and loss by means of the following process : i. It classifies the trial balance so as to gather, either on separate sheets, or on the opposite sides of a sheet divided 396 TRIAL BALANCE WORKING BALANCE SHEET 397 in the middle, real accounts, accounts partially real and partially nominal, and nominal accounts having a debit balance; liabilities, surplus, components, free or appro- priated, and nominal accounts having a debit balance. 2. It provides for journal adjustments, debits, and credits, necessary to apply inventories or to redistribute certain items. 3. It classifies the resulting figures as between : a. Income debits and assets b. Income credits and liabilities In fact, it aims at the presentation of a picture of a gen- eral ledger subdivided into the assets and liabilities section, and the income section. When completed, its accuracy is determined by : 1. Adding together the trial balance debits and the debit journal adjustments, and deducting from the total thus obtained the credit journal adjustments, and comparing the remainder with the total of the assets and of the income debits. 2. Adding together the trial balance credits and the credit journal adjustments, and deducting from the total thus obtained the debit journal adjust- ments, and comparing the remainder with the total of the liabilities and of the income credits. The working balance sheet as described is frequently used by accountants who, having to establish financial state- ments within a stated period, find the general ledger in- complete, improperly kept, or grossly inaccurate. They take as a starting point a trial balance the exactness of which has been established, gather the facts of the subsequent period from the books of original entry, journalize the results, and post them on the working sheet, which is thus raised to the dignity of a ledger. 398 FINANCIAL STATEMENTS The handling of the working balance sheet is at no time difficult; however, it cannot be used successfully by anyone not thoroughly familiar with the mechanism of ledger ac- counts. To illustrate this point, let us attempt to use the sheet described in the foregoing, for the solution of a New York C. P. A. examination problem. PROBLEM (New York C. P. A. Examination, June 30, 1912)* The following balances are taken from the books of the Roberts Manufacturing Co. of New York City, on the 3ist of December, 1910: Inventory of Finished Goods (Jan. i ) $3,684.57 Inventory of Raw Materials (Jan. I ) 1 1,392.70 Purchases of Raw Materials 62,519.85 Sales 217,387.42 Wages 109,317.88 Rent 19,500.00 Discounts Received on Purchases 375-6o Discounts Allowed on Sales 186.36 Power, Light, and Heat 8,710.64 Light and Heat for Office 168.00 Repairs 1,090.00 Packing 2,017.00 Factory Expense 3.270.00 General Expense 5,230.00 Factory Insurance 1,050.00 General Insurance 750.00 Machinery and Plant 12,350.00 Tools 2,600.00 Commissions 7,642.00 Office Salaries 9,700.00 Salesmen's Salaries 8,930.00 Interest on Loans 440.00 Loans Payable 22,000.00 Discount Lost 120.00 Notes Receivable 130,000.00 Notes Receivable, Discounted 8,000.00 Notes Payable 19,500.00 * Certain of the requirements of this problem have been omitted, as having no connection with the purpose of the illustration. TRIAL BALANCE WORKING BALANCE SHEET 399 Accounts Receivable 101,026.00 Accounts Payable 30,020.00 Office Furniture 1,100.00 Furniture and Fixtures 1,950.00 Cash on Hand 1,825.00 Cash in Banks 26,467.00 Returned Sales 276.00 Capital Stock ; 200,000.00 Reserve for Depreciation 3,236.98 Reserve for Bad Debts 5,727.00 Freight and Cartage Inward 727.00 Stable Expenses 2,750.00 Horses, Wagons and Harness 8,500.00 Postage and Expressage 1,250.00 Superintendence 3,500.00 Taxes 250.00 Good- Will 10,000.00 Stationery and Printing 1,080.00 Advertising 8,630.00 Surplus (1909) 63,753.00 1. Prepare from the above a trial balance arranged in systematic order, so as to facilitate the preparation of finan- cial or business statements. 2. Draft journal entries for closing the books. The following items are to be taken into consideration : Inventories : Raw Materials $16,250.00 Finished Goods 9,386.00 Tools 2,000.00 Office Furniture 1,000.00 Furniture and Fixtures 1,500.00 Stationery and Printing 300.00 Allow for depreciations: on machinery, 5%; on horses, wagons and harness, 10%. Reserve for bad debts, 3% on accounts receivable only. The item for rent, $19,500, is to be apportioned as fol- lows: 53% for factory, 22% for salesrooms, and 25% for office. The item of superintendence, $3,500, is to be divided, y$ to factory and 2 /-> to general expense. 4OO FINANCIAL STATEMENTS SOLUTION The arrangement of the trial balance need not, in this instance, be particularly respectful of the different theories which dictate the position to be occupied in the statement of income by the sundry elements of income, profits, expenses, and losses. These theories will be fully explained later. Let it be sufficient, at this point, to be orderly and logical. The purpose of the working sheet will stand out clearly at all events. Having classified the trial balance, the first care should be to journalize the adjustments to be made, and to post the journal entries in the working papers, precisely as we would in the ledger. JOURNAL ENTRIES Inventory Raw Materials New Account $16,250.00 Inventory Finished Goods " " 9,386.00 Tools " 2,000.00 Office Furniture " 1,000.00 Furniture and Fixtures " 1,500.00 Stationery and Printing " 300.00 To Inventory Raw Materials Old Account $16,250.00 " Inventory Finished Goods " 9,386.00 " Tools " 2,000.00 " Office Furniture " 1,000.00 " Furniture and Fixtures 1,500.00 " Stationery and Printing 300.00 To apply closing inventories. Provision for Depreciation of Machinery and Plant, 5% 617.50 Provision for Depreciation of Delivery Equip- ment, 10% 850.00 To Reserve for Depreciation 1,467.50 To provide for depreciation of physical assets. Reserve for Bad Debts 2,696.22 To Surplus 2,696.22 To reduce reserve to 3% of balance of asset account, i.e., $101,026.00. TRIAL BALANCE WORKING BALANCE SHEET 4OI Factory Rent 53% 10,335.00 Rent of Salesroom 22% 4,290.00 Rent of Office 25% 4,875.00 100% To Rent 19,500.00 To distribute. Superintendence Factory 3/5 3,100.00 Office Salaries 2/5 1,400.00 5/5 To Superintendence 3,500.00 To distribute. ' Tools Consumed 600.00 Furniture and Fixtures Written Off 450.00 Office Furniture Written Off 100.00 To Tools , 600.00 " Furniture and Fixtures 450.00 " Office Furniture 100.00 To apply loss due to reappraisal of above properties. Stationery and Printing Consumed 780.00 To Stationery and Printing 780.00 To take out of asset account the part of it which is nominal. Inventory of Raw Materials 4,857.30 To Profit and Loss 4,857.30 For increase of inventory. This will act in the Profit and Loss account as a reduction of the cost of goods purchased, and determine the cost of goods manufactured. Inventory of Finished Goods Old Account 5,701.43 To Profit and Loss 5,70143 For increase of inventory. This will act in the Profit and Loss account as a reduction of the cost of goods manufactured, and deter- mine the cost of goods sold. The adjusting entries having been made, the closing entries would consist in gathering all items constituting classes of economic facts, and closing them by classes in the Profit and Loss account, in order to make the latter repro- duce accurately the skeleton of the statement of income and 402 FINANCIAL STATEMENTS i 888888888 8888 M~ i-T oo o 5 w W CO W U S3 < iJ < cq O - tx OS\O t-x O' t^ 10 -itxi-(>-( ro OOO^OOtxuicq^Otx Pd O en O : rt v [in ( U ^ -*- C ! 1 K }t : - = - 4 r P : : . c P '-t- 5 C i c i r i i i 1 ' U * <3 - r -'J 5 ^ 'C 52 i l i j i r r, Light and Heat, rs Consumed.. . S "3 'g jg S g WT3 <% u O bE.q o TRIAL BALANCE WORKING BALANCE SHEET 403 Omoot^QOOiOoO moo O txr^ioO 1-1 OvtOTfrroinO t^\O c*} w ^ ""I ^1^ O O\ i>x "I 00 .. M N r<5 o" i-T of of -*tao tCoo" of " ^f to oo^ooooo o 00 tOOO to to <* 01 to t^0)i-it>.0^-i-i CO * * to o d CO O ON ' : ||j > i ; oo : : : : : : H c u !c I/ t^ 5 t- O Q 5 O O . d d IO O fO 04 ?i O 01 <* 80 o o o g O O 888 i : 8S 8 :OVO O O C O ro O O C OC 8 00 K VO < 8 8d d tx d 04 FX 10 * " PO "^ o o o " CO to O Ov tx t^ S^ c : c if dvd d d c ooo to to T ti 8 fO f5 M of CO* ! .00 04 ON u 1 O \ 1-i o h- fs. IO i rt <- m . . . . E : i i : en t- O f Machiner] itt ' O ; Q s 1<-I CO .5 "~ "Cr^l rt5f > rt HH ^ c a c 3 i|l|l|^|1 Wc/)<; -*- t- -^ ^J C ^- 4- C he ;3 rt v O Jfl O *" OT 4 c.23- .2* 5S 2 fe 'r H V- '" (^ ^J **^ 3QPL, en teO 404 FINANCIAL STATEMENTS 8 88888%o o o d\ ooo K<$ &8 $ o <2 ' tx 10 06 OQ i-x to *5 CO irj " 5 (A i u a" . . : SS : I : i ;&; I -i . IOOO g S B (5' o 1 co, S S w ^ H ^ g Q fe p PO 8 85? CX O (N PM 2 a Hrs10Tiary mliHtJorm, , r , , . , x, , 2. American Experience table at.... per cent, on* $ Same for reversionary additions $ . Same fOT rmprslnnary arfditiona ...,,.,! .. 4. Other tables and rates, viz.:* $.. Same for reversionary additions 5. Net present value of annuities (including those in reduction of premiums). Give tables and rates of Interest, viz.: $.. Total | 6. Deduct net value of risks of this company reinsured in other solvent 7. Reserve to provide for health and accident benefits contained In life policies 8 Net Reserve (Pald-for basis) | $ 9. Present value of amounts not yet due on supplementary contracts nel involving life contingencies, computed by the 10. Liability on policies cancelled and not included in "net reserve" upon 12. Claims for death losses in process of adjustment, or adjusted and not due 13. Claims for death losses incurred for which no proofs have been received 14. Claims for matured endowments due and unpaid 15. Claims for death losses and other policy claims resisted by th< 16. Due and unpaid on annuity claims involving life contingenci 17. Total Policy Claims company ee 18. Due and unpaid on supplementary contracts not involving life contingenci 19. Dividends left with the company to accumulate at interest, and accrue 88 d interest 20. Premiums paid In advance, including surrender values so api (lied . . 24. "Cost of collection" on uncollected and deferred premiums, in excess of the loading 25. Salaries, rents, office expenses, bills and accounts due or accn 26. Medical examiners' fees $ and legal fees $ due or accn 27. Estimated amount hereafter payable for federal, state, and oth led er taxes based upon ... 28. Advances by officers or others on account of expenses of organization or otherwise 31. Dividends or other profits due pollcyholders, including those contingent on payment 32. Dividends declared on or apportioned to annual dividend policies payable to policy- holders during 1913, whether contingent upon the payment of renewal pre- 33. Dividends declared on or apportioned to deferred dividend policies payable to pollcyholders during 1913 34. Amounts set apart, apportioned, provisionally ascertained, calculated, declared or held awaiting apportionment upon deferred dividend policies, not included in Item 33 35. Beeerve, special or surplus funds not included above (give items and amounts sepa- rately, and state for what purpose each of said funds is held): 37 39. All other liabilities (give items and amounts): 40 41. 4S. 43. . $ 44. Capital stock 46. Total 9~ State definitely the dates of issue and class of policies covered by each basis of valuation. 424 FINANCIAL STATEMENTS Balance Sheet of Steam Roads Engaged in Interstate Com- merce The form presented here is nothing more than the ex- pression of the requirements of the Interstate Commerce Commission, as formulated in their pamphlet (first revised issue effective June I5th, 1910) entitled "General Balance Sheet Statements as prescribed by the Interstate Commerce Commission for Steam Roads, in accordance with Section 20 of the Act to regulate Commerce." BALANCE SHEET STATEMENT Assets Property Investment: I. Road and Equipment: Bia Investment to June 30, 1907: Road $ Equipment Bib Investment since June 30, 1907 : Road Equipment General Expenditures Total Road and Equipment Bic Reserve for Accrued Depreciation (Cr.).. Total Road and Equipment. II. Securities: 62 Securities of Proprietary, Affiliated, and Controlled Companies Pledged 63 Securities Issued or Assumed Pledged.. 64 Securities of Proprietary, Affiliated, and Controlled Companies Unpledged Total Securities . III. Other Investments : BS Advances to Proprietary, Affiliated, and Controlled Companies for Construc- tion, Equipment, and Betterments $ SPECIAL FORMS OF BALANCE SHEETS BALANCE-SHEET STATEMENT Continued B6 Miscellaneous Investments: Physical Property 425 Securities Pledged . . Securities Unpledged Total Other Investments $ Total Property Investment Working Assets: 67 Cash $. B8 Securities Issued or Assumed Held in Treasury : Stocks Funded Debt Miscellaneous Bp Marketable Securities: Stocks Funded Debt Miscellaneous Bio Loans and Bills Receivable Bn Traffic and Car Service Balances Due from Other Companies Bi2 Net Balance Due from Agents and Con- ductors 613 Miscellaneous Accounts Receivable 614 Materials and Supplies (Depreciation de- ducted) Bis Other Working Assets Total Working Assets. Accrued Income Not Due: Bi6 Unmatured Interest, Dividends, and Rents Receivable Deferred Debit Items: 617 Advances : Temporary Advances to Proprietary, Affiliated, and Controlled Companies $. Working Funds Other Advances Bi8 Rent and Insurance Paid in Advance Big Taxes Paid in Advance 426 FINANCIAL STATEMENTS BALANCE SHEET STATEMENT Continued B2O Unextinguished Discount on Securities: On Capital Stock On Funded Debt 621 Property Abandoned, chargeable to Operating Expenses 622 Special Deposits 623 Cash and Securities in Sinking and Re- demption Funds 624 Cash and Securities in Insurance and Other Reserve Funds 625 Cash and Securities in Provident Funds. . 626 Other Deferred Debit Items Total Deferred Debit Items. Profit and Loss: 627 Balance Total $. Liabilities Stock: 628 Capital Stock : Held in Treasury: Common Stock $ Preferred Stock Debenture Stock Total Issued and Outstanding: Common Stock $. Preferred Stock Debenture Stock Receipts Outstanding for Instalments Paid .. Total $. Bag Stock Liability for Conversion of Securi- ties of Constituent Companies $. 630 Premiums Realized on Capital Stock Total Stock $. SPECIAL FORMS OF BALANCE SHEETS 427 BALANCE SHEET STATEMENT Continued Bonded Mortgage and Secured Debt: 831 Funded Debt : Held in Treasury : (a) Mortgage Bonds $ (b) Collateral Trust Bonds (c) Plain Bonds, Debentures, and Notes (d) Income Bonds (e) Equipment Trust Obligations (f) Miscellaneous Funded Obliga- tions Total $. Issued and Outstanding: (a) Mortgage Bonds $. (b) Collateral Trust Bonds (c) Plain Bonds, Debentures, and Notes (d) Income Bonds (e) Equipment Trust Obligations () Miscellaneous Funded Obliga- tions (g) Receipts Outstanding for Funded Debt . Total $. 632 Receivers' Certificates $. 633 Obligations for Advances Received for Construction, Equipment, and Better- ments Total Bonded Mortgage and Secured Debt. Working Liabilities: 634 Loans and Bills Payable $ 835 Traffic and Car Service Balances Due to Other Companies 636 Audited Vouchers and Wages Unpaid 637 Miscellaneous Accounts Payable 838 Matured Interest, Dividends, and Rents Unpaid 42 g FINANCIAL STATEMENTS BALANCE SHEET STATEMENT Continued 839 Matured Bonded Mortgage and Secured Debt Unpaid 640 Working Advances Due to Other Com- panies 641 Other Working Liabilities , Total Working Liabilities Accrued Liabilities Not Due: 642 Unmatured Interest, Dividends, and Rents Payable 643 Taxes Accrued Total Accrued Liabilities. Deferred Credit Items: 844 Unextinguished Premiums on Outstand- ing Funded Debt 845 Operating Reserves 846 Liability on Account of Provident Funds 847 Other Deferred Credit Items Total Deferred Credit Items. Appropriated Surplus: 848 Additions to Property since June 30, 1007, through Income $. 849 Reserves from Income or Surplus : Invested in Sinking and Redemption Funds Invested in Other Reserve Funds Not Specifically Invested Total Appropriated Surplus. Profit and Loss: 850 Balance ... Total $. In departing from generally accepted accounting classifi- cations, the commission has fulfilled excellently its purpose, which was to control the presentation of facts by steam roads so that it would be possible to judge them all accord- SPECIAL FORMS OF BALANCE SHEETS 429 ing to the same standard. The distinctions made between working assets and deferred debit items are at times a trifle academic, and it is not always easy to explain the reason why certain facts should be in one group, while other facts apparently similar in every respect are to be found in an- other group. Generally speaking, however, it may be said with propriety that the commissions' requirements have re- flected a great amount of light upon the real value of financial facts which, in the past, were included in groups created to act as deflectors or as screens. The balance sheet of public utility corporations which are under the control of the various public service commis- sions created by the states of the Union, will not be found to differ greatly in spirit from the form given above for steam roads regulated by the Interstate Commerce Commission. They may, however, adopt a different terminology and per- haps, in a few instances, somewhat alter the requirements of the different groups. The powers of the said commissions in connection with uniform systems of accounting can only be obtained from the statutes creating them, or from amend- ments thereto brought about by the recommendations of the commissions themselves in their report to the state legislatures. CHAPTER XXXVII THE STATEMENT OF INCOME AND PROFIT AND LOSS Elements of Statement Speaking of a business enterprise as an abstract proposi- tion, the result of operations discloses: operating profits, operating losses, expense, profit and loss charges, profit and loss credits, income from sources other than operations ; de- ductions from income and profits ; adjustments of profits or losses of prior periods. "Operating Profit" is that part of the trading capital sent out which has returned in excess of the value of the outgo. "Operating Loss" is that part of the trading capital sent out which has not returned and will not return. "Expense" is that part of the invested capital which must be given up in exchange for such services as the busi- ness requires. "Profit and Loss Charges" are losses of capital incurred in a particular accounting period otherwise than through operations; they are due to the sale of non-trading assets below the cost thereof; to inefficiency, carelessness, malignity, or dishonesty of employees, or to natural causes over which the administration has no control. "Profit and Loss Credits" are gains of capital made in a particular accounting period otherwise than through opera- tions or through the regular and expected earnings of in- vested values. 