% 
 
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 THE LIBRARY 
 
 OF 
 
 THE UNIVERSITY 
 
 OF CALIFORNIA 
 
 HENRY RAND HATFIELD 
 MEMORIAL COLLECTION 
 
 PRESENTED BY 
 
 FRIENDS IN THE ACCOUNTING 
 
 PROFESSION 
 
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 BERKELEY CALIFORNIA 
 
Digitized by the Internet Archive 
 
 in 2007 with funding from 
 
 IVIicrosoft Corporation 
 
 http://www.archive.org/details/bookkeepingaccouOOcolerich 
 
INTERNATIONAL BUSINESS LIBRARY 
 
 BOOKKEEPING 
 ACCOUNTING 
 
 AND 
 
 AUDITING 
 
 BY 
 
 WILLIAM MORSE COLE, A. M. 
 
 Assistant Professor of Accounting in the 
 Harvard University. 
 
 Graduate School of Business Administratioa. 
 
 NATIONAL INSTITUTE OF BUSINESS 
 
 RACINE - CHICAGO 
 
COPYRIGHT 1914 BY 
 INTERNATIONAL LAW & BUSINESS INSTITUTE 
 
 WHITMAN PUBLISHING CO. 
 RACINE - CHICAGO 
 

 "Ever judge of men by their professions. For 
 though the bright moment of promising is but a mo- 
 ment, and cannot be prolonged, yet if sincere in its 
 moment's extravagant goodness, why, trust it, and 
 know the man by it, not by his performance." — 
 Browning, 
 
 "A lawyer without history or literature is a mechanic, 
 a mere working mason ; if he possesses some knowledge 
 of these he may venture to call himself an architect." 
 ^Sir Walter Scott. 
 
 ivi511300 
 
PREFACE 
 
 One thing which distinguishes bookkeeping and 
 accounting from most other lines of human activity 
 is that they deal with figures which are more or less 
 abstract. One does not handle in bookkeeping and 
 accounting definite things which can be coimted, 
 looked at, examined, and held in the mind's eye 
 while one is thinking about them. One's thinking 
 must be done through the imagination. One must 
 reason and draw conclusions about things which, 
 though real, can be grasped only by the brain; for 
 the accountant cannot cut up every article of mer- 
 chandise and every note into a portion which is 
 investment and another portion which is profit. This^ 
 involves at first a certain amount of hard thinking, 
 but by long practice one may become so familiar with 
 f imdamental principles that for common transactions 
 one reaches right conclusions unconsciously, from 
 force of habit. So one escapes the confusion of try- 
 ing to think about several sets of abstract things at 
 once. That is to say, if the figures themselves are 
 abstract and require on the accountant's part some 
 effort to hold them firmly in his mind, he ought not 
 to be trying at the same time to reason out the 
 method which he shall use in making an entry; for 
 he may find the effort to do two lines of thinking at 
 
 3 
 
4 PREFACE 
 
 once so confusing as to lead to wrong results. The 
 principles of bookkeeping and of accounting, there- 
 fore, should be so thoroughly familiar that they are, 
 for most transactions, matters of second nature. 
 
 Everyone who is not an expert pianist wonders 
 how a skilled performer can work his fingers with 
 such rapidity and hit the right notes with just the 
 right force, hold them for just the right time, and 
 at the same time work the pedals so that no note 
 shall be sustained beyond its due season. It appears 
 as if the pianist were reading the signature to indi- 
 cate sharps or flats, the notes to indicate what keys 
 should be pressed, the value of the notes to indicate 
 the duration, the marks of expression, the keys under 
 his fingers, and the pedals under his feet, all at the 
 same time. This looks like superhuman power. As a 
 matter of fact, of course, the experienced performer 
 is perfectly unconscious, after he has begun to play, 
 of the signature — ^because once in the swing of the 
 key he unconsciously introduces the proper sharps or 
 flats because of long practice — ^lie unconsciously holds 
 the notes the right length of time — because from long 
 practice the sight of a certain type of note produces 
 almost automatically in his fingers the right length 
 of pressure upon the key, — and without his con- 
 sciousness of it the sight of the pedal-mark on the 
 page depresses his feet, or the ring of the notes in his 
 ear results in an automatic pressure of the pedal. 
 The player, in other words, though he appears to be 
 doing many things at once, involving the sight of 
 many things at once, is doing most of his work almost 
 unconsciously, and is governed almost entirely hr 
 the sensation produced in his ear by the automatic 
 