430 STATEMENT OF INCOME 43! "Income from Sources Other Than Operations" repre- sents the earnings of capital invested otherwise than to satisfy the requirements of the basic business purpose. "Deductions from Income and Profits" are the part of his income and profits which the business man must share with others for the use of their wealth in the conduct of his business, or must pay to others as a compensation for the safeguards with which they surround his business interests. "Surplus or Capital Adjustments" represent the changes which must be made in the net results of the operations of past periods in order that conditions unknown then, but now understood, may not erroneously affect the results of the prior period. When attempting to express the causes which have brought about operating profits or operating losses, it is necessary to state : 1. The amount of the values which have come in, in exchange for the values which have gone out 2. The amount of the values which have gone out in ex- change for the values which have come in Non-trading concerns call the first group of facts re- ceipts, revenue, operating earnings, or any name which applies unequivocally to the particular operations of the enterprise. Trading concerns as well as manufacturing concerns en- gaged in trading, oppose sales to the cost of the goods sold. Accountants have taken the habit of calling sales "income from sales," and deductions therefrom, "deductions from income from sales." They have been led to this harmless distortion of the meaning of the word "income" by the' praiseworthy desire of giving to the statement to be presented by them an anatomical aspect suggestive of logic, clarity, and analytical power. 432 FINANCIAL STATEMENTS The marshaling and the grouping of the various ele- ments which constitute the sundry classes of financial facts indicated in the foregoing, is the purpose of the "Statement of Income and Profit and Loss." Mechanism of Statement The mechanism of the "Statement of Income and Profit and Loss" is simplicity itself ; it is as follows : 1. The income from operations is given at its gross figure. From that gross figure are deducted all the items which have reduced it, either through cancellation of the original transactions, or through partial reductions thereof, or again through expenditures which were positively in- cluded in, and deductible from, the amount receivable from operations in accordance with the expressed or implied terms of the contract which made them possible. 2. The cost of obtaining that income, i.e., the operating cost, is given next, in order that by its deduction, the gross profit represented by the excess of the returns over cost may be gauged. 3. The cost of bringing about the conditions which made operations possible follows. When this is deducted the re- sult, in mercantile as well as in manufacturing concerns, is known as the selling profit. 4. If from the selling profit, the cost of administering the business is deducted, the resulting figure is the net income, or the profit from operations. 5. To this profit is added the income obtained from other sources. 6. From the sum of sections 4 and 5, there is deducted the voluntary or unavoidable sharing of income and profits with others who lend their financial or their protective assistance to the business. 7. 8. To the remainder, the profit and loss credits are STATEMENT OF INCOME 433 added, and from the remainder the profit and loss charges are deducted. 9. The result is the net profit from all sources, for the period. 10. From this net profit there is to be deducted appropria- tions for contingencies of the future, that is to say, pro- visions for reserves. 1 1. To this result there must be added the undivided pro- fits of the prior periods, adjusted by adding thereto, or de- ducting therefrom, the losses maturing during the present period and denying gains taken as such in a prior period (or vice versa if conditions are reversed). 12. The result is, of necessity, the amount of undivided profits known as "surplus" in corporate balance sheets, and stated at the same figure by the statement showing the financial status. If the concern is a sole proprietorship, or a copartnership, the result of section 10 is added to the capital accounts of the proprietors adjusted as suggested in section n. The result, then, is the actual equity of the proprietors in their assets, as expressed by the balance sheet. The following statement of income and profit and loss of the Black Diamond Manufacturing Company* will serve as an illustration : THE BLACK DIAMOND MANUFACTURING COMPANY STATEMENT OF INCOME AND PROFIT AND Loss FOR THE YEAR ENDED DECEMBER 31, 1913 . Income from Sales: Gross Sales $788,968.41 Less Returns 3,434-17 Net Sales.... $785,534.24 * See balance sheet given in Chapter XXXV. FINANCIAL STATEMENTS STATEMENT OF INCOME Continued Deductions from Sales : Allowances to Customers: On Sale Price ............................ $380.10 On Damaged Goods ....................... 276.04 Freight and Cartage Outward on Sales ..... 40,300.00 Stable and Automobile Expense Proportion Applicable to Sales ....................... 7,851.68 Total Deductions from Sales $48,807.82 Income from Sales $736,726.42 Cost of Goods Sold: Manufacturing Cost of Goods Finished During the Period : Prime Cost: Materials and Supplies Consumed Includ- ing Freight and Cartage thereon $295,379.01 Productive Labor 55,316.83 Total Prime Cost $350,695.84 Manufacturing Overhead: Superintendence $7,370.49 Unproductive Labor 8,221.40 Heat, Light, and Power 3,677.82 Factory Expense 8,405.06 Repairs and Maintenance, Machinery and Tools 5,120.09 Total Manufacturing Overhead $32,794.86 General Factory Overhead : Salaries and Wages Shipping Department $7,982.36 Shipping Material Consumed 1,114.77 Shipping Department Supplies 9.21 Miscellaneous Shipping Expense 447-86 Traveling Expense Shipping Department. 275.21 Stationery and Printing Consumed by Factory 7.53 Total General Factory Overhead $9,836.94 Total Manufacturing Cost for the Period $393,327.64 Deduct : Increase of Inventory of Goods in Process as between January i and De- cember 31, 1913 STATEMENT OF INCOME STATEMENT OF INCOME Continued Add: Decrease of Inventory of Goods in Process as between January i and Decem- ber 31, 1913 2,088.36 435 Manufacturing Cost of Goods Finished Dur- ing the Period $395,416.00 Inventory Adjustment: Deduct : Increase of Inventory of Finished Goods as between January i and December 31, 1913, after deduction therefrom of the value of goods distributed free, and used by salesmen 7,95439 Add : Decrease of Inventory of Finished Goods as between January i and Decem- ber 31, 1913, after deduction therefrom of the value of goods distributed free, and used by salesmen Manufacturing Cost of Goods Sold $387,461.61 Additional Cost Freight, Handling and Ware- housing of Raw Materials Consumed 4,905.27 Total Cost of Goods Sold 392,366.88 Gross Profit on Sales $344,359-54 Selling Expense: Salaries of Selling Management $6,099.12 Salaries, Commissions, and Expenses of Salesmen 128,650.42 Advertising Expense 12,033.28 Free Goods 33,428.14 Traveling Expense of Sales Manager 1,079.67 Premiums 1,954-86 Stationery and Printing Consumed by Office of Sales Manager 416.21 Special Inducements to Jobbers 2,100.95 Salesmen's Samples used in demonstration... 7,537.88 Sundry Expense of Sales Office 297.54 Total Selling Expense 193,598.07 Selling Profit $150,761.47 436 FINANCIAL STATEMENTS STATEMENT OF INCOME Continued Administrative and General Expenses: Administrative : Office Salaries $17,462.91 General Office Expenses and Supplies 918.45 Telephones and Telegrams !53-i6 Legal Expense 172.82 Traveling Expense of Administrative Officers 900.00 Postage Expense 2,135.54 Stationery and Printing Office 530.79 Heat and Light Office 918.19 Miscellaneous 2,012.92 $25,204.78 General : Repairs and Maintenance of Buildings $5,852.39 Experimental Expense Processes and New Goods 2,888.49 Experimental Expense Machinery 1,288.44 $10,029.32 Total Administrative and General Expense 35,234.10 Profit from Operations $115,527.37 Additions to Income: Interest on Notes Receivable $2.71 Sundry Sales of Materials and Empty Con- tainers 1,480.57 Discounts Gained on Creditors' Accounts (Cash Discounts) 4,700.00 Interest on Bank Balances 112.10 Total Additions to Income. 6,295.38 Total $121,822.75 Deductions from Income: Taxes, Licenses, and Fees $2,627.86 Fire Protection 2,704.09 Discounts Lost on Customers' Accounts (Cash Discounts) 3,788.15 Interest and Discounts Notes Payable 22,131.77 Collection Fees and Other Bank Charges 71.05 Total Deductions from Income 31,323.82 Gross Profit and Income from Operating and Other Sources $90498.93 STATEMENT OF INCOME STATEMENT OF INCOME Continued Extraordinary Losses of the Period: Frozen Goods $842.84 Accounts Receivable Uncollectable 2,635.55 Breakage of Carboys and Other Empty Con- tainers Returnable to Shippers 254.77 Total Extraordinary Losses of the Period 3,733-i6 Net Profit for the Year Ended December 31, 1913 $86,765.77 Reserved: For Depreciation of Physical Assets $9,481.39 For Possible Losses of Accounts Receivable. . 2,715.34 Total Reserved 12,196.73 Profit and Loss Surplus at December 31, 1913 $74,569.04 Surplus at January i, 1913 $171,368.31 Less Adjustments during the Period: Returned Sales of prior periods, and Frozen Goods sold in prior periods, the profit on which figures in the surplus as established at January I, 1913, including freight and all expenses paid by the Company on such returns 8,652.33 Net Adjusted Surplus, January i, 1913 162,715.98 Surplus at January i, 1914 (as per Balance Sheet of this Company given in the foregoing) $237,285.02 Comment on the Statement If the internal anatomy of the statement varies at all, the variations are due, not to elasticity of the mechanism, but to differences of opinion as to the legitimacy of theories which establish the position to be occupied by individual facts. Some accountants claim that the income from sales is represented by the total of the charges to customers, less : i-a. The credits taken by them for returns, canceling the sales in part or in full 438 FINANCIAL STATEMENTS b. Allowances given to them for shortages, injuries to goods, etc. c. Trade discounts 2. All expenses which the vendor had agreed to stand in order to consummate the sale, such as the freight, cartage, and other possible delivery ex- penses to the point where the goods are to be delivered. Other accountants, on the other hand, while admitting items a, b, and c under i, deny that under any conditions freight and cartage, expressage, and delivery outward are anything but selling expense, or, in some cases, administra- tive expenses. Cash Discounts Economically speaking, cash discounts given and re- ceived measure the ability of the administration to give up part of the income from sales, in order that it may obtain a greater benefit in the settlement of its accounts payable. In other words, cash discounts given are considered as a financial bait intended to induce cash to flow in more readily than the terms of credit give the right to expect, in order that this cash may be used to take advantage of similar offers by creditors. It is said, however, that unless rates of dis- counts are obtained in a greater amount than they are given, discounts on both sides are useless. Many accountants, of course, refuse to consider cash discounts otherwise than as deductions from income from sales or from cost of goods. Cost of Goods The section of the statement which contains the cost of the goods sold is the one which gives rise to the widest differences of opinion. Speaking of the cost of manu- factured goods, some accountants claim that it is represented by: STATEMENT OF INCOME 439 1. Pre-process cost, i.e., freight inward, handling and store charges 2. Material consumed 3. Labor expended 4. Manufacturing overhead applicable on some legiti- mate basis, and including, among other items, re- pairs to machinery and tools and depreciation thereof 5. General factory overhead applicable as above and including rent, actual or theoretical, of factory space, interest on capital invested in the factory, taxes on factory building, fire protection of the manufacturing property, etc. An equally positive group of accountants deny that de- preciation, being at best an estimate, can be charged to cost of goods which, supposed to be accurately positive, cannot afford to deal with estimates. They claim, further, that in- terest on the investment in physical assets necessary to the proper conduct of the business, is cost to the buyer of the goods, and is, as such, properly included in the sale price of the goods offered for sale, but is not cost of manufacture. Interest as an Element of Cost Among all these theories, the business man often loses his way ; he reads a book on cost-finding advocating the in- clusion of interest and theoretical rent among the com- ponents of the cost of goods, and he adopts the theory, until it is pointed out to him that theoretical rent and theoretical interest, when added to cost, must be taken as income ; that if the closing inventory is large, it is inflated by theoretical values which, reflected in the income, make him subject to a revenue tax greater by a certain percentage of the theoretical values than the amount which he would other- wise pay. Then, realizing that he has actually received neither rent nor interest, he is not quite so sure of the 440 FINANCIAL STATEMENTS infallibility of his author's views. If proper appreciation of one's welfare is able to settle the odious controversies into which accountants have been dragged concerning interest applicable to cost, the Federal Government should be thanked for taxing income. Book Increase of Cost It is undeniable that when the creation of a new depart- ment is contemplated by a business enterprise, and it is de- sired to compute the probable cost of the new departure, it is proper to include in the statistical computations every item which may represent a possible channel of outgo for capital ; but much of the data thus marshaled is only statistical, and has no value as financial fact, when weighed upon the scales of actuality. We have all heard the argument to the effect that when a man goes into business he expects to secure a capital return at a rate which, after deduction therefrom of what his capital would produce if invested in securities, will appear fair to him. According to this, if an individual, by investing his wealth in a business enterprise, makes 10% on his investment, he has the right to say: "I could make 6% by investing in bonds and mortgages; the difference is not worth my while." With such an argument to defend his idleness a man would command little respect ; and yet, by charging cost of goods with interest lost by investing wealth in capital assets, we end by reducing the gross profits on sales to a percentum which may lead to a disastrous conclusion. But the worst of it all is that, con- trary to the principle of business which states that with the efflux of years, carrying experience in its wake, the cost of manufacturing should steadily become smaller, the inclu- sion of theoretical interest in cost makes such cost climb upwards in direct ratio with the increase of physical assets. Thus, the more profits we reinvest in the business in a physical way, the more it costs us to manufacture. STATEMENT OF INCOME 441 In the example of the statement of income submitted above, taxes and fire protection have been treated as deduc- tions from income. This is in accordance with the tenets of the economic theory of income, which state that everything which one pays out for the protection of the capital repre- sented by physical assets, is equivalent to voluntary sharing of one's income with some one else willing to give his serv- ices in return for proper compensation. Statement in Account Form The statement of income presented on pages 433-437 could be prepared in account form instead of in report form without losing any of its value, lucidity, or analytical power. The truth of this assertion will be demonstrated by the following skeleton : THE BLACK DIAMOND MANUFACTURING COMPANY PROFIT AND Loss ACCOUNT FOR THE YEAR ENDED DECEMBER 31, 1913 Cost of Goods Sold. . . Gross Profit on Sales. Selling Expense. Selling Profits.... General and Administra- tive Expense Profit from Operations . . Income from Sales: Sales Less Deductions.. $. Net Sales $. E Gross Profit on Sales (brought down) $. $- Selling Profits (brought down) $. 442 FINANCIAL STATEMENTS THE BLACK DIAMOND MANUFACTURING COMPANY PROFIT AND Loss ACCOUNT FOR THE YEAR ENDED DECEMBER 31, 1913 Continued Deductions from Income $. Gross Profit and Income from operating and other sources.. Profit and Loss Debits.. Net Profit for the Period Appropriations for Re- serves Profit and Loss Surplus for the Period Profit from Operations (brought down) $. Additions to Income . . Gross Profit and Income from operating and other sources (brought down) $. Profit and Loss Credits.. Net Profit for the Period (brought down) $. SURPLUS 1913 1913 Dec. 31 Adjustments. . . $ Jan. i Balance $ Balance Dec 31 Adjustments . . . " " Profit and Loss. $.. $.., Statement for Steam Roads Engaged in Interstate Traffic This statement is divided into two distinct sections, one for income and one for profit and loss. The income section has a skeleton of which the following are the most important parts : STATEMENT OF INCOME 44, 1. Railway Operating Income $ 2. Other Income . i plus 2 = Gross Income (or Loss) $. 3. Deductions from Gross Income Remainder is Net Income (or Loss) $. 4. Disposition of Net Income Remainder, transferred to debit or credit of Profit and Loss $. The skeleton of the profit and loss section is as follows Credits: Balance at beginning of fiscal period $ 1. Credit Balance transferred from Income Account 2. Profit on Road and Equipment Sold 3. Delayed Income Credits 4. Miscellaneous Credits Balance carried to General Balance Sheet. . , . $ Debits: Balance at beginning of fiscal period $. 5. Debit Balance transferred from Income Account 6. Appropriations of Surplus to Sinking and Other Reserve Funds 7. Dividend Appropriations of Surplus 8. Appropriations of Surplus for additions and betterments. . . . 9. Appropriations of Surplus for new lines and extensions . . 10. Stock Discount extinguished through Surplus .. 11. Debt Discount extinguished through Surplus 12. Miscellaneous Appropriations of Surplus 13. Loss on Retired Road and Equipment 14. Delayed Income Debits 15. Miscellaneous Debits Balance carried to General Balance Sheet $. So far as the income statement is concerned, the first section is of great interest because it opposes : i. Rail operating revenues to rail operating expenses. 444 FINANCIAL STATEMENTS 2. Auxiliary operating revenues to auxiliary operating expenses, and adds the net result of the latter group of opposing items to the net result of the former group. Under the heading "Disposition of Net Income," there are given : 1. Appropriations of income for sinking and other re- demption funds 2. Dividend appropriations of income 3. Appropriations of income for additions and better- ments 4. Appropriations of income for new lines and exten- sions 5. Stock discount extinguished through income 6. Miscellaneous appropriations of income It will be noted with interest that the requirements of the Interstate Commerce Commission demand a strict dif- ferentiation between income and surplus. It is to be hoped that American accountants, when presenting statements sup- posed to be analytical and enlightening, will have for the meanings of accounting facts, the respect which they de- serve. It is well enough for the majority of us to treat all transactions of a period which have resulted in a gain, a loss, a revenue expenditure, or an appropriation of profits, as debits or credits to the Profit and Loss account. It is also quite satisfactory to many that capital expenditures be recorded on the credit side of the account which produced the funds. But our statements too often fail to show that some losses and gains affect past profits undistributed ; that some expenditures have been made out of current profits reinvested ; that dividends have been declared out of current profits ; that reserves of the past have been consumed during the current period. We are far too prone to treat a state- ment of results as an accumulation of figures which must STATEMENT OF INCOME 445 balance "by hook or by crook" and are too willing to in- trench ourselves behind our supposed mastery of a science the very elements of which we do not always know. Statement of Cash Receipts and Disbursements Many accountants believe that this statement is merely a recital, more or less logical, of the cash transactions of the period; and still a greater number believe that it is a use- less duplication of figures given in full detail by the cash book. And yet, it is more than true that the cash book carries forward no individual amount of prior transactions ; that few cash books can be provided with enough columns to give a clear idea of the transactions which they record, and that a clear and purposeful resume of the all-important cash transactions of a given period may be as interesting to the officers of a concern as the other financial statements presented. To illustrate this point the statement of cash receipts and cash disbursements of the Black Diamond Manufacturing Company, for the six months ended Decem- ber 31, 1913, is given below : BLACK DIAMOND MANUFACTURING COMPANY STATEMENT OF CASH RECEIPTS AND DISBURSEMENTS Debits Cash Received: I. From the Collection of Current Assets : Customers' Accounts $366,487.14 Claims against Transportation Companies 2,183.93 Notes and Loans Receivable, and Interest thereon 1,42749 $370,098.56 2. From the Sale of Working Assets : Materials and Supplies Sold to Employees $S9.oi Carboys and Empty Containers 1,000.00 1,059.01 3, From the Incurrence of Liabilities: Notes and Loans Payable $153,016.34 Deposits by Employees 15.00 Credit Accounts of Officers 2,106. 10 155,13744 446 FINANCIAL STATEMENTS CASH RECEIPTS AND DISBURSEMENTS Continued 4. From Miscellaneous Sources: Fire Insurance Premiums Refunded $10.05 Dividends on Mutual Fire Policies 364.38 Refunds by Creditors, for overpayments and allowances not deductible from bills 6.15 380.58 5. Total Receipts for Period 526,675.59 6. Balance on Hand, July i, 1913 7,643.05 7. Total Debits $534,318.64 Credits Cash Disbursed: 1. For Liabilities Liquidated : To Creditors $171,350.29 " Employees for Wages 42,650.19 " Banks for Loans and Notes 177,589.99 " Mortgagee for Reduction of Mortgage 19,000.00 $410,590.47 2. To Interest on Indebtedness 6,251.07 3. For Reduction of Credit Accounts of Officers 9,680.15 4. For Pre- Process Cost of Goods Manufactured: Freight and Cartage Inward and Handling Charge. .. 3,882.44 5. For Factory Overhead Expenses : Automobile Expense $317.80 Warehouse Cliarges and Cartage 40.25 General Expense of Factory 150.05 Miscellaneous Shipping Expense 1,040.65 1,548.75 6. For Selling Expenses : Salaries and Commissions of Salesmen... $58,115.40 Advertising Expense 10,251.53 Special Commissions to Jobbers 222.66 68,589.59 7. For General and Administration Expense: Salaries $12,000.00 Postage Expense 1,398.89 Telephone and Telegrams 93^06 Traveling Expense of Officers 450.06 Legal Expense 1,027.59 Miscellaneous Expense 33-42 15,003.02 8. Total Cash Disbursements for Period 515,545-49 9. Balance on Hand, December 31, 1913 18,773,15 10. Total Credits $534,318.64 CHAPTER XXXVIII THE CONSOLIDATED BALANCE SHEET "Consolidation" and "Consolidated" Balance Sheets When it is desired to gather together the assets and the liabilities of several companies which it is proposed to consolidate, the resulting balance sheet is called a "Con- solidation of the Balance Sheets of Companies A, B, C," etc., at a given date. The process is very simple, consist- ing merely in expressing in one amount the assets and the liabilities of the various units. Thus, if Companies A, B, and C have a capital stock of $1,000,000 each, the capital stock of the three companies together is given as $3,000,000. The object of such a balance sheet is to show: 1. The assets which will enter the combination. 2. The liabilities to be liquidated out of them. 3. The total equity of the stockholders taken as a whole, in order that the probable amount of the new capital stock to be issued if the consolida- tion takes place, may be estimated. In contradistinction, the term "consolidated" is made to apply to balance sheets which attempt to show to the owners of the stock of a company holding the stock of others, the exact status of the assets which they control, and of the liabilities to be met out of the assets. The purpose of holding companies is to acquire the control of the stock of operating companies and to receive as their income the income of these companies. It is 447 448 FINANCIAL STATEMENTS plain, of course, that behind the financing scheme there lies an internal organization created with the object of reducing, through systematic and enlightened manage- ment, the cost of operating the controlled companies. It is also evident that, in principle, the financing of a weak member of the community of components, can be attended to much more economically through internal channels than it can by means of outside assistance. Thus, it is not infrequent to find on the balance sheet of a controlled company an asset which is the liability of another con- trolled company. The situation created by such internal financing, while not in the least peculiar, is interesting because it raises the question of accounting by offsets. If a father had intrusted the management of $300,000 of personal property to three of his sons, in equal amount, they to enjoy the income of the trust, it might be that, at the end of a given period, the marshaling of the units of the principal of the trust fund might show that John had loaned $50,000 to James, who in turn had loaned $25,000 to Charles. But the balance sheets submitted by the three trustees would not in the aggregate reveal any- thing of great importance to the father, since the fund remains intact. If James repaid John the $50,000 which he owes him, and, in turn, Charles repaid to James the $25,000 loaned by the latter, John's balance sheet would be richer in liquid assets, while that of James and Charles would be poorer in liquid assets and richer in reduction of liabilities; but the father would not have one cent more. If, then, the components of a holding company, as represented by the stock which the latter controls, have been financed one by the other, all the debts of an indi- vidual member which are the assets of another member must be omitted from a statement endeavoring to show the exact status of the assets controlled by the parent company. THE CONSOLIDATED BALANCE SHEET 449 Form of Consolidated Balance Sheet The following problem taken from the New York C.P.A. examination of January, 1913, is brought in as a basis for the preparation of a consolidated balance sheet : Company C was incorporated in May, 1910, to acquire the stock of Companies A and B. Company C's capital stock is divided into preferred, $2,500,000, common, $1,500,000; all the stock is outstanding and fully paid; it has been issued (i) for stock to the stockholders of Companies A and B, (2) $20,000 of preferred for organiza- tion expenses, (3) for cash. The stockholders of A and B received preferred stock for the intrinsic, undepreciated book value of the assets, as reflected by the following balance sheets of their companies at June 30, 1910, and $300,000 of common stock divisible equally between Com- panies A and B. 'Assets Plant Land $90,000 $195,000 Building and Equipment 254,000 318,000 Machinery and Tools 228,600 276,800 Transportation Equipment 21,000 17,000 Investment in Land 150,000 Investment in Bonds Co. B 60,000 Investment Stocks 200,000 Goods in Process 4S,ooo 49,341 Finished Goods 69,000 76,340 Material and Supplies 58,000 51,300 Cash 17,420 19,175 Accounts Receivable 51,000 92,800 Demand Notes Co. B 5,ooo Accrued Interest 1,800 $1,100,820 $1,245,756 Liabilities Capital Stock Outstanding: Common $700,000 $1,000,000 Preferred 100,000 6% Bonds, 1915, J. & J. and Interest Accrued 92,70* 4 - FINANCIAL STATEMENTS Liabilities Continued Accounts Payable 59,8oo 41,656 Loans Payable 65,800 35,ooo Audited Vouchers Unpaid 18,320 13,400 Demand Notes Payable S.ooo Reserve for Depreciation 24,900 30,000 Reserve for Doubtful Accounts 5,000 2,000 Reserve for Contingencies 16,000 Surplus -. 1 1 1,000 26,000 $1,100,820 $1,245,756 Between July I and July 31, 1910, the following transactions occurred: organization expenses paid in cash by Company C, $5,000; intercompany advances by C: to A, $60,000; to B, $60,000; Company A reduced its ac- counts payable by $25,000; its loans payable by $30,000 and its audited vouchers by $15,000; Company B reduced its accounts payable by $29,500, liquidated its audited vouchers unpaid and its interest due under the bonds. The manufacturing operations of the period show: Company A labor, $10,000; overhead expenses, $8,000; materials consumed, $9,886; inventory of goods in process, $46,300; of finished goods, $50,740; selling expenses paid, $1,600; administration expenses, $2,500; sales, $72,500; collections of open accounts, $86,400. Company B labor, $3,600; overhead, $2,350; materials, $5,210; inven- tory of goods in process, $40,500; of finished goods, $46,380; sales, $98,000; collections, $109,150; administra- tion expenses, $3,000.75; selling expenses, $1,040. No materials were purchased during the period and the current expenses were paid as soon as the invoices were audited. Company A declared a dividend of $100,000 and Company B a dividend of $25,000. Prepare the consolidated balance sheet of Companies A and B and C, at July 31, 1910, to be submitted to the directors of Company C and so arranged as to show them the exact detail of the properties that they control. THE CONSOLIDATED BALANCE SHEET 451 O 1-4 ON oooooo .a dodddd OOOOO oiocso a oot-ocoiHia o i to a 3 oioa i.~ < 01 I n S S 00 WOO I- *!-( CN I t^rH I ** I I ' H ll oo qq do oo oo do o ! o 55 O i i H D _5 O CO "o o * r i . oooo o S qqqq q > dodo d a oooo o S 00000 O Q woo"^ d j iH t- 1H O - j-ieoei IH 000 qqq odd c-. o OOM d n"'*-^ 00 oo >0 00 O^ao-H C5 O ^ ^ W *oo .rHO-* rHPSt- *O COO t-l eii-T CO 00 I CO !* I ^ I I N I ffl a g-s :::j::lfi -a 'c>O illii ifll 111 - fl d a _ >>2 a a a led?*- 1 - 1 !- wi-i IfcSSi 5 ?, * 0) ^J 8 3 Ot'C 73-3 g o-a " Sa cSSOfa ft KSi-^qco eor-^ia r-co M :s sl:S| iljli MlP ^'g-S Pill gaigsls 5 OQ o B v > ! 3 < oo' fl 00 oq a oo 3 oo ooooo qqqoq doodd OOOMO coqwcoq COCDCO O o oo o oo OS OO . 0) : a 2.SRS'> 0510 io" O rH C a I sii' .?a* m t a te : cos f A A a pria ble ca of o of of A ropri ila talics indi Composed Excess asset Surplus o a. Appr b. Avai THE CONSOLIDATED BALANCE SHEET 453 Formation of Consolidated Balance Sheet A discussion of the foregoing solution will be sufficient to clear up the supposed intricacies of the consolidated balance sheet. Before proceeding, however, it may be well to present the ledger accounts of the three companies, built up from the facts given by the text of the problem. These are given in order to show how the closing facts are obtained. LEDGER ACCOUNTS COMPANY A Cash Balance . $17.420.00 Accounts Payable . . . . . $25,000 oo Company C 60,000.00 . 86,400.00 1,800.00 Loans Payable 30,000 oo Accounts Receivable.. Interest on Bonds Audited Vouchers. . . ... 15,000.00 Labor 10,000.00 Balance .. Factory Expense. . . . 8,000.00 Selling 1.600.00 Administration Expense 2,500.00 Balance ii.e.-^r\ no $165,620.00 $165,620.00 . $73,520.00 Goods in Process Balance $45,000.00 Materials and Supplies.. 9,886.00 Cash Labor 10,000.00 Cash Factory Expense 8,000.00 $72,886.00 Balance $46,300.00 Finished Goods $26,586.00 Inventory 46,300.00 $72,886.00 454 FINANCIAL STATEMENTS Profit and Loss Finished Goods $44,846.00 Selling Expense 1,600.00 Administration Expense 2,500.00 Surplus 23,854.00 $72,800.00 Finished Goods Sales Interest on Bonds. $72,500.00 300.00 $72,800.00 Goods in Process $26,586.00 Balance 69,000.00 $95,586.00 Inventory Profit and Loss. $50,740-00 44,846.00 $95,586.00 Surplus Dividends $100,000.00 Balance 34,854,00 $134354.00 Balance $111,000.00 Profit and Loss 23,854.00 $134,854.00 Balance $34,854.00 COMPANY B Cash Balance . $10.17^.00 Accounts Payable. . .... $29,500.00 Company C . . 60,000.00 Audited Vouchers. 13,400.00 Accounts Receivable 109 15000 Interest on Bonds. . .... 2,700.00 Labor .... 3,600.00 Factory Expense . . 2.TCO.OO Selling .... 1,040.00 Administration Ex- .... 3,000.75 Balance . I12.7'U.2 l i $188,325.00 $188,325.00 Balance .. . .$132.734.25 THE CONSOLIDATED BALANCE SHEET Goods in Process 455 Balance $49,341.00 Materials and Supplies. 5,210.00 Cash Labor 3,600.00 Cash Factory Expense 2,350.00 $60,501.00 Balance $40,500.00 Finished Goods $20,001.00 Inventory 40,500.00 $60,501.00 Profit and Loss Finished Goods $49,961.00 Selling Expense 1,040.00 Administration Expense 3,000.75 Interest on Bonds 450.00 Surplus 43,548.25 5,000.00 Sales $98,000.00 $98,000.00 Finished Goods Goods in Process $20,001.0,, Balance 76,340.00 $06,341.00 Inventory $46,380.00' Profit and Loss 49,961.00 $96,341.00 Surplus Dividends $25,000.00 Balance 44,548.25 $69,548.25 Balance $26,000.00 Profit and Loss 43,548.75 $69,548.25 456 FINANCIAL STATEMENTS COMPANY C Cash Preferred Capital Stock $465,100.00 Common Capital Stock 1,200,000.00 $1,665,100.00 Balance $1,540,100.00 Advances $120,000.00 Organization Expenses 5,000.00 Balance 1,540,100.00 $1,665,100.00 Capital Stock Preferred Preferred Capital Stock Authorized. .$2,500,000.00 $2,500,000.00 Investment in Stocks. $956,900.00 Investment in Stocks. 1,058,000.00 Organization Expenses 20,000.00 Cash 465,100.00 $2,500,000.00 Capital Stock Common Common Capital Stock Authorized $1,500,000.00 $1,500,000.00 Investment in Stocks. $300,000.00 Cash 1,200,000.00 $1,500,000.00 Investments in Stocks of Other Companies Preferred Capital Stock $956,900.00 Preferred Capital Stock 1,058,000.00 Common Capital Stock 300,000.00 $2,314,900.00 Balance $2,314,900.00 Balance $2,314,900.00 $2,314,900.00 THE CONSOLIDATED BALANCE SHEET 457 The points of interest in the foregoing problem appear to be: 1. The amount of cash which has been obtained by Company C through the issue of stock is not given; and since the amount of stock issued by C in exchange for the capital stock of A and B is not mentioned, the accurate building up of the cash account of C depends upon the understanding of what constitutes "intrinsic, undepre- ciated book value of the assets." 2. The good-will which, so far as C is concerned, repre- sents the difference between the intrinsic book value of the assets and the price paid for the stock of A and B, i.e., $300,000, will have to be expressed in the consolidated balance sheet at a figure which can be obtained only from careful consideration of its components. 3. All the intercompany holdings will have to be eliminated from the consolidation, upon the ground that this exclusion will not in any way alter the status of a single one of the assets of A and B controlled by C. If this test cannot be applied to a proposed eliminiation, it should not be made. i. The Amount of the Issues of Stock for Cash. The term "intrinsic, undepreciated book value" means all the assets of A and B, as appearing on the balance sheets submitted, less their liabilities to outsiders, no cognizance whatever being taken of the reserves. Thus, since the intrinsic, undepreciated book value of the assets of A and B is in the aggregate $2,014,900, this amount of preferred stock was issued by C to the stockholders of A and B. Further, if $20,000 of the same stock was issued for organ- ization expense, the company must have received $465,100 in cash for the balance. As to the common stock, it is plain that the price paid in stock by Company C for the excess of cost over intrinsic value being $300,000, the 458 FINANCIAL STATEMENTS balance of the authorization, i.e., $1,200,000, was issued for cash. 2. The Component Parts of the Good- Will. The assets of A and B, as appearing in the balance sheets of these two companies at June 30, 1910, aggregate $2,346,576.00 Deducting from this figure the amount which has been ac- quired through the use of credit, i.e., through the in- currence of liabilities to outsiders 331,676.00 We obtain an amount of $2,014,900.00 Which represents, according to principles of accounting. .. 1,800,000.00 of assets acquired through the use of the capital con- tributions of the stockholders, as evidenced by the capital stock liabilities of the two companies. Deducting the capital stock we have a remainder of $214,900.00 which cannot be anything else than the assets acquired by companies A and B through the reinvestment of their undivided profits of prior periods, as measured by : 1. The surplus available for dividends $137,000.00 2. The surplus appropriated for the purpose of reserves. . 77,900.00 $214,900.00 Thus we have found two of the components of the good-will acquired by Company C. As to the third, it must of necessity be the $300,000 of common stock issued by C in excess of the intrinsic value of the assets of A and B. To prove that the resulting figure of $514,900, which is called good-will on the consolidated balance sheet sub- mitted above, is truly what it pretends to be, let us assume that, instead of expressing its investment in stocks of other companies at cost, as appears to have been done, Company C had expressed it at the par of the stocks acquired. The journal entry, under these circumstances, would have been : THE CONSOLIDATED BALANCE SHEET Investment in Stocks of Other Companies.. . $1,800,000.00 Good- Will 514,900.00 To Capital Stock Preferred $2,014,900.00 ' Capital Stock Common 300,000.00 For acquisition of the stock of companies A and B, the good-will being represented by: 1. Undivided profits $137,000.00 2. Appropriations of surplus 77,900.00 3. The good-will value of the investment covers the intrinsic value of the assets acquired 300,000.00 $514,900.00 3. The Eliminations. Irrespective of their importance to Companies A and B in their capacity as separate enti- ties, the debts of A to B and of B to A are nothing to C, who owns the stock of both. It is plain that if, for instance, the demand notes held by A against B were to be repaid by the latter, A would have more cash, and less claims against other companies, while B would have less cash, and a lesser amount of liabilities to outsiders. But it is also evident that the consolidation of the cash account of A, B, and C would give a figure absolutely identical with the one shown in the balance sheet, i.e., $1,746,354.25, which is the true extent of C's control of available cash. If the same reasoning is applied to any one of the elimina- tions shown in the above solution, the same result will be obtained. The investment in stocks of other companies as carried by C in its balance sheet, must be eliminated because, in- stead of expressing the amount of the investment, it is required that the assets which it controls, subject to whatever liabilities attach to them, be expressed in detail. The elimination of the capital stock of Companies A and B 460 FINANCIAL STATEMENTS is indicated by logic. If the said stock originally con- trolled the assets of A and B, and has since been replaced by the stock of C, it is only the latter which controls the assets; the former is a nonentity to C for purposes of a consolidated balance sheet. It represents only docu- mentary evidence of the transfer of the assets which were originally acquired out of it. CHAPTER XXXIX THE STATEMENT OF AFFAIRS Appointment of Receivers The term "financial embarrassment" suggests to many people the state of insolvency and consequent re- ceivership. And yet the appointment of receivers by courts of equity is looked upon as an extreme measure, only to be resorted to when the courts are convinced that such action is essential to secure properties from waste pending readjustment of finances or eventual liquidation. As a matter of law, no receiver is appointed unless the referee in the case has found: 1. That the plaintiff has some right or lien upon the properties at issue. 2. That in principle he has a legal right to consider the property as a fund to be devoted to the satisfaction of his claim, or 3. That the respondent has fraudulently entered into possession of the thing in litigation, or 4. That insolvency is so evident that the assets are in serious danger of being lost through sheer waste, to the prejudice of the creditors. Status of the Statement of Affairs To the student of accountancy, the statement of affairs is essentially a receiver's statement. As a matter of fact, neither the receiver nor the assignee is permitted by New York courts to file such a statement. 461 462 FINANCIAL STATEMENTS A receiver may, upon being appointed, ask an account- ant to prepare for him a statement showing what are the assets of the concern whose affairs he is to administer, and to what classes of liabilities they are subject; he may fur- ther wish to know, as soon as possible, the probable amount of the free assets of which he will dispose for the settlement of unsecured claims. But what is more prob- able, he will ask for a list of all the assets and of all the liabilities as they stand on the books. Then he will have the assets appraised; he will ask through the courts that all creditors prove their claims and, within a reasonable time, he will file the lists. Subsequently, he will keep such accounts as will permit him to show what he collected on the said assets, and what he paid on the liabilities, as filed. Thus, so far as the receiver is concerned, the "state- ment of affairs," which has assumed such importance in C.P.A. examinations, is essentially theoretical. If it has any value at all, it is in other directions. A concern whose finances have been badly managed may, while actually prosperous if judged by the standard of profits, be compelled to throw itself on the mercy of its creditors for extension of time, or for further credit. Before granting the request, the creditors may ask that a clear insight be given them as to: 1. The financial status of the concern if liquidation of its affairs is deemed advisable. 2. The causes of the conditions which make further credit necessary. 3. The marshaling of the losses so as to show which are due to mismanagement and which to un- profitable trading conditions, and what losses will be incurred by a forced liquidation, if such a drastic action is contemplated. Thus understood, the theoretical statement of affairs assumes proportions which make it a valuable document THE STATEMENT OF AFFAIRS 463 in the hands of creditors, be they laymen or financial institutions. In truth, the statement has no power other than that which it borrows from the power of logic and accounting analysis of the one who prepares it and draws proper conclusions from the arrangement of its otherwise meaningless results in a deficiency account. Asset Side of Statement The theoretical form of the statement of affairs is shown on pages 464, 465. In the form as given the division of .the space for "Estimated to Realize" into two columns, is to facilitate the deduction of liabilities from assets, or assets from liabilities, as explained below, and as illustrated by the solution of the New York C. P. A. problem given on page 469. The theoretical skeleton of the account is as follows : 1. State the assets in the probable order of their realization. 2. Deduct from the appraised value of pledged assets, the amount of the liabilities which they secure in full. 3. Deduct the appraised value of assets partially se- curing liabilities, from the liabilities to which they are pledged. 4. Total the remainder of the appraised value of the assets. Liability Side of Statement i. State the liabilities at the value at which they stand on the books, classifying them as follows: a. Unsecured Claims b. Fully Secured Claims c. Partially Secured Claims d. Preferred Claims 464 FINANCIAL STATEMENTS i THE STATEMENT OF AFFAIRS 465 4 66 FINANCIAL STATEMENTS 2. Deduct the fully secured claims from the assets which are pledged to them. 3. Deduct the appraised value of assets partially se- curing liabilities from the liabilities to which they are pledged, and extend the remainder as unsecured. 4. Deduct the preferred claims from the remainder of the appraised value of the assets as shown by the second column of the space headed "Estimated to Realize." 5. Total the unsecured claims as extended in the second column of the space headed "Expected to Rank." Bring the statement to a close by establishing either on the asset side, or on the liability side: 1. The amount by which the liabilities unsecured ex- ceed the remainder of free assets, at their appraised value; or 2. The amount by which the remainder of free assets exceeds the unsecured liabilities. Preparation of Statement of Affairs The solution of the following problem taken from the New York C.P.A. examination of January, 1912, will illustrate further the theory of the statement of affairs and the deficiency account, and also the method of their preparation. PROBLEM Under pressure of financial difficulties the General Contracting Company has applied to its creditors for ex- tension of credit. The creditors' committee has engaged accountants to examine the books, and appraisers to appraise the physical property of the company. The examiners and appraisers are given, as a basis for their work, the following balance sheet, prepared by the com- pany's bookkeeper June 30, 191 1 : THE STATEMENT OF AFFAIRS 467 Debits Plant and Equipment $150,000 Horse, Wagon and Har- ness 3,ooo Machinery and Tools... 110,000 Shop and Hand Tools.. 17,000 Materials and Supplies.. 38,000 Finished Goods 5,675 Uncompleted Contracts. . 72,300 Cash 48,800 Accounts Receivable 11,150 Notes Receivable 15,000 Accrued Interest on Notes Receivable 530 Stationery and Printing.. 1,220 Unexpired Insurance 280 $472,955 Credits Capital Stock Authorized and Outstanding $100,000 Bond and Mortgage Pay- able, 6%, due Jan. i, 1912 85,000 Notes Payable 35,ooo Audited Vouchers Un- paid 156,000 Uncompleted Contracts, Instalments 45,ooo Dividend No. 6 Payable. 5,000 Wages Accrued 2,650 Interest Accrued on Bond and Mortgage Payable 425 Interest Accrued on Notes Payable 470 Reserve for Plant and Plant Equipment 6,000 Reserve for Machinery and Machine Tools 5,400 Reserve for Shop and Hand Tools 1,500 Reserve for Horse, Wagon and Harness. . M50 Reserve for Contract Contingencies 5,200 Surplus 23,860 $472,955 In due time the accountants render a report which, among- other things, contains the following remarks: "The account 'Finished Goods' represents the inven- tory, at cost, of certain machines built under contract during the six months of the present accounting period ended June 30, 1911, which the other contracting parties decline to accept, owing to flaws and violations of speci- fications. The accounts receivable are made up as fol- lows: (a) subject to bona fide and admittedly reasonable claims by customers, for unsatisfactory goods manufac- 468 FINANCIAL STATEMENTS tured under contract during prior period, $3,600; (b) last instalment due this company under contracts of the prior period, completed and delivered, $7,550; the aggregate amount of these instalments is due August I, 1911, but is subject to certain guarantees which have subjected the company to fines of $1,500 on account of defective work; these fines will be deducted from the instalments when due; the balance of the amount of $7,550 will be collected in due time. The account 'Uncompleted Contracts, In- stalments,' represents amounts paid by customers during June, 1911, on certain contracts reaching a specific stage of development. The unexpired insurance premiums would, if the policies were canceled, produce $160. There exists no liability for discounted notes. The notes re- ceivable on hand are indorsed by responsible parties." The appraisers report as follows: "The physical assets of the company, as appraised by us, would produce at forced sale: plant and plant equip- ment, $90,000; machinery and tools, $55,000; shop and hand tools, $5,000; horse, wagon and harness, $1,000. The uncompleted contracts would require, to carry them to completion, an expenditure of the following: material, $10,000; labor, $7,000; factory overhead, $3,000, irrespec- tive of general overhead. We are informed by the surety company, who have guaranteed the completion of the contracts, that it will undertake to complete them pro- vided this company will sell them for $9,000, the amount of materials which we have estimated to be necessary for completion, and provided further, that this company will accept in settlement the cost to it of the contracts as they stand on its books at June 30, 1911, with 4% of the said amount added for profits. The balance of the materials and supplies would produce $20,000. The finished goods are worth only their scrap value, i.e., $250. The station- ery and printing is worth $10." 469 The books of the company show that the contracts in process will, when completed, produce $130,000. From the above facts prepare: 1. Statement of affairs at June 30, 1911. 2. Deficiency account that will account logically for the losses incurred by the company and by its creditors under the assumption that the cred- itors are considering favorably the dissolution of the company and the completion of the con- tracts by the guarantors. SOLUTION STATEMENT OF AFFAIRS Assets Book Value Estimated to Realize Cash $48,800.00 $48,800.00 Accounts Receivable : Good 6,050.00 6,050.00 Uncollectable 5,100.00 Notes Receivable 15,000.00 15,000.00 Accrued Interest on Notes Receiv- able 530.oo 530.00 Stationery and Printing 1,220.00 10.00 Unexpired Insurance Premiums... 280.00 160.00 Plant and Plant Equipment (re- serve for depreciation deducted) 144,000.00 $90,000.00 Less Bond and Mortgage Payable: Principal $85,000.00 Interest 425.00 85,425.00 4,575.oo Horse, Wagon and Harness (re- serve for depreciation deducted) 1,550.00 1,000.00 Machinery and Tools 104,600.00 55,000.00 Shop and Hand Tools i5.SOO.oo 5,000.00 Materials and Supplies: To be sold to the Surety Company 10,000.00 9,000.00 Balance remaining in store 28,000.00 30,000.00 470 FINANCIAL STATEMENTS STATEMENT OF AFFAIRS Continued Book Value Estimated to Realize Finished Goods $5,675.00 $250.00 Uncompleted Contracts 72,300.00 $75,192.00* Less Instalments collected there- under 45,000.00 30,192.00 Total $458,605.00 $195,567.00 Deduct Preferred Claims : Wages Accrued 2,650.00 Balance available for distribution to unsecured creditors, being 98.19% of their claims, subject to ex- penses incident to realization and liquidation $192,917.00 Deficiency, as per Account 3,553-00 Total $196470.00 Liabilities Unsecured Claims: Notes Payable : Principal Interest Audited Vouchers Unpaid Dividends Payable Fully Secured Claims: Bond and Mortgage Payable : Principal $85,000.00 Interest 425.00 As Per Books Expected to Rank $35,000.00 470.00 156,000.00 5,000.00 85,425.00 $35,000.00 470.00 156,000.00 5,000.00 Deducted from estimated amount to be realized on property pledged $85425.00 Partially Secured Claims (None) Preferred Claims: Wages Accrued 2,650.00 Deducted from remainder of free assets estimated to be realized 2,650.00 *=Cost + 4% THE STATEMENT OF AFFAIRS 471 STATEMENT OF AFFAIRS Continued Uncompleted Contracts: A * Per Books Expected to Rank Received in Cash $45,000.00 Instalments received in cash, de- ducted from the amount to be realized on such contracts $45,000.00 Reserves, Capital and Surplus: Reserves for Contract Contingencies 5,200.00 Capital Stock 100,000.00 Surplus 23,860.00 Total Book Liabilities, Capital and Surplus $458,605.00 Total Deducted from Assets. Total Unsecured Claims. . $133,075-00 $196,470.00 Preparation of Deficiency Account From the foregoing facts, supported by the analysis of the accounts and by the appraised valuation of certain assets, the following deficiency account is established: DEFICIENCY ACCOUNT Estimated Losses: 1. On Realization of Assets : Plant and Plant Equipment $54,000.00 Horse. Wagon and Harness 550.00 Machinery and Ma- chine Tools 49.600.00 Shop and Hand Tools 10,500.00 Materials and Sup- plies 9,000.00 Total $123,650.00 2. Incident to Realization and Liquidation : Stationery and Print- ing $1,210.00 Insurance Premiums deferred from prior periods 120.00 Total $1,330.00 Net Loss, to be sustained by: 1. Unsecured Creditors : Deficiency, as per statement $3,553.00 2. Stockholders : Capital Stock Out- standing 100,000.00 Surplus : As per books. $23,860.00 Add: Transfer of bal ance of Reserve for Contract Contingencies. .100.00 23,960.00 472 FINANCIAL STATEMENTS DEFICIENCY ACCOUNT Continued Total Losses Due to or Incident to Realization and Liquidation $124,980.00 Operating Losses: Defective goods manu- factured during this period, under con- tract, rejected by customers : Cost $5,675.00 Less esti- mated scrap value 250.00 $5,425.00 Less operating gains, 4% on cost of con- tracts, offered by the Surety Co. 2,892.00 $2,533.00 Loss of Appropriated Surplus: Fines Incurred for vlola- t io n s of specifica- tions under contracts . . $1,500.00 Allowances to customers for claims under con- tracts 3,600.00 Total.. $5,100.00 Less Reserve for Contract Contingen- cies 5,100.00 Total Losses $127,513.00 $127,513.00 Treatment of Reserves The treatment of reserves in the statement of affairs and in the deficiency account is twofold: 1. Reserves may be deducted from the book value of the assets in order that the remainder, or depreciated book value, when compared with the estimated realization may give the amount of the true loss not provided for. 2. Reserves may be treated on the liability side of the statement as appropriated surplus, and deducted in the deficiency account from the estimated losses said to be due to forced liquidation. THE STATEMENT OF AFFAIRS 473 Arrangement of the Statement of Affairs The arrangement of the statement is, of course, a matter of personal opinion, since we are dealing with theory not consecrated by practice. 1. The assets may be shown on the debit side or on the credit side of the statement. 2. The statement may start with a perfect balance by showing in the "Book Value" column all the open ac- counts, debits and credits, found in the general ledger; or it may treat only of assets which are to be realized, and of liabilities to outsiders. 3. It may present the liabilities in the order given in the above solution, or it may state them in the order pre- scribed by the summary of debts and assets to be pre- sented by bankruptcy petitioners ; i.e. : 1. Preferred Claims 2. Secured Claims 3. Unsecured Claims 4. Contingent Liabilities 5. Accommodation Paper Arrangement of Deficiency Account As to the deficiency account, any arrangement which fails to bring it down to the level of accounting under- standing possessed by the average layman, and requires expert explanation for its clear comprehension, is to be condemned whether we deal with theory or with practice. If the statement of affairs ends with an excess of free assets over and above the amount of unsecured claims, the deficiency account can still be made; but, instead of showing deficiency to meet the claims of outsiders, it is satisfactory to show that deficiency which measures the impairment of the capital of the insiders, be they sole traders, copartners, or stockholders. CHAPTER XL REALIZATION AND LIQUIDATION Method of Closing Concerns in voluntary liquidation close their books in the usual manner. As the assets are collected the amount of the proceeds is debited to cash and credited to the assets. Excess or deficiency of proceeds is credited or debited to the surplus to be distributed to the stock- holders, or to the capital accounts of the proprietors. The liability accounts are closed as the individual items are liquidated; any gain due to a compromise is, of course, credited to Surplus or to Capital account. When all the assets have been realized and all the lia- bilities liquidated, the only accounts remaining on the books are, the Cash account, the Capital Stock account, and the Surplus account, if the concern is a corporation, or the Cash account and the capital accounts of the pro- prietors, if the concern is a sole proprietorship or a co- partnership. In the case of copartnerships, the accounts of the partners are debited with the cash distributed to them individually. This closes the books. In the case of corporations, the Capital Stock account is debited with the par of the shares returned by the stockholders for cancellation, and the Surplus account is debited with the amount which the stockholders receive, in the ratio of the shares which they hold. 474 REALIZATION AND LIQUIDATION 475 It goes without saying that if the surplus is converted into an impairment of the stock, the amount of the im- pairment being debited to the Capital Stock account re- duces the latter to the exact amount of cash available for distribution. It is from the above simple closing process that the "Statement of Realization and Liquidation" has been evolved. It is not a practical statement, in the sense that it is probably never used; but as a theoretical statement it has the great advantage of testing the analytic and syn- thetic powers of the student. It is probably for that reason that the New York Board of C.P.A. Examiners has given the statement of realization and liquidation such prominence in their examinations. Statement of Realization and Liquidation The mechanism of this statement is logic pure and simple. It must show: 1. The individual assets to be realized 2. The individual liabilities to be liquidated 3. The amount realized on the assets 4. The amount paid to liquidate the debts 5. The expenses incident to the realization and liqui- dation 6. The assets not realized 7. The liabilities not liquidated 8. The gains on realization 9. The losses on realization To show all these factors in a single account and bring them to a balance, requires less ingenuity than belief in the truth of accounting principles and ability to handle delicate accounting mechanisms. In fact, the Realization and Liquidation account is practically a copy of the trans- actions incident to the liquidation, so arranged as to make it possible for a reader not wholly deficient in accounting 476 FINANCIAL STATEMENTS knowledge, to perceive at a glance the nature of the closing operations. If the statement is adequately pre- pared, one must be able to single out any asset, ascertain its original amount, its increase during liquidation, the proceeds of its sale, and the gain or the loss made on its realization. One must, besides, be in a position to obtain an accurate idea of the aggregate of gains, losses, ex- penses, and settlements which were made before the affairs of the concern were effectively liquidated. Preparation of Realization and Liquidation Account The following problem and its solution will serve as an illustration of the method of preparing the Realization and Liquidation account and the principles involved: PROBLEM The Concrete and Blue Stone Construction Company finds itself in the position of having to liquidate, owing to its inability to obtain extension of credit and to borrow money. Its books show at January 30, 1914: Cash $2,000.00 Land and Buildings 30,000.00 Plant Equipment 22,600.00 Materials and Supplies Inventory 8,100.00 Contracts in Process 32,000.00 Finished Contracts 7,000.00 Accounts Receivable 5,400.00 Bonds of Other Com- panies 1 1,300.00 General and Administra- tion Expense 9,340,50 Profit and Loss 1,600.00 $129,340.50 ist Mortgage, Land and Building, Interest and Principal $17,230.00 Notes Payable 12,300.00 Sundry Creditors 52,340.50 Salaries Due 2,350.00 Taxes Due 120,00 Capital Stock Outstand- ing 45,000.00 $129,340.50 The account "Finished Contracts" contains charges representing allowances to customers for unsatisfactory REALIZATION AND LIQUIDATION 477 contracts; as an asset, it is worthless. The accounts re- ceivable represent charges made by the company against customers for what the company calls extra work not included in specifications; of the whole amount $3,200 is disclaimed by customers, and will probably be lost. The bonds of other companies were received in settlement of contracts, and are worth about $5,000. They are pledged to secure $6,000 of notes payable. The account "Con- tracts in Process" represents cost to date; the amount to be received by the company when the contracts are completed is $45,000; but it is estimated that it will re- quire $15,000 to complete said contracts. The sureties on the contracts will provide the amount required; they purchase, for $6,350, the materials and supplies held by the company, and apply them toward the completion of the contracts. The Cash account shows, at March 30, 1914: Initial Balance $2,000.00 Sale of Land and Build- ings 29,150.00 Sale of Plant Equipment 15,165.40 Sale of Materials and Supplies 6,911.10 Collection of Accounts Receivable 2,741.20 Received on Contracts Finished by Sureties. 31,140.00 Interest Credited on Bank Balances 71-25 Sale of Bonds 9,100.00 $06,278.95 Paid on Mortgage : Principal $17,000.00 Interest 250,30 Paid for Salaries and Wages 2,350.00 Paid for Taxes 120.00 Paid to Creditors 52,340.50 Paid at Maturity of Notes 12,300,00 Paid for Expenses of Liquidation 2,938.10 Balance Paid to Stock- holders 8,980.05 $96,278.95 Required : The Realization and Liquidation account, showing clearly what took place. 478 FINANCIAL STATEMENTS 8OOOOOO Q O OQ 55 m 5 O m O"? r? oo o Q o o o* d oo o o co 5 *! in 01 TJ- O O) vo Oj co CO CO -< CO o cO CO tx oi oi 04 ^~ in O* oS i-c M m oo *! w 04 vt- * " i t c .2 aT bo c .J CO 1 5 H P B>a> S -f Q ^>-^bo Ji 3 -O a w O rt 3 S -w ||!f ! 1- a |S U ^O^^s"^ -2 ShShS . U ^.^j^rtuH LO^/5 ^, , < ^ O *ZJ "Q ^ p ^Q O W rt "*"* PH L w "*^ 3 frt rt to o o o o >S H ,^T ** W ^ PH _) as M oi w H H 8OOOOQ O O OOO co O in O O OO O locoii gin o\ in in c o\o c 3 o 5 oo q" d d o' d o' d d d oiod m o ^J* in 04 *o O\ co OI ro co co i co O O\ -" Ox d d o_^ d\d c 5^ i 5 d I ? 0? tCofofof ^f *^ O~inof vo" \O"oo" u ? c o~ <&- &r ^ ^Q ^ h n 04 ^ <- to 23 83- ^ ^2 . CO 'jj ^ G* I CD o o u :"3 to ^ ^ rt O ( "ij U '5 3 c"5 'cO o ." i ^o jj'ZJPQ .2*0 O JC/3 3 .. a & ? ti co :| it i i_ 'B.*^ u ] to '3 ^QS-og .a.= nterest i 2 : *i ' g c8 3 IM O i5 4J 5 Ort_- CM i i I.Q _0 2 rt ^ 3 '-5 ^ C rt u > w /?0 -0 ^Pn S '35 2 S ,0 - fe g c^ 2 oo occOj_ ( vn | u toI2 ^ ^ > '^ o c o -E'co.P. y:: pL,O "S" "o * O " Franklin Castle St. Martin Hall....J (f) 2,500.0O 3,231.00 2,850.70 I,550.OO " Janitors' Supplies Co.. 45.25 Insurance Account.. . (c) 920.10 Karl Smith, Drawings (d) 16,930.00 Cash Shortage (e) 380.00 Salaries 12,140.00 Office Expense 3,130.00 Furniture and Equip- ment 4,150.75 $40,307.50 $40,307-50 PRACTICAL PROBLEMS 531 Notation by the accountant : (a) Remittances on account of collection of October rents, paid in advance upon signing lease, not as yet credited to the principals. Settlements to be made on the 2Qth of every month. (b) Balances representing payments from March to June, 1916, for advertising, decorating and supplies, for the account of managed prop- erties. Paid bills cannot be found; no details available ; itemized receipted bills asked for by letter; no answer at September 30, 1916. (c) Premiums on fire insurance placed by agent for account of sundry clients not principals. Premiums will be paid to agent if risk is ac- cepted and he will deduct commissions of from $% to 15% from settlement with companies. (d) Probably contains charges which might properly be capitalized under caption "Furniture and Fixtures" if positive information were available. (e) Entries made in cash book by accountant for rent collections appearing in monthly statements to principals, but not appearing in cash book nor in duplicate of bank deposits obtained from banks. (f) According to the terms of his employment the agent must remit on the fifth day in every month. Prepare the trial balance of the general ledger of Karl Smith as corrected by the accountant. Divide the said statement into two distinct parts, one showing what belongs to the agent, the other showing what belongs to the principals. 532 PRACTICAL PROBLEMS PROBLEM VI To illustrate one of the methods of passing from the copartnership to corporation, and the recording of the trans- actions incident thereto. (See Chapter XXII.) The Smithers-Jones Company is incorporated tinder the laws of the State of New York to acquire and conduct the business of the firm of H. B. Smithers and T. Jones. The authorized capital stock of the company is $800,000, di- vided into $450,000 of preferred stock and $350,000 of common stock, of the par value of $100 per share for both stocks. The preferred stock is entitled to receive a 7% dividend before any dividends are paid to common stock; but after the latter has received an equal dividend, both classes of stock shall participate equally in the balance of surplus declared as dividends to be distributed. The pre- ferred stock is preferred as to assets. The following assets and liabilities of Smithers and Jones, acquired and assumed by the Smithers-Jones Com- pany, appear on the books of the vendor at January 31, 1917: Assets Land $50,000.00 Liabilities Mortgage Payable $32,500.00 Building 150,000.00 Accounts Payable 110,023.00 Transportation Equip- Notes Payable 16,500.00 ment 10,000.00 Reserve for Deprecia- Furniture and Fixtures 5,000.00 Machinery and Tools 72 ooo oo tion of Physical Property 51,300.00 Goods in Process 68,195.00 Capital of Partners 350,000.00 Finished Goods 51,830.00 Materials and Supplies 22,650.00 Accounts Receivable... 114,648.00 Notes Receivable 16,000.00 $560,323.00 $560,323.00 PRACTICAL PROBLEMS The price which the corporation has agreed to pay for the properties taken over is $500,000, which is to be paid in stock of the corporation to the three partners of the vendor firm in the proportion in which they have divided their profits in the past, i.e., H. B. Smithers, ^ ; T. Jones, ft\ X. Vreeland, ft. The stock is issued on February 2, 1917, and at their meeting of February 15, 1917, the directors of the com- pany decide to carry the value of the land at $70,000; the building at $160,000; the transportation equipment at $13,000; the furniture and fixtures at $7,000; the machinery and tools at $80,000; these increases are based on the pres- ent replacement value of the properties affected. The re- serve for depreciation is to be carried at a figure decreased in the amount of the increases of the book value of the physical assets other than land. The balance of the purchase price is to be set up as good- will, to cover the firm's name and the good-will it conveys, in addition to trade-marks and patents written off by the copartnership in the last five years to the extent of $17,000, their original value. Required : Explicit journal entries recording the above facts on the books of the Smithers- Jones Company. PROBLEM VII To illustrate a second method of passing from copartner- ship to corporation, and the recording of the transactions incident thereto on the books of the vendee and the vendor. (See Chapter XXII.) 534 PRACTICAL PROBLEMS The firm of Bowman & Turner, including J. Vermont as a silent partner, decides to sell out to the International Novelty Company, which the partners have incorporated with an authorized capital stock of $200,000, divided into 700 shares of 6% cumulative non- voting preferred stock, and 1,300 shares of common voting stock, all of the par value of $100 per share. The preferred stock is preferred as to assets. The contract of sale refers only to fixed assets and work- ing and trading assets, the copartnership having agreed to liquidate its current liabilities. The balance sheet of the vendor firm shows at September 30, 1916: Cash $i 1,254.00 Accounts Payable. . . . $4=;,6'^.40 Accounts Receivable... 39,616.00 Notes Payable 11,000.00 Notes Receivable 7,000.00 \Vages Payable 1,234.60 Finished Goods 5,320.00 T. S. Bowman 75,000.00 Goods in Process 20,040 oo S D Turner 4=1,000.00 Materials and Supplies 25,600.00 J Vermont . . . 40,000.00 Furniture and Fixtures 3,800.00 Shop Tools 6,540.00 Machinery and Machine Tools 38 700.00 Land, Factory, and Equipment 60,000.00 $217,870.00 $217,870.00 The price agreed upon as between the copartnership and the corporation is $194,000, which is subject to the follow- ing agreement : J. Vermont, special partner, whose investment has, in the past, netted him 6% per annum, will receive 6% non- voting preferred stock; T. S. Bowman and S. D. Turner are to have equality in the management of the corporation. The excess price to be paid by the corporation over the net worth of the assets transferred by the copartnership is to PRACTICAL PROBLEMS 535 be settled in bonds of the denomination of $500 each, due 1932, bearing interest at 6%, interest and principal to be secured by a mortgage on all the property and equipment. The general partners only are to share in the salable value of the good-will. Required : 1. The expression, in journal entry form, of such of the above facts as concern the corporation. 2. The journal entries necessary to close the books of the copartnership. PROBLEM VIII To illustrate the effect of careless accounting upon the books of corporations which have been created for the pur- chase of copartnerships. (See Chapter XXII.) A and B were copartners in a newspaper publishing business, sharing profits and losses equally. A trial balance of their general ledger at December 31, 1916, was as follows : Operating Expenses (less earnings) $1,343-89 A's Investment Account (representing losses over and above capital contributed) 1, 5*9-79 B's Investment Account (representing losses over and above capital contributed) 1,51978 A's Loan Account $6,839.31 B's Loan Account 110.36 General Expenses 281.06 Accounts Receivable 2,012.14 Cash . 273.01 $6,949-67 $6,949-6? 536 PRACTICAL PROBLEMS A and B agreed to sell to the Daily Star Publishing Company, a New York corporation, as of January i, 1917, the newspaper published by them, together with all the assets of their publishing business in consideration of 45 shares, par value $100 each, of the company's capital stock (total issue, $5,000) and $500 in cash, the company to as- sume all the outstanding liabilities of the business carried on by A and B. No new books were opened for the corporation, the books of the partnership having been retained as suitable for the corporate body. No journal entries relating to the assets acquired, liabilities assumed, and capital stock issued, were made. Prior to the establishment of the above trial balance, the company received a check for $500 from one of the incorporators, in payment of subscribers' shares, which was credited in error to A's loan account. The pay- ment of $500 in cash to A and B as part consideration of the business purchased has not been made. Amounts of $6,839.31 and $110.36 due to A and B, respectively, are to be considered as liabilities of the corporation. The debit balances in A's and B's investment accounts and the operat- ing and general expenses shown above, were closed out to profit and loss on the books of the company in subsequent periods. Required : 1. The journal entries necessary to correct the books of the corporation in respect of its capital stock and other accounts; express the facts in view of a possible lawsuit involving your taking the stand as a witness. 2. The trial balance of the books as adjusted by you. 3. All the ledger accounts affected by your adjust- ments. PRACTICAL PROBLEMS PROBLEM IX To illustrate the recording of certain phases of corpora- tion finance, and the difficulty of giving accounting expres- sion to careless resolutions of boards of directors. (See Clmpter XXII.) Two-thirds of the stockholders of the Precision Ma- chine Company, incorporated under the laws of the State of New York, have consented to an issue of bonds by the company. Accordingly, on January 5, 1916, they pass resolutions authorizing the issue, and define the amount, denomination, interest rate, and terms of the bonds, as follows : 200 bonds of $1,000 each, dated January i, 1916, due December 31, 1922, bearing interest at 4 l /2%, pay- able annually on December 31; amount of bonds, $200,000. 200 bonds of $500 each, dated January i, 1916, due December 31, 1924, bearing interest at 4^%, pay- able annually on December 3 1 ; amount of bonds, $100,000. 200 bonds of $500 each, dated January i, 1916, due December 31, 1928, bearing interest at $%, payable annually on December 3 1 ; amount otf "bonds, $100,000. The bonds are secured by a blanket mortgage on the land, factory buildings, factory equipment, and materials and supplies, the conditions of the indenture being such that, as soon as one of the issues of bonds is retired, the share of the mortgage securing it will apply to the unretired issues of January i, 1916. The indenture contains a clause relat- ing to the creation of a sinking fund out of annual profits for the redemption of bonds at maturity. 538 PRACTICAL PROBLEMS In order that the sinking fund provision of the indenture may be properly carried out, the directors of the company, at a meeting held January 8, 1916, resolve that there shall be charged annually to profits as ascertained at December 31, an amount representing 1/7, 1/9, and 1/13 of the par value of the bonds issued, less the amount of interest earned by the sinking fund during the prior period ; that an amount of cash equal to the amount of the reserve shall be set aside annually, and deposited with a trust company at interest; that the interest earned by the fund shall be deposited with the fund and credited to revenue. The board denies itself the right to use the sinking fund for any purposes other than that for which it is created. The board, at the same meeting, resolves that the dis- count and premiums which may be lost or gained on the sales of bonds shall be amortized in equal yearly amounts, throughout the life of the bonds. The bonds were sold during January, 1916, as fol- lows: Issue of 4 l /2% bonds due 1922, sold at 99 " " 4^4% " " 1924, " " par " " 5% " 1928, " " 103 The trust company with which the sinking fund is to be deposited, has agreed to pay thereon 4%. interest annually. Required : 1. The cash book entries for the two years ended De- cember 31, 1916, and December 31, 1917, giving expression to the facts recited by the problem. 2. The journal entries, for the same period, affecting the sinking fund provision of the indenture, and the amortization. PRACTICAL PROBLEMS PROBLEM X From New York C. P. A. Examination of January, 1914* (See Chapter XXIII.) An investment bond house purchases 10 New Jersey Traction Company first mortgage $% bonds at 83^; 10 New Orleans Gas Light and Power Company first mort- gage $% bonds at 104 (accrued interest is not to be considered). Prepare the necessary entries to record properly these transactions on the books of the bond house. PROBLEM XI From New York C. P. A. Examination of January, 1914. (See Chapter XXIV.) A trust company assumes the responsibility of a sinking fund on which it guarantees to pay 3% interest. The trustee receives $103,000 deposited to the credit of the sink- ing fund, and on January i, 1911, invests on a 3% basis in 100 Clair County Light, Heat & Power Company $% $1,000 first mortgage gold bonds, due July i, 1912, interest payable semiannually. Prepare the accounts of the trust company, showing the invested amount and the amortization of the premiums at the several interest periods. Auditing requirements left out. 540 PRACTICAL PROBLEMS PROBLEM XII Showing the effect which the ignorance of the theory of accounts has upon accounting results. Adapted from prac- tical problem in New York C. P. A. Examination of June, 1912. (See Chapter XXV.) The books of Vincent Armstrong at June 30, 1916, show the following : Debits Cash . . . $9,800.00 Credits Brooklyn Terminal Co., Real Estate . . . 3,000.00 (a) $3,000.00 Office Furniture.... 1,095.00 Contracts 1-2-3 (b) 11,850.00 Investments, Stocks Bonds Margin count Receivable Accounts Expense Account . . . 7,650.00 . . . 2,300.00 Ac- . . . 12,000.00 16,000.00 (f) 970000 L. V. Tramways Co... (c) 1,640.00 Consulting Earnings.... 1,980.00 Report Earnings (d) 15,000.00 A.B.C. Stock Brokers. .. 10,310.00 Stocks and Bonds... (e) 2,600.00 Capital 16,250.30 Interest (e) 1.08=; ?o $62,630.30 $62,630.30 The books were kept from June 30, 1915, to June 30, 1916, by three different bookkeepers, and an audit discloses : (a) The account "Brooklyn Terminal Company" con- tains receipts of consulting fees during the first six months of 1916. This is a monthly contract involving no expense whatever to V. Armstrong. (b) "Contracts 1-2-3" are contracts for reports on the engineering possibilities of certain properties. The reports have been rendered and the expenses incident thereto have been credited to expense and debited to the amount received under the contracts. (c) "L. V. Tramways Company" represents $2,000 re- ceived on May I, 1916 (less expenses) on account of a con- PRACTICAL PROBLEMS 541 tract according to the terms of which Armstrong is to act as consulting engineer for 10 months from May i and to receive altogether $5.000. Nothing has been received in June and there are to be no further expenses to Armstrong, the amount incurred in May representing the fee paid to, and the expenses of, an engineer who took Armstrong's place while the latter was incapacitated by illness. (d) "Report Earnings" contains fees received under contracts for reports on properties, the contracts being exactly similar to Contracts 1-2-3. The account represents: 1. Received on account of contracts on which nothing has been done up to June 30, 1916, $8,500. 2. Balance earned. (e) "Stocks and Bonds" represents the credit balance of the general investment account ; all the securities at one time included in this account have been sold. (f) The "Expense Account" is composed of: salary Armstrong, $6,000; other salaries, $1,700; rent, $900; ad- vertising, $700; telegrams, $90; office expenses, $150; other expenses, $160. (g) Interest represents: debits charged by A. B. C. brokers on margin account, $1,300; paid on loans since liquidated, $185.30; credits: dividends on stocks still held, credited by the brokers, $400. (h) From June 30, 1915, to June 30, 1916, there was received as dividends on stocks, $1,750; of this amount $1,000 was placed to the credit of stocks still held at June 30, 1916; the balance went to the credit of general invest- ment account "Stocks and Bonds." Required : Journal entries necessary to adjust the books of Vin- cent Armstrong and make them conform to account- ing principles. PRACTICAL PROBLEMS PROBLEM XIII To illustrate the necessity of analytical accounting, and the accounting meaning of terms "Book Value," "Replace- ment Value," "Depreciated Book Value," "Providing for Reserves by Reappraisement." (See Chapter XXXII.) An analysis of the "Property, Plant, and Equipment" of a corporation which began business January I, 1914, reveals the following at December 31, 1916: Total book value of the account $1,011,340.00 Analysis : Land Cost $50,000.00 Buildings Book Value 575,000.00 4 factory buildings, built of stone and brick, costing each $140,000, erected in 1914, estimated to last 35 years ; not depreciated ; 3 store houses valued at $5,ooo each, built of wood and tin ; erected in 1914, estimated to last 10 years ; not depreciated. Factory Equipment Cost 45,000.00 Boiler Plant, costing $16,000, installed in 1914, not de- preciated. Power Plant, costing $18,500, installed in 1914, estimated to last 15 years ; not depreciated. Belting, Shafting, Pulleys, costing $10,500, installed in 1914, estimated to last 10 years; not depreciated; no charges to account other than cost. Machinery Book Value 320,000.00 40 machines as follows : 20 Universal standard machines, cost, $10,000 each, purchased new in 1914, estimated to last 15 years, with residual value of $2,000 each. Not depreciated. No charges to account other than cost. 15 Special machines, average cost, $7,500 each, con- structed in 1914 for the requirements of the factory; estimated to last 10 years, with residual value of $500 each and minimum annual repairs of $100 per machine; $500 charged to income in 1915-1916 for repairs on all these machines. Not depreciated. These machines are subject to being discarded long before their estimated life, if better machines are invented for the line of work PRACTICAL PROBLEMS 543 which they do. Experience has shown that machines of this kind become obsolete about every five years, and have a residual value of $150. 5 Second-hand machines, cost, $1,500 each, acquired in 1915, estimated to last 5 years, with a residual value of $60 each. Machine Tools Book Value 12/31/16 14,000.00 Original cost, 1914, $18,000; written off the account in 1915, $2,000. In 1916, $2,000, when issued to factory. In 1916, purchases amounting to $5,340 were charged to fac- tory expense. Shop Tools Book Value 12/31/16 7,340.00 Issued to factory, credited to Tools account, and charged to factory expense : 1914 $1,450.00 1915 1,840.20 1916 1,530.40 Purchased in 1916, and charged to factory expense, $2,130.20. Sundry items of equipment, amounting to $1,390, charged to factory expense when acquired in 1915. $1,011,340.00 An independent appraisal has been made at the same time as the investigation. The appraisal, as recapitulated by the appraisers, shows the following results : Replacement Depreciated Value Value 12/31/16 12/31/16 Buildings Stone, Brick and Steel $568,000.00 $560,000.00 Buildings Frame and Tin 17,000.00 12,000.00 Boiler Plant 17,500.00 14,500.00 Power Plant 19,000.00 17,000.00 Belting, Shafting and Pulleys 12,000.00 9,000.00 Machines Universal Standard 203,000.00 200,000.00 Machines Special 114,000.00 93,000.00 Machines Other 8,000.00 5,100.00 Machine Tools 23,000.00 20,800.00 Shop Tools 9,450.00 7,000.00 Other Equipment 1,500.00 950.00 $992,450.00 $939,350.00 544 PRACTICAL PROBLEMS The appraisal company recommends that the book value of property appraised be increased to the replacement value. Inasmuch as some of the work in erecting the buildings has been done by the employees of the company; and as, further, the basing, erecting, and fitting of the machinery, machine tools, and equipment has been done by factory hands with material taken from stores (which facts, how- ever, are not disclosed by the analysis made by the com- pany), the directors realize that their property and plant is probably undervalued. Accordingly, they accept the sug- gestion of the appraisal company, and decide that the ac- count "Property, Plant, and Equipment" is to be divided into its component parts at December 31, 1916, and stated at the replacement value arrived at by the appraisers. Reserves for depreciation are to be created on the basis of the depreciated values, ^ as of 1915, and YZ as of 1916. Required : 1. Journal entries setting up the component parts of the property account on the basis of the com- pany's figures adjusted so as to reflect the true cost of the individual units. 2. Journal entries adjusting the books on the basis of the replacement value, and providing for re- serves for depreciation. PROBLEM XIV From the New York C. P. A. Examination of June, 1898. (See Chapter XXXIII.) The balance sheet of a joint-stock company, January i, 1897, shows the following state of affairs: PRACTICAL PROBLEMS 545 Capital Stock $200,000.00 Creditors Open Ac- counts 16,000.00 Bills Payable 30,000.00 Profit and Loss Ac- count 30,500.00 $276,500.00 Real Estate $50,000.00 Plant and Machinery. . . 85,000.00 Horses and Wagons... 15,000.00 Patents and Good-Will 20,500.00 Inventory 49,000.00 Accounts Receivable... 35,000.00 Cash in Bank 22,000.00 $276,500.00 A year later, January i, 1898, after an audit of the books and accounts, the balance sheet stands as follows: Capital Stock $200,000.00 Creditors Open Ac- counts 17,000.00 Mortgage 25,000.00 Profit and Loss Ac- count : Balance last year $30,500.00 Profit this year 23,400.00 53,900.00 $295,900.00 Real Estate $52,000.00 Plant and Machinery : Balance Jan. I, 1897. . .$85,000.00 Less depre- ciation... 8,500.00 76,500.00 Horses and Wagons: Balance Jan. i, 1897... $15,000.00 Less depre- ciation... 2,250.00 12,750.00 Patents and Good- Will. 20,500.00 Inventory 65,000.00 Accounts Receivable. . . 33,000.00 Agency Investments.. .. 15,000.00 Cash in Bank 21,150.00 $295,900.00 From the foregoing it will be seen that for the year a net profit of $23,400 has been earned, while the accounts receivable are smaller, and the cash balance on hand is less than at the beginning of the year, though no dividend has in the meantime been paid. Prepare account showing what has become of the profits earned. 546 PRACTICAL PROBLEMS X J M O Ox PH -> O I ig .5 .j i -5 a w 3| \H H-* . H . W U ffi M H ,a-i ~ in m w m q q d in in d 8888 8 in d d d d NO in o o tr 01 m co \O 8 88 o do W n ^ t/> rt Sffi o (0 M '& a .2 o o, bc-^ bo T3," 8888 ad do o oo o 8 88 4 ~2 p* 3 CQ W) -a ej '"^^_,^ ^cCww^^v S rr :> :> rt t-l o\^ o "- 1 -4-> O hn 3 * - 1 O .- 43 O &* OJ 43 en U o S3 03 43 S ^ r; c CO J5 CU rt "* S cu 3 O (L> (S 43 ,_, ^ "5 ^2 o\' rt -TI t-i ^ "!=! (U S3 D ' >-, OJ 43 O ^ s - S S 5 tft 5 H-> PRACTICAL PROBLEMS PROBLEM XVI Based upon the systematisation of books of account for the purpose of facilitating financial statements, and upon the closing journal entries necessary to group certain facts to be included in said statements. From the New York C. P. A. Examination of June, 1912. (See Chapters XXXV, XXXVII.) The following balances are taken from the books of the Roberts Manufacturing Company of New York City, on December 31, 1910: Inventory of Finished Goods (January i) $3,684.57 Inventory of Raw Materials (January i) 11,392.76 Purchases of Raw Materials 62,519.85 Sales 217,387.42 Wages 109,317.88 Rent 19,500.00 Discounts Received on Purchases 375-6o Discounts Allowed on Sales 186.36 Power, Light, and Heat 8,710.64 Light and Heat for Office 168.00 Repairs 1,090.00 Packing 2,017.00 Factory Expense 3,270.00 General Expense 5,230.00 Factory Insurance 1,050.00 General Insurance 7SO.OO Machinery and Plant 12,350.00 Tools 2,600.00 Commissions 7,642.00 Office Salaries 9,700.00 Salesmen's Salaries 8,930.00 Interest on Loans 440.00 Loans Payable 22,000.00 Discount Lost I2ao Notes Receivable 130,000.00 Notes Receivable, Discounted 8,000.00 Notes Payable 19,500.00 Accounts Receivable 101,026.00 548 PRACTICAL PROBLEMS Accounts Payable 30,020.00 Office Furniture 1,100.00 Furniture and Fixtures 1,950.00 Cash on Hand 1,825.00 Cash in Banks 26,467.00 Returned Sales 276.00 Capital Stock 200,000.00 Reserve for Depreciations 3,236.98 Reserve for Bad Debts 5,727.00 Freight and Cartage Inward 727.00 Stable Expenses 2,750.00 Horses, Wagons and Harnesses 8,500.00 Postage and Expressage 1,250.00 Superintendence 3,500.00 Taxes 250.00 Good- Will 10,000.00 Stationery and Printing 1,080.00 Advertising 8,630.00 Surplus (1909) 63,753.00 1. Prepare from the above a trial balance arranged in systematic order, so as to facilitate the preparation of fi- nancial or business statements. 2. Draft journal entries for closing the books. 3. Certify your results by a balance sheet. Support the surplus shown by the balance sheet by a statement of income and profit and loss. The following items are to be taken into consideration : Inventories : Raw Materials $16,250.00 Finished Goods 9,386.00 Tools 2,000.00 Office Furniture 1,000.00 Furniture and Fixtures 1,500.00 Stationery and Printing 300.00 Allow for depreciations: on machinery, $%', on horses, wagons and harnesses, 10%. Reserve for bad debts: 3% on accounts receivable only. PRACTICAL PROBLEMS The item for rent, $19,500, is to be apportioned as fol- lows: 53 % for factory, 22% for salesrooms, and 25% for office. The item of superintendence, $3,500, is to be divided, 3/5 to factory and 2/5 to general expense. Based on the application of double-entry principles to the establishment of financial statements introducing the technique of journalising, and the theories which underlie the various forms assumed by the said statements. (See Part V.) Armstrong & Campbell accept the offer made to them by H. Dover on July i, by which he is to invest $25,000 in the business, becoming a special partner, and sharing to the extent of one-fifth in their profits. On July 2 Dover agrees to exert all his business ability towards the welfare of the concern. He pays to the business an addi- tional $5,000 in cash; this is to be treated as additional capital invested by J. Armstrong and A. Campbell equally and is in the light of a payment by Dover to the old partners personally for their services in acquiring the good-will which the business possesses. The value of good-will has been agreed to be $6,000. The new articles of copartnership provide that the part- ners shall share in the profits to the extent of, Armstrong, two-fifths; Campbell, two-fifths; Dover, one-fifth. No in- terest is to be credited on capital invested. A new bookkeeper has been engaged by the firm, and at July 31, 1916, he presents the following trial balance: 550 PRACTICAL PROBLEMS TRIAL BALANCE, JULY 31, 1916 Debits Cash $45,961.90 Land and Building 6,000.00 Furniture and Fixtures. 975 .00 Horse, Wagon and Har- ness 3,150.00 Good- Will 6,000.00 Merchandise Inventory.. 59,843.04 Freight Inward on Pur- chases Sold 662.80 Freight Inward on Pur- chases Unsold 95.90 Trade Discount Cus- tomers 1,614.60 Allowances on Defective Sales 307.20 Freight and Cartage, Outward 101.50 Heat and Light 6.40 Stable Expenses 112.15 Salaries Clerks 160.00 " Partners 100.00 " Salesmen 300.00 Sundry Expense 65.00 Accounts Receivable.... 20,238.67 Notes Receivable 8,200.00 Foreign Exchange 12.30 Legal Expense 60.00 Purchases Merchandise 25,350.30 Sales Returned 2,647.87 $181,964.63 Credits Returned Purchases $1,960.30 Sales 72,105.00 Interest on Bank Bal- ance 22.IO Commission Consign- ment 345-i8 Trade Discount Credi- tors 1,085.50 Allowances on Purchases 241.26 ist Mortgage, Payable 1918 2,500.00 Notes Payable 1 1,400.00 Accounts Payable 10,640.21 J. Armstrong, Capital... 29,265.30 A. Campbell, " ... 27,399.78 H. Dover, " ... 25,000.00 $181,964.63 The following facts are submitted: Inventory, July 31, 1916: merchandise, $28,423.34. Notes receivable; notes outstanding July i, 1916, collected, $9,800; new notes received, $6,000. PRACTICAL PROBLEMS 551 Notes payable: notes outstanding July I, 1916, paid, $26,600; new notes given, $8,000. Consignments all sold, all sales collected ; allowances : No. i, $4.50; No. 2, $6.20; freight on sales: No. I, $30.10; No. 2, $45.02; No. 3, $2.25. Balance due to consignors, remitted. Stable expense 50% applicable to freight and cartage inward ; the balance applies to goods sold. From the foregoing, and from the facts in Problem IV, prepare : 1. The journal entries incident to the admission of the new partner, and to the closing of the books. 2. Statement of income and profit and loss. 3. General balance sheet. 4. Trading and profit and loss account subdivided into sections corresponding to the main groups of facts found in the "Statement of Income and Profit and Loss." 5. Account sales to consignor No. i from March to July, 1916, both inclusive. PROBLEM XVIII From the New York C.P. A. Examination of February, 1910. (See Part V.) The directors of a manufacturing company, before the closing and auditing of the books for the half year ending December 31, declared out of the net earnings of the com- pany, a dividend for the half year of 4% on the preferred stock of $100,000 and 3% on the common stock of $100,000. 552 PRACTICAL PROBLEMS There has been brought forward from the last half year an undivided balance of profit of $4,000 and after the audit of the books the trial balance is found to be as fol- lows: TRIAL BALANCE, DECEMBER 31 Real Estate and Build- ing $32,500.00 Plant and Machinery... 40,000.00 Patents and Good- Will. 80,000.00 Inventory, July 1 29,000.00 Purchases 82,500.00 Labor 88,000.00 Coal 6,000.00 Salaries General 11,000.00 Salaries Management .. 5,000.00 Insurance 875.00 Allowances 6,250.00 Freight 1,500.00 Discount and Interest. . . 750.00 Cash in Bank 8,000.00 Investments 15,500.00 Miscellaneous Expense. . 4,300.00 Book Debts 42,000.00 Preferred Stock in Treasury 5,000.00 Repairs 1,000.00 $459,175.00 Preferred Stock. . Common Stock... Sales Notes Payable Accounts Payable. .$100,000.00 . 100,000.00 . 219,175.00 . 26,000.00 . 14,000.00 $459,175-00 Stock on hand, $26,500. From the above prepare profit and loss and income statement and balance sheet, giving effect in accounts to depreciation at the rate of 7 l /2% a year on plant and machinery, and making an allowance of 5% on the book debts to provide for bad debts; also create a liability in the balance sheet for dividend as stated. PRACTICAL PROBLEMS PROBLEM XIX 553 Introducing one of the methods of merging corporations. From the New York C. P. A. Examination of January, (See Part V .) The Burnwell Gas Company is incorporated on January i, 1910, with an authorized capital of $300,000 (2/3 preferred stock and 1/3 common),* to acquire and conduct the business of the Safety Gas Company, whose general balance sheet shows the following on December 31, 1909: Buildings, Machinery and Equipment $100,000.00 Mains, Conduits, Meters and Connections 70,000.00 Franchises, Rights, Privileges, etc 50,000.00 Materials and Supplies. 15,000.00 Tools and Emergency Equipment 10,000.00 Cash 1 1,800.00 Accounts Receivable. . . 35,200.00 $292,000.00 Notes Payable $10,000.00 Accounts Payable 52,000.00 Capital Stock 200,000,00 Surplus 30,000.00 $292,000.00 On January 15, 1910, all the preferred and common stock of the Burnwell Gas Company was issued to the 20 stockholders of the Safety Gas Company, in exchange for their holdings of stock of the latter company, in the proportion of one share of preferred and one share of common for each share of stock exchanged. At a meeting of the board of directors of the Safety The original problem reads: "All the shares being of the par value of $:oo." As this is unworkable from the point of view of the issue of stock, the problem has been changed to read as above. The error is evidently due to a misprint 554 PRACTICAL PROBLEMS Gas Company, held January 20, 1910, it was resolved to carry out the provisions of a plan of merger in accordance with which the Safety Gas Company was to transfer its assets and liabilities to the Burnwell Gas Company and surrender its charter. A certificate of merger was issued at the close of the meeting. At a meeting held January 31, 1910, the board of di- rectors of the Burnwell Gas Company resolved to open ac- counts on the general books of the company, with the in- dividual assets and liabilities taken over and assumed, at the figures shown by the balance sheet of the Safety Gas Company at December 31, 1909, with the following excep- tions: (a) franchises, etc., to be raised to $70,000; (b) sur- plus not to be carried. As to the January operating transactions, they were recorded in special books, in order that they might be em- bodied at the proper time in the books of the Burnwell Gas Company. Prepare : 1. Chronological journal entries reflecting on the books of the Burnwell Gas Company the different stages of the merger. 2. A journal entry closing the books of the Safety Gas Company. PROBLEM XX To introduce the subject of the holding company, and to illustrate the theory of consolidated balance sheets, (See Chapter XXXVIIL) The Great Eastern Securities Company is organized un- der the laws of the State of New Jersey, "to purchase, hold, PRACTICAL PROBLEMS 555 sell, assign, transfer, pledge, or otherwise dispose of the shares of the capital stock of, or any bond, securities, or other evidences of indebtedness created by, any other cor- poration or corporations of this or any state." The company has an outstanding capital stock of $6,000,000, represented by 60,000 shares of common stock, which has all been subscribed and $0% paid in. In July, 1916, the Up-State Electric Lighting Company, doing business in the State of New York and capitalized at $1,000,000, of which $200,000 is preferred stock, and having an outstanding issue of $500,000 of 6% bonds due August 15, 1916, finds itself so discredited, owing to bad management and losses due to floods, that it cannot hope to provide funds to retire the issue of bonds at maturity. In the course of the life of the bonds, the Up-State Com- pany has created an adequate reserve for its bonded in- debtedness, which now equals the liability for bonds, but has not been funded. The Up-State Company has a surplus of $175,000, but among its assets there is an investment of $250,000, rep- resenting cost, amortized to par, of 6% sewer bonds of the City of Rochester and Town of Gates. These bonds were defaulted as to principal in 1914, the City of Rochester having disclaimed liability thereunder. The Great Eastern Company, being cognizant of the financial distress of the Up-State Company, offers to pur- chase its whole capital stock outstanding, paying $98 for the preferred and $95 for the common. It also offers to advance to the Up-State Company $500,000 to retire out- standing bonds at maturity, and to purchase at $94 the whole of a new issue of bonds amounting to $500,000, due 1930, to be made by the Up-State Company, and to be secured by the same mortgage now covering the issue to be retired. 556 PRACTICAL PROBLEMS The Great Eastern Company further proposes to ac- quire, at $0% of their face value, the sewer bonds held by the Up-State Company. The purchaser has informa- tion leading to the belief that 50 or 60% of the face value of the securities will eventually be paid to the bond- holders. The negotiations go through, and all these transac- tions take place during the month of August. The whole capital stock of the Great Eastern Company is issued in August. The balance sheet of the Up-State Electric Company at the time of the acquisition of that company's stock by the Great Eastern Securities Company was as follows: Land and Buildings. . .$550,750.00 Machinery, Service Lines and Mains. . . .1,079,380.00 Tools and Supplies 124,350.00 Cash 30,150.00 Investments 250,000.00 Accounts Receivable... 182,750.00 Deferred Charges to Income 7,35O.oo $2,224,730.00 Capital Stock: Preferred $200,000.00 Common 800,000.00 6% Bonds, 1916 500,000.00 Accounts Payable 49,730.00 Surplus 175,000.00 Reserve for Redemption of Bonds 500,000.00 $2,224,730.00 Required : 1. The journal entries expressing the above transac- tions on the books of the Great Eastern Securi- ties Company. 2. The balance sheet of the Great Eastern Securities Company at August 31, 1916. 3. The balance sheet of the Up-State Electric Light- ing Company at August 31, 1916. 4. The consolidated balance sheet of the two com- panies at August 31, 1916. PRACTICAL PROBLEMS PROBLEM XXI 557 Illustrating the technique of the consolidated balance sheet. (See Chapter XXXVIII.) The F. L. Company owns the stock of two operating companies ; the investment stands on its books at $500,000, for which the holding company issued its own stock in the amount of $200,000 of preferred and $200,000 of common, and $100,000 of 5% gold bonds. The authorized capital stock of the holding company is $500,000, $300,000 being preferred; the authorized bond issue is $100,000; the capital stock is all issued, full-paid, and non-assessable. The bal- ance sheet of the operating companies, at the time the hold- ing company purchased their stock, was as follows: Assets Co. X Co. Y Land, Buildings and Realty Fixtures* $50,000.00 $74,000.00 Machinery and Machine Tools 45,000.00 39,000.00 Plant Movable Equipment 10,000.00 7,000.00 Shop and Hand Tools 6,000.00 3,000.00 Furniture and Personalty Fixtures 4,900.00 5,000.00 Office Equipment 1,050.00 1,740.00 Goods in Progress 15,000.00 17,300.00 Finished Goods 7,5oo.oo 11,800.00 Raw Materials 17,000.00 21,850.00 Sundry Factory Supplies 3,500.oo 6,650.00 Investments : Bonds, Company Y 50,000.00 Bonds, Other Industrial Companies 10,000.00 Accounts Receivable 34,850.00 31,580.00 Cash 3,941-00 30,500.00 Demand Notes Company 5,000.00 Accrued Interest: Bonds, Company Y 1,500.00 Bonds, Other Industrial Companies 300.00 Advances Company X 10,000.00 $265,541.00 $259,420.00 Depreciation charged to cost of goods, deducted from the asset in the amount of $9soo. 558 PRACTICAL PROBLEMS Liabilities Co. X Co. Y Capital Stock: Preferred $100,000.00 Common 100,000.00 $50,000.00 Bonds : Principal 150,000.00 Interest 4,500.00 Notes Payable 2,000.00 15,000.00 Advances Payable 10,000.00 Accounts Payable 15,300.00 9,345.oo Surplus : Reserved : For Depreciation of Physical Assets (not charged to cost of goods) 11,300.00 For Redemption of Bonds 7,500.00 For Doubtful Accounts Receivable 1,035.00 637.00 Available for Dividends 37,206.00 11,138.00 $265,541.00 $259,420.00 Required : The consolidated balance sheet of the three companies, established in accordance with the request of the board of directors of the F. L. Company for exact information as to the properties which the latter company controls. PROBLEM XXII Introducing a discussion of the effect of the rulings of the Interstate Commerce Commission upon generally ac- cepted accounting theories and methods. (See Part V.) From the following trial balance after closing and the footnotes attached, prepare the balance sheet of the Blank Railroad Company as at December 31, 1916, in accordance with the rulings of the Interstate Commerce Commission, effective July I, 1914. PRACTICAL PROBLEMS TRIAL BALANCE 559 (l) Investment in Road and Equipment. .$17,900,900 (2) Miscellaneous Physical Property 684,750 Capital Stock: (a) Preferred . . (b) Common . . . (14) Funded Debt $5,000,000 10,000,000 7,348,900 (3) Expenditures on Leased Railway Property 360,000 (15) Accounts Payable. Loans Payable Unmatured Divi- 798,190 500,000 (4) Sinking Funds : (a) ForRedemp- t i o n o Equipment dends Declared.. ( 16) Accrued Liabilities Premiums on Fund- ed Debt 2,300,000 23,050 41 O^O Certificate.. 465,900 (b) ForRedemp- Premium on Cap- ital Stock 2Q.64S t i o n of (17) Land Grants 3OO,OOO Mortgage (18) Reserves i.'Ui.igo Bonds 550,000 Investments : (5) ( a ) Investments in Affiliated Companies . 2,355,000 (6) (b) Other In- vestments.. 306,500 (7) Cash 1,943,900 Profit and Loss.. . . 3,008,072 (8) Deposits and Loans 3,968,600 (9) Accounts Receiv- able 694,000 (10) Materials and Sup- plies 315,000 (ll) Interest and Rents Receivable 360,150 Working Funds in Hands of General and Special Agents 18,410 Rentals Paid in Advance .... I > I 5O Insurance Paid in Advance 5,68o (12) Suspense Account 284,471 Discounts on Cap- ital Stock (net). 18,560 c6o PRACTICAL PROBLEMS TRIAL BALANCE Continued Discounts on Fund- ed Debt (net) ... 39,106 (13) Securities Issued Unsold 2,300,000 $32,662,077 $32,662,077 (1) Credits for abandoned property subsequent to June, 1916, $75,000. (2) As follows: mines, $150,000; hotels and restaurants, $75,000; tim- ber lands, $160,000; land and buildings not used for operations, $250,000; materials leased to others, $49,750. (3) Expenditures represent improvements. (4) As follows: (a) cash, $155,000; securities of other companies, book value, $310,900; (b) cash, $50,000; securities issued by the company (par value), $500,000. (5) Stocks, $1,550,000; bonds, $600,000; notes, $75,000; advances, $130,000. (6) Stocks, $250,000; bonds, $100,000; advances, $36,000; miscellaneous, $10,500. (7) As follows: deposits subject to check, $1,850,000; sight drafts and sight bills of exchange credited to remitters, $75,000; cash in offices, $18,900. (8) As follows : demand loans fully secured, $60,000 ; demand de- posits, banks, $159,000; time drafts receivable, $45,800; time deposits, banks, $800,000; deposits for dividends, $2,300,000; guarantee deposits (contracts for construction), $500,000; de- posits for injuries, $49,800; unsecured loans and bills, maturity less than one year, $54,000. (9) As follows : traffic and car service balances, $609,000 ; due from conductors and agents, etc., $39,800; collectible from U. S. Government (mail), $19,600; individuals and companies, $25,600. (10) As follows: materials in stores, cost, $340,000; depreciation, $25,000. (n) As follows: interest, $210,000; rents, $50,150; dividends declared on stocks owned, $100,000. (12) Contains: remainder of value of property abandoned prior to June, 1916, $201,340; property abandoned subsequent to June, 1916, $75,000; freight claims paid, not investigated so far as other carriers are concerned, $3,ioi ; estimated depreciation on equipment leased, $5,030. PRACTICAL PROBLEMS 561 (13) As follows: bonds, $1,000,000, of which $500,000 are pledged to secure loans; stocks issued and reacquired by purchase, not pledged, $300,000. Not sold, but signed and ready for sale, $1,000,000. (14) As follows: equipment obligations, $1,203,900; mortgage bonds, $5,600,000; miscellaneous, $395,000; long term, non-negotiable notes to affiliated companies, $150,000. (15) As follows: traffic and car service balances, $701,450; audited vouchers unpaid, $42,830 ; wages payable, $50,200 ; miscellaneous, $3,7io. (16) As follows: interest accrued, $11,300; rents accrued, $4,650; taxes accrued, $7,100. (17) Original value of land granted in aid of construction. (18) Unapplied balance of current charges to equalize revenue. Main- tenance of road and equipment, $20,640; injuries, $49,800. Charges to operating expense for depreciation of road, $1,001,- 500; for equipment, $500,000; miscellaneous physical property, $55,000. For redemption of mortgage bonds, $550,000; for re- demption of equipment certificate, $465,900; for addition to property, $350,000; for funded debt now retired, $260,000; miscellaneous reserves not specifically invested, $60,350. PROBLEM XXIII To illustrate the theory of the statement of affairs in connection with sole proprietorship and copartnership and the meaning of the deficiency account. (See Chap- ter XXXIX.) On October i, 1916, John Doe finds himself insolvent. His creditors may agree to allow him to settle his affairs under the provision of the state insolvency laws, as he wishes to do, but they withhold their decision until sub- mission to them of a statement of affairs. John Doe's books show: 562 PRACTICAL PROBLEMS Debits Cash $3,000.00 Credits 1st Mortgage 5%, due Land and Building 40,000.00 Dec. 31, 1916 $26,000.00 Furniture and Fixtures.. 5,000.00 Delivery Equipment 3 ooo.oo Notes Payable (no in- terest) 23 ooo.oo Merchandise Inventory Accounts Payable 71,600.00 Sept 30 32,000.00 Taxes Due 130.00 Accounts Receivable 61,130.00 Notes Receivable (no in- Salaries and Wages Due 315.00 Merchandise 5,140.25 terest) 8,000.00 Interest Accrued on Insurance on Building, Mortgage 260.00 Unexpired 50 oo Capital 32,610.15 Advertising Unexpired.. 100.00 Salaries 2,620.00 Expenses 4,155.40 $159,05540 $159,05540 The personal debts of John Doe amount to $625, rep- resented by the following : Due to Butcher $75-OO " " Grocer 89.40 " " K. T. Realty Co. for rent 350.00 " " Constant & Sinclair, Dry-Goods 110.60 $625.00 His personal property is as follows : One Horse, valued at $250.00 One Surrey and Harness, valued at 350.00 25 shares of Golden Horn Mining Co., par, $50. . . 1,250.00 Cash in Southern Bank 51 1.30 $2,361.30 In due course of time the following 1 appraisals are ob- tained : PRACTICAL PROBLEMS 55- Land and building, $42,000; furniture and fixtures, $3,000; delivery equipment, $2,100; merchandise in- ventory, $25,000. The accounts receivable are found to be : Good, $29,600; doubtful, $15,650; uncollectable, $15,880. It is estimated that the doubtful accounts may realize $4,500 ; the notes receivable will prob- ably be met at maturity; advertising contracts are lost; insurance refund will approximate $17.10. As to personal property : The delivery equipment will realize $400; the market value of the Golden Horn stock is $40 per share. Required : A statement of affairs and a deficiency account. PROBLEM XXIV From the New York C. P. A. Examination of January, 1906. (See Chapter XXXIX.) The Parker Construction Company is unable to meet its obligations and is forced into liquidation. At the time the receiver takes charge of its affairs, the following trial balance is prepared from the company's books : Cash $500.00 Land and Buildings 10,000.00 Mortgage on Land and Buildings $8,000.00 Plant and Equipment 20,000.00 Creditors 59,400.00 Completed Contract Accounts (Losses) 18,000.00 Capital 50,000.00 564 PRACTICAL PROBLEMS Uncompleted Contract Accounts (Outlay) 30,000.00 Debtors' Accounts for Completed Contracts 6,000.00 Securities Acquired in Settlements 15,000.00 Inventory of Materials 2,000.00 Expenses 6,500.00 Profit and Loss (Deficiency) 9,400.00 $117,400.00 $117,400.00 The sureties on the unfinished contracts estimate that a further outlay of $20,000 will be required to complete the work and realize the contract price of $40,000, and their offer to take over the materials on hand for $1,500, as part of said cost, is accepted by the receiver. Of the securities acquired, $5,000 is pledged to secure $11,000 due creditors, and $10,000 is pledged to secure $9,000 due credi- tors. The company owes for taxes on real estate, $100, and for salaries and wages of employees, $1,200, which sums do not appear on the books. The company has dis- counted customers' notes for $3,000, of which subsequent advices indicate that $1,000 will be dishonored, and a debtor owing $1,500 on unsecured account has failed and disap- peared. It is estimated that the amount realized on land and buildings will be sufficient to satisfy the mortgage only, and that plant and equipment will realize only 60% of the book value. Prepare a statement of affairs and deficiency account. PROBLEM XXV From the New York C. P. A. Examination. (See Chap- ter XXXIX.) The Republican Asphalt Contracting Company is forced into liquidation ; and the receiver, when taking possession, finds the books of account to show : PRACTICAL PROBLEMS 565 Liabilities Bills Payable $18,000.00 Creditors' Open Accounts 75,500.00 Mortgage on Real Estate and Improvements. . . 17,500.00 Mortgage on Contracting Equipment 7,000.00 Capital Stock Subscribed $100,000.00 Less Not Paid Up 2,500.00 97,500.00 $215,500.00 Cash in Bank and Office $700.00 Bills Receivable 4,300.00 Debtors' Accounts 8,200.00 Bonds and Warrants 23,000.00 Real Estate and Improvements 35,000.00 Manufacturing Plant 24,000.00 Contracting Equipment 14,000.00 Uncompleted Contracts (Cost) 41,000.00 Inventory of Materials^and Supplies 3,500.00 $153,700.00 The bondsmen on the unfinished contract estimate that an expenditure of $25,000 will complete the uncompleted contract and realize the contract price of $60,000, and their offer of $2,750 for the inventory of material and supplies as part of said expenditure, is accepted by the receiver. The company owes for personal taxes and adjustment of em- ployer's liability premiums, $175 and $100, respectively, and unpaid labor accounts amounting to $1,700, which amounts do not show on the books of account. The bills receivable, amounting- to $4,300, are pledged as collateral for $3,500 due creditors, and $20,000 of the bonds and warrants have been given as security for $33,000 due creditors. $1,000 of the bills receivable is subsequently dishonored. The receiver finds that $1,100 of the debtors' accounts is collectable. The sale of real estate and improvements (book value of $35,000) realizes $32,500; manufacturing 566 PRACTICAL PROBLEMS plant, 40% of the book value; contracting equipment, 35% of book value. Prepare a statement of affairs and deficiency account. PROBLEM XXVI From the New York C. P. A. Examination of June, 1907. (See Chapter XL.) The Fox and Dix Company, a close corporation, became embarrassed through the failure of a friendly company to whom they had given their accommodation paper, and a trustee was appointed February I, 1906, to take charge of their affairs for the benefit of the creditors. The condition of the estate, when the trustee took charge, was as follows: Liabilities Mortgage on Real Estate, maturing February i, 1907 $15,000.00 Interest, due February i, 1906, six months, at 5% 375-00 Taxes Due 210.00 Book Accounts Payable 3,900.00 Bills Payable (including accommodation paper, $56,000) 57,400.00 Capital Stock 40,000.00 Surplus, per profit and loss account 3,987.00 $120,872.00 Assets Cash on Hand and in Bank $650.00 Merchandise (stock of goods) 25,310.00 Book Debts (including accommodation account, $56,000) .... 60,800.00 Bills Receivable 4,112.00 Real Estate 30,000.00 $120,872.00 PRACTICAL PROBLEMS 567 In order to complete contracts and so realize to the best advantage on the goods in stock, the trustee purchased mer- chandise to the amount of $50,000, and during the year collected $100,002 cash from sales. The accommodation account was settled for 60%. The other book debts realized $4,100, and the bills receivable, $3,600. Balance, lost. The accommodation paper was settled by paying $40,- ooo cash and renewing $16,000, entailing legal fees, interest, and petty expenses of $2,200. The other bills payable, the accounts payable, taxes and interest on mortgage for eighteen months, were paid in course of settlement, and the principal of the mortgage was paid off at maturity. The running expenses were as follows : clerk hire, $1,500; office expenses, $1,000; allowances to officers, $3,000; trustee's commissions, $3,000. On February I, 1907, the trustee surrendered charge of the company's offices and paid over the cash balances in his hands. On said date there were also uncollected book debts amounting to $2,000, and merchandise stock, $8,000. Prepare a realization and liquidation account, a trustee's cash account, and a balance sheet of the estate at termina- tion of trust. PROBLEM XXVII From the New York C. P. A. Examination of June, 1912. (See Chapter XL,) The following is the trial balance of the Rawdeal Com- 5 68 PRACTICAL PROBLEMS pany, June I, 1911, on which day the directors of the com- pany resolve that the secretary of the company be author- ized to call a meeting- of the stockholders, to vote on the immediate dissolution of the company : Land $15,000.00 Building and Realty Fix- tures 40,000.00 Machinery and Machine Tools 35,000.00 Shop and Hand Tools (in store) 5,000.00 Furniture and Personalty Fixtures 9,700.00 Raw Materials and Freight thereon 10,350.00 Accounts Receivable 23,400.00 Cash in Bank and in Offices 11,320.00 $149,770.00 Bond Secured by Mort- gage* 6% $26,000.00 Interest Accrued on Bond Secured by Mort- gage 312.00 Accounts Payable 21,700.00 Reserve for Depreciation of Building 5,300.00 Reserve for Depreciation of Machinery 8,000.00 Reserve for Depreciation of Furniture and Fix- tures 5,100.00 Surplus 23,358.00 Capital Stock, Author- ized, Issued and Out- standing 60,000.00 $i49,770.oo Building and realty fixtures pledged thereunder. The stockholders' meeting was held on July i, 1911, and the dissolution took place. The company sold the build- ing and its equipment to the mortgagee for $34,000 as of August 15, 1911. On September I, 1911, the cash book showed : Debits : Building and realty fixtures, $7,454; machinery, $25,340; shop and hand tools, $2,100; furniture and fixtures, $3,700; raw materials, $7,950; accounts re- ceivable, $23,130. PRACTICAL PROBLEMS Credits : Accounts payable, $21,700; expenses, $1,530.20. Prepare : 1. The journal entries affecting the dissolution of the company. 2. A statement of realization and liquidation that will show the per cent received by the stockholders on their holdings. PROBLEM XXVIII Based upon the same principles as the preceding prob- lem. From the New York C. P. A. Examination of Janu- ary, 1913. (See Chapter XL.) James Stetson is appointed trustee of the manufactur- ing business of John Brightlawn, for the purpose of rehabilitation. On taking charge he finds that the avail- able assets are : cash in bank, $356 ; accounts receivable : (a) good, $3,712; (b) probably uncollectable, $350. The working and trading assets consist of raw materials, $17,258; sundry manufacturing supplies, $700; finished goods, $8,000; goods in process, $30,945.70. Other assets comprise: machinery and machine tools, $41,000; shop and hand tools, $1,300; deferred debits to manufacturing, $530. The liabilities are as follows: creditors' accounts, $39,700; wages accrued: productive, $500; unskilled, $230. The transactions under the trusteeship are as follows: Loaned by creditors for immediate needs, $7,000. Pur- chased on book accounts: raw materials, $8,300; sundry manufacturing supplies, $9,500. Factory expense: paid in cash, $1,300; incurred as a liability to creditors and sub- sequently liquidated, $2,100. The doubtful accounts re- ceivable proved worthless. Cash paid for : productive labor, 570 PRACTICAL PROBLEMS $16,000; unskilled labor, $2,500; general expense, $8,000; additional shop tools, $609; freight inward, on raw ma- terials manufactured and sold, $60. Interest allowed to creditors on their accounts amounted to $143.10. The trustee advanced $4,300 to John Brightlawn on account of expected profits; the sales of finished goods amounted to $91,000. At the close of the trusteeship, the trustee's books show the working and trading assets to be : finished goods, $11,000; goods in process, $10,450; raw materials, $1,945.70; manufacturing supplies, $395.25. There is be- sides an amount of $750.10 representing factory expenses unapplied. The creditors' accounts show a balance of $1,650.30, while the uncollected accounts receivable amount to $2,975.36. The shop and hand tools amount to $1,609. Prepare an account which, while respecting the fidu- ciary character of the relations of the trustee and of the proprietor of the business, will reflect logically and clearly the result of J. Stetson's administration. PROBLEM XXIX To introduce the legal requirements of the bankruptcy schedules. (See Chapter XXXIX.) On July I, 1916, John Doe petitions the Court, asking to be adjudged a voluntary bankrupt. The facts embodied in the required schedules which he presents to the Court are as follows: Statement showing trial balance of the books of John Doe at June 31, 1916, and the estimated worth of assets: PRACTICAL PROBLEMS Assets 571 Trial Estimated Balance Worth Cash on Hand $1,000.00 $1,000.00 Cash in Banks 5,830.40 5,830.40 Accounts Receivable 42,540.20 35,000.00 Land and Building 60,000.00 50,000.00 Machinery and Machine Tools 31,500.00 15,000.00 Shop Tools 3,700.00 1,100.00 Notes Receivable 5,000.00 5,000.00 Furniture and Fixtures 4,000.00 1,900.00 Patents 10,000.00 3,000.00 Stationery and Printing (books of account and records in use) 380.00 380.00 Transportation Equipment 2,350.00 1,500.00 Materials and Supplies 17,000.00 9,000.00 Goods in Process (materials only) 39,700.00 22,000.00 Finished Goods 21,500.00 20,000.00 Wages 1 1,150.40 Selling Expense 3,100.00 Factory Overhead 2,150.00 General Administration Expense 7,930.00 $268,831.00 $170,710.40 Liabilities Trial Balance Capital and Profits $60,500.00 Mortgage Payable, December, 1916 40,000.00 Accounts Payable i37,975-6o Wages Payable 3,150.40 State Taxes Due 205.00 Notes Payable 19,000.00 Reserve for Depreciation of Machinery and Tools 5,000.00 Reserve for Depreciation of Building 3,000.00 $268,831.00 Inventory of the personal property and debts of John Doe at June 31, 1916: 572 PRACTICAL PROBLEMS Stock 25 shares of Mex- ican Mines market value $1,000.00 (Par value, $50.) Household Furniture: Kitchen Utensils, esti- mated worth 150.00 Other Furniture, esti- mated worth 1,500.00 Library, estimated worth. 400.00 Wearing Apparel includ- ing S. N. G. uniforms and equipment Jewelry, estimated worth. Cash in House Cash in Bank Saddle Horse and Equip- ment, estimated worth. 580.00 250.00 75.00 1,210.00 395-00 $5,560.00 Due for Rent K. Ostengo. $200.00 Due for Groceries J. Al- brecht 50.00 Due for Meat P. Sohmer. 25.00 Due for Wearing Apparel S. Trotter 75.00 Due to Clubs, for Mem- bership 80.00 Due to Housekeeper, wages I month 50.00 Due to Valet, wages I month 50.00 Due to City Stables, keep of Saddle Horse 65.50 $595-50 John Doe discounted in June, 1916, $4,000 of notes due August, 1916, and indorsed two notes of B. Burns, amounting collectively to $800, due September, 1916. Required : Summary of debts and assets to be submitted to the Court, made in accordance with requirements pre- vailing in such cases. PROBLEM XXX To introduce the theory of the accounts of executors. (See Chapter XLL) PRACTICAL PROBLEMS M. T. Fordham's will named A. Abner as his executor. Fordham died May i, 1916; his will was duly probated, and on May 10, 1916, the Court issued to A. Abner letters testamentary. Prior to the receipt of said letters, Abner paid $475 for the funeral expenses of the deceased. Soon after qualifying as executor, Abner filed with the Surrogate of the County of New York the following in- ventory of the assets, established as of May 10, 1916: 1st Mortgage, 6%, due July 10, 1916, on Land and Building of S. Turner, which is located at iSist St., Bronx $5,000.00 Interest accrued thereon 250.00 Note Receivable, J. Simpson, dated March 26, 1916, due May 25, 1916, bearing interest, indorsed by J. Spruce 1,100.00 Cash in U. S. Mortgage & Trust Company 500.00 Cash in Dime Savings Bank 110.20 Insurance Policy, New York Life Insurance Company (pay- able to estate) 1,000.00 Salary due M. T. Fordham by Browner & Simplex 350.00 50 shares of capital stock of the Bacillac Company, par $100 (worth par) 5,000.00 Personal Wearing Apparel and Jewelry (appraised) 300.00 Total $13,610.20 The debts amounted to : Due for Rent of Apartment $80.00 Due to T. B. Roe, M.D 210.00 Due to Universal Pharmacy 3I-5O Due to Miss Spence, trained nurse 150.00 Total $471.50 The expenses incident to the death and burial of the testator were: Funeral Expenses $475-OO Legal Expenses in connection with Probate, etc 150.00 Total.. $625.00 574 PRACTICAL PROBLEMS The will provides as follows : Legacy to Miss Anna Fordham, sister of testator $3,000.00 Legacy to Mrs. Mary Fordham, mother of testator 6,000.00 Remainder of the estate to go to George and Ruth Tesley, the testator's nephew and niece. The expenses of the executor amounted to $60.40. Dur- ing the month of June, the Bacillac Company declared and paid a dividend of 6% per share. The executor collected $32.40 interest on bank balances, and sold the stock of the Bacillac Company at $102, paying no commission on the sale, which was to a private party, and incurring no ex- penses thereunder. The mortgage was paid at maturity, with interest. Having collected and paid all assets and debts, as per above, the executor distributed the legacies in accordance with the will, and rendered his accounting to the Surrogate's Court. Required : 1. The schedules required in the final accounting to the Surrogate's Court. 2. The summary statement required in such cases. PROBLEM XXXI Based on the theory of the account of executors. From the New York C. P. A. Examination of January, 1903. (See Chapter XLL) By the will of Henry Palmer, deceased, specific bequests were made to three of his children, viz. : William, $100,000; Mary, $75,000; and Emma, $75,000. A sum of $20,000 PRACTICAL PROBLEMS 575 was bequeathed to charitable institutions, and his eldest son, Henry, was named as residuary legatee. In accordance with the terms of the will all real estate was sold, the amount realized being $75,000. The inventory filed by John Jacobs, executor, was as follows: bonds and stocks, $87,500; bonds secured by mortgages, $135,000; furniture and other house- hold effects, $2,750; cash in bank, $1,237.50. On an accounting 1 the executor's books showed dis- bursements as follows : undertaker's bill and other funeral expenses, $675 ; probate of will, legal expenses, publishing citations, etc., $14,278.75; debts of testator, $10,875.25; stationery, postage, etc., $118.75; improvements on real estate, $750.50; repairs on real estate, $4,860.75; taxes and insurance, $17,505; care of cemetery plot, $350; services of accountant, $1,800; cost of executor's bond, $1,400. Receipts were as follows: sale of bonds and stocks, $86,327; bonds and mortgages paid, $98,915 ; sale of furni- ture, etc., $2,285.75 ! interest on bonds and mortgages, $61,270.50; interest on deposits with trust companies, $1,275.45; rents, $17,250; dividends on bonds and stocks, $37,918.50. The inventory at the date of accounting showed bonds and stocks, $18,755; bonds and mortgages, $30,375; and cash in accordance with the foregoing transactions, in- cluding satisfaction of the specific bequests of the will. Prepare, with due distinction as to principal and in- come, a summary statement of the executor's account, show- ing the amount of the executor's commission and the amount due the residuary legatee. 1HERN REGIONAL UBRARVFACJUTY Yli I tn T"" A