PREFACE 5 
 
 connection between the printed notes and his fingers 
 and feet. The same thing is true of any practical 
 work. Only after we have had much experience 
 in any line of work can we do difficult things 
 easily, but those things which to a novice seem 
 beyond comprehension are matters of commonplace 
 after the wonders of reflex action have had oppor- 
 tunity to work. 
 
 The singular thing about reflex action is that 
 instead of waiting for the nerves to carry a message 
 to the brain, and then the brain to send another mes- 
 sage back to a muscle telling it to move, a short cut 
 has been made directlv from a nerve to a muscle, 
 which causes the muscle to act even before the brain 
 knows what is going on. If, for instance, I move my 
 hand unconsciously against a thistle, before I am 
 really aware of the fact that I am in pain my hand 
 has involuntarily shrunk away from the sharp point. 
 I become aware of the pain practically at the same 
 moment, or even after the withdrawal of the hand, 
 because the nerve which felt the pain sends a message 
 directly to the muscle and causes the hand to be 
 withdrawn at the same time that it sends the message 
 to the brain notifying it of the discomfort. This is 
 the secret, as has been suggested, of all skill, and the 
 bookkeeper is not competent to do rapid work — or, 
 we may almost say, even accurate work — unless the 
 principles to govern his operations are so far a part 
 of his mental equipment that without stopping to 
 think how the thing ought to be done he does it in 
 the correct way. The first step for anyone wishing 
 to learn to be an accountant is, therefore, to master 
 thoroughly the fundamental principles — ^to master 
 
6 PEEFACE 
 
 them so thoroughly that he never has to stop to think 
 what should be debited or what credited in any trans- 
 actions but those which are of an unusual nature. 
 
 This book is intended to discuss all the common 
 principles of accounting as found in normal business, 
 and to make them clear to persons who wish to study 
 them without a teacher. The best teacher is not so 
 much the one who teaches as the one who gives his 
 pupils opportunity and guidance in learning. The 
 learning must be done by the pupil himself. This 
 book professes only to give the opportunity and the 
 guidance. It is undesirable in a book of this tyipe to 
 afford a large amount of practice in bookkeeping or 
 accounting work, for if that were done the pages 
 would be filled with repetitions of similar transac- 
 tions which, though necessary for the beginner, 
 would deprive him of the opportunity to do his own 
 thinking. The common transactions of business are 
 so well understood by everyone above childhood that 
 practice can usually be provided by each student for 
 himself through a very simple exercise of the imag- 
 ination. For instance, one needs to know automatic- 
 ally that a sale of merchandise for cash involves a 
 debit to Cash and a credit to Merchandise; and the 
 student should have come across that transaction and 
 made the proper entry so many times that instinct- 
 ively the sight of the words *^sold for cash" brings 
 up to his mind the words ^ ^ Cash to Merchandise. ' ' It 
 is recommended, therefore, that anyone undertaking 
 to use this book as a means of learning the arts of 
 bookkeeping and accounting construct for himself a 
 large number of imaginary transactions involving, 
 over and over^ all the common transactions. This 
 
PKEFACE 7 
 
 should not be done, however, by outlining a large 
 number of transactions of the same sort following 
 one another in immediate succession. If one writes 
 one hundred transactions of the same sort one after 
 another one is not cultivating the habit of think- 
 ing about them; indeed, one is doing nothing more 
 than training the hand to make entries in the right 
 form; for after the first entry, with a knowledge that 
 the transactions are the same, the brain is not called 
 into play. The proper method, then, of inventing 
 transactions for practice is to alternate them so that 
 very seldom do two of the same sort come together. 
 If a sale for cash is foUow^ed by the issue of a note 
 in payment of a bill, and that by the payment of 
 wages, and that by the borrowing of money, or the 
 payment of a bill in cash, or the receipt of interest 
 money, etc., so that the mind is obliged to jump 
 around from one sort of thing to another with great 
 rapidity, and all these transactions come again and 
 again and again, the mind soon acquires the ability 
 to make the entries by the kind of reflex action 
 already referred to. When one has acquired facility 
 in making these common entries one should attempt 
 to make entries of a peculiar type, beginning with 
 those that are merely unusual, though simple, and 
 then gradually increasing complexity until one has 
 mastered the ready handling of practically all cases 
 that may arise. In the appendix will be found a 
 number of such rather complex cases to illustrate 
 the sort of practice necessary. 
 
 In the first part of the following pages will be 
 found not only a careful working-out of the common 
 transactions of business, each repeated in one form 
 
8 PEEFACE 
 
 or another several times, but an indication, by 
 typical illustrations, of the bookkeeping for less fre- 
 quent transactions. Anyone who has absolutely 
 mastered the principles here expounded — that is, 
 has mastered them so thoroughly that he is not likely 
 to stumble in their application — ^is competent to 
 make the entry for any transaction that he under- 
 stands. 
 
 Accounting principles require somewhat the same 
 sort of practice as that suggested in connection with 
 bookkeeping, though to construct for it situations 
 out of pure imagination is not quite so easy. The 
 reader who wishes to master accounting is recom- 
 mended to invent for himself situations involving 
 the principles expounded in the latter part of this 
 book — such as the distinction between capital and 
 revenue, between one class of expenses and another, 
 between stable values and depreciating values, be- 
 tween values involving only capital and those involv- 
 ing interest and discount. Then such transactions 
 may be made more complicated by the introduction 
 of two or three of these distinctions at the same time, 
 and so on until a high degree of complication has 
 been handled successfully. Students of accounting 
 commonly have the expei^ence of thinking they 
 understand what in reality they do not understand. 
 Often they understand just what they see before 
 them as a problem but fail to see just how big 
 the problem is. Every principle should be worked 
 out in detail, in Hack and white, and the student 
 should accustom himself to thinking exactly how 
 every situation would look upon the books. If all 
 situations desirable to study were presented in type 
 
PEEFACE 9 
 
 in this text-book, the student would be deprived of 
 the valuable practice of working them out for him- 
 self, and would become better accustomed to seeing 
 them in type than to seeing them in his mind's eye. 
 He should, therefore, in thinking of situations de- 
 scribed in this book, try to see how each would look 
 in books of account, and then he should write the en- 
 tries for himself. As he reads the text, he may then 
 see whether the facts there mentioned apply to the 
 situation that he has put before himself. If not, he 
 should go back and see what is the discrepancy be- 
 tween the situation he has recorded and that de- 
 scribed. Then he is in a position to try the conclu- 
 sions suggested in the book with the actual figures 
 before him. This method fixes in his mind the 
 appearance on the books of all common situations 
 and enables him in practice to recognize at once the 
 things which he has here been studying theoretically. 
 This should be done particularly for things that are 
 here discussed but not worked out in detail in the 
 printed form. 
 
 For the interpretation of accounts the best prac- 
 tice is to get hold of the reports of corporations and 
 partnerships, though the latter are seldom published, 
 and attempt to read between the lines — to see, for 
 instance, why each particular kind of asset was in- 
 creased or decreased from one year to another, from 
 what source the assets were increased and the liabili- 
 ties decreased, or how it happened that the assets 
 were decreased or the liabilities increased. Wherever 
 statistics can be obtained to show the detailed opera- 
 tions of any company, as is always possible with 
 railroads, the attempt should be made to relate those 
 
10 PEEFAOE 
 
 operations to the income sheet and to the balance 
 sheet so that one may see how far the various parts 
 of a report are consistent and what light each part 
 throws upon the others. 
 
CONTENTS 
 
 CHAPTEE I. INTRODUCTION 13 
 
 CHAPTER II. DEBIT AND CREDIT 19 
 
 CHAPTER III. THE METHOD OF ENTRY 33 
 
 CHAPTER IV. THE COMMON LEDGER ACCOUNTS. 49 
 
 CHAPTER V. THE PRACTICAL OPERATIONS OF 
 
 BOOKKEEPING 109 
 
 CHAPTER VI. DRAWING CONCLUSIONS FROM THE 
 
 BOOKS 139 
 
 CHAPTER VII SOME HIGHLY DEVELOPED TYPES 
 
 OF BOOKKEEPING 175 
 
 CHAPTER VIII. THE PECULIARITIES OF CORPO- 
 RATION ACCOUNTS 213 
 
 CHAPTER IX. PROPERTY OR EXPENSE ? 239 
 
 CHAPTER X. DEPRECIATION ' 263 
 
 CHAPTER XL PROFITS 281 
 
 CHAPTER XIL THE INCOME SHEET 305 
 
 CHAPTER XIII. THE BALANCE SHEET 315 
 
 CHAPTER XIV. THE INTERPRETATION OF BAL- 
 ANCE SHEETS 331 
 
 XI 
 
12 CONTENTS 
 
 CHAPTER XV. THE DETEEMINATION OF COSTS. . 347 
 
 CHAPTER XVI. SETTLEMENTS BASED ON AC- 
 COUNTS—PARTNERSHIPS, IN- 
 SOLVENCY, TRUSTEESHIPS. ... 375 
 
 CHAPTER XVIL AUDITING 397 
 
 APPENDIX 451 
 
 INDEX 475 
 
ACCOUNTING AND AUDITING 
 
 CHAPTEE I 
 
 INTEODUCTION 
 
 The art of accounting is commonly thought to 
 include only making a record of facts. It chances 
 that as industry has developed in recent years the 
 making of the record is the least important part of 
 the accountant's task. Accountancy is something 
 more than bookkeeping. Bookkeeping is the art of 
 making the record of known facts in such shape that 
 the record can be interpreted and mathematical con- 
 clusions drawn. Bookkeeping, that is to say, assimaes 
 that the fact is known before the records are con- 
 structed. Accounting, on the other hand, is not an 
 art of making records but is the art of learning the 
 facts which bookkeeping is supposed to record. This 
 may be illustrated by a manufacturing business. The 
 bookkeeper records the expenses for raw material, 
 wages, fuel, taxes, rent, interest, insurance, and also 
 the returns from sales of goods. Speaking roughly, 
 a comparison of the two sets of figures gives the 
 profit. This is bookkeeping. The accountant, on 
 the other hand, will desire to know very much more 
 than this. He will desire to know just how much a 
 
 13 
 
14 ACCOUIN'TING AND AUDITING 
 
 dollar's expense in labor has returned in product, 
 how much every dollar's worth of goods sold has 
 cost in the factory, what is the relation between the 
 fuel consumed and the amount of product, whether 
 all the articles produced show the same ratio between 
 manufacturing cost and selling cost, or whether the 
 profit is very much larger on some things than on 
 others, whether the cost of each step in production 
 is greater or less this year than in preceding years. 
 These figures enable him to determine three things: 
 first, what price he can best afford to put upon his 
 product; second, what is the most profitable part of 
 his business and whether any part is unprofitable; 
 third, whether the greatest economy is practiced in 
 obtaining the product. He is concerned also to see 
 that proper allowances are made periodically for 
 changing values: that is to say, he is concerned to 
 see that at proper intervals allowance is made for 
 changes in value of real estate, merchandise on hand, 
 machinery and tools, investments, and innumerable 
 other things which share in the vicissitudes of all 
 things earthly. When these facts have been deter- 
 mined by the accountant, it is a simple matter for 
 the bookkeeper to make them matters of record. 
 Thus it is true, as already suggested, that the ac- 
 countant is concerned with learning facts which are 
 not obvious, and the bookkeeper is concerned with 
 recording both the obvious facts and those which the 
 accountant has ascertained. 
 
 The work of the accountant cannot be made me- 
 chanical, nor can it be taught by any rules which one 
 may commit to memory. It is almost entirely 
 governed by judgment, and judgment is acquired 
 
INTRODUCTION 16 
 
 through experience in actual business or through 
 experience in dealing with imaginary cases which 
 might well arise in business. Not all people have the 
 power of cultivating judgment, for certain qualities 
 of mind are essential. These may be improved by 
 education, but they cannot be created. It is true, 
 however, that even those who have not naturally 
 good judgment may as a result of education become 
 more trustworthy than other persons of natural good 
 judgment who have not taken the trouble to acquaint 
 themselves with the facts of business. It follows, 
 therefore, that though no book can rightly profess 
 to furnish judgment, and so to make accountants out 
 of bookkeepers, study of a good book should make a 
 better bookkeeper, and one who is capable of doing 
 some accounting work, even out of one who is not 
 naturally possessed of good judgment; for so far as 
 the exact problems to arise can be studied in ad- 
 vance, accounting solutions may be provided in 
 advance. So far, however, as problems arising for 
 any accountant are new to him, he must solve them 
 out of pure judgment or from their similarity to 
 other cases of which the solution is familiar to him. 
 It is the purpose of this volume to take up the 
 commoner sorts of accounting problems in the vari- 
 ous forms under which they are likely to arise, 
 and to work them through so as to furnish illustra- 
 tions for most of the simpler cases that are likely to 
 appear in actual business. It is impossible, how- 
 ever, that all kinds of cases shall be covered, for 
 things are constantly happening in business unlike 
 any that ever occurred before — or at least unlike any 
 
16 ACCOUNTING AND AUDITING 
 
 that could have been foreseen and provided for by 
 any teaching. 
 
 The first thing to do in an attempt at education 
 of this sort is to cover the fundamental principles of 
 bookkeeping. These are really only three in num- 
 ber. The first is the distinction between debit and 
 credit, and involves a determination for every entry 
 of the exact responsibility which is involved in the 
 transaction. The second fundamental principle is 
 concerned simply with the kind of account which 
 shall be debited or credited for each transaction; that 
 is to say, not merely the name of the account but the 
 use that shall in the end be made of that account in 
 determining profit and loss and values at the end of 
 any period. The third of these principles is con- 
 cerned merely with the saving of labor in so arrang- 
 ing the books that the minimum amount of writing 
 and turning of pages shall give the maximum in- 
 formation; this is done by providing special columns 
 and special books for special figures, so that they 
 may be handled in totals rather than in small details. 
 When these three principles have been thoroughly 
 mastered, one knows practically all there is to be 
 known about bookkeeping. The remainder of the 
 art consists in applying these principles to the 
 specific conditions found in any particular business. 
 No man can be familiar with all the bookkeeping 
 forms which may be best for all lines of business, 
 for the number is far too great. Yet a man with 
 originality and judgment should be able for any busi- 
 ness to devise a system on the three principles just 
 mentioned. 
 
 When this preliminary study of bookkeeping has 
 
INTRODUCTION 17 
 
 been made we may pass on to take the accounting 
 principles — both those which must be applied in 
 learning the facts for the bookkeeping entries, and 
 those which must be applied in interpreting the book- 
 keeping entries so as to give a final judgment about 
 the profit and value of any business. 
 
 A. & A-i 
 
CHAPTER n 
 
 DEBIT AND CREDIT 
 
 As was indicated in the introduction, one of the 
 three principles that cover the whole of bookkeeping 
 is the fundamental distinction between debit and 
 credit. It must be understood, in the first place, that 
 in order to make properly a debit or a credit one 
 must be sure of the point of view. If Jones buys 
 goods of Smith, and has them charged to his account, 
 on Smith's books they will appear in a fashion 
 exactly opposite to that on Jones's own books; that 
 is to say. Smith's books must show that the money is 
 owed by Jones, but they do not read to show that it 
 is owed to Smith, for Smith's books relate only, of 
 course, to Smith's affairs; but the books of Jones 
 must show that the money is owed to Smith, though 
 they do not need to show that it is owed by Jones. 
 The same transaction, then, will be entered dif- 
 ferently when it is viewed from different stand- 
 points, for always the books upon which it appears 
 are the key note of the situation. Smith's books 
 must show by whom the money is owed to Smith's 
 business, and Jones's must show to whom money is 
 owed by Jones 's business. If, in making an entry on 
 Jones's books we make the error of taking the point 
 of view that belongs to Smith's books, we have 
 misrepresented the facts. The first step, then, in 
 
 19 
 
20 AGCOUNTING AND AUDITING 
 
 any entry is to see in what relation the transaction 
 stands to the business covered by the books on which 
 the record is to be made. It must be understood 
 always that debit and credit are always relative, — 
 that is, that their meaning is not known in any 
 particular case until one knows on what set of books 
 they appear. 
 
 The basis of all entries in the books of account is 
 the accountability of the person or thing named. 
 This accountability may arise from any one of 
 several things, and it may imply either a duty to be 
 performed by the business for the benefit of a person 
 or thing named on the books, or a duty to be per- 
 formed by an outsider, or by a special department of 
 the business toward the business as a whole. A duty 
 to be performed by an outsider, or by a department 
 of the business itself toward the business as a whole, 
 is always called a debit, and is made through what is 
 called a ^^ charge" to the account representing that 
 person or thing. A duty to be performed by the busi- 
 ness for an outsider or for one of the business 's own 
 departments is always a credit. We, in common 
 language, speak of a thing as creditable when we 
 mean that it may be counted in the favor of the 
 person or thing concerned. This is exactly what we 
 mean when, in bookkeeping, we credit an account. 
 We may credit not only when it is our duty to pay 
 for the benefit that we have received, but also when 
 we wish merely to record the fact that the account 
 named has conferred upon the business a benefit 
 which the business will keep for itself. Similarly, 
 in bookkeeping, we debit an account representing a 
 person or a department of the business not only when 
 
DEBIT AND CEEDIT 21 
 
 the benefit, which the business as a whole conferred, 
 must be paid for, but also when we wish merely to 
 record the fact that the account named has received 
 what the business sacrificed. So, in any case, a debit 
 and a credit merely register the fact that an account- 
 ability or a responsibility has been recognized or 
 transferred. Debit means that the account debited 
 is responsible to the business either as a debtor to 
 repay the sum debited, as a repository to accoun<t for 
 property intrusted to it, or as a force explaining the 
 sacrifice of property by the business. For illustra- 
 tion, to debit Jones is to indicate either that he must 
 repay the money as a debtor, or that he has been 
 paid something for a debt which the business owed 
 him and so he must cancel the debt; to debit real 
 estate is to indicate not that the money must be re- 
 turned, but merely that somewhere in connection 
 with the business real property should be found to 
 account for the expenditure of the money; to debit 
 rent account is usually to indicate that the business 
 has sacrificed a certain amount of value because of 
 the fact that men cannot normally use other peoples' 
 property without paying for its use. Similarly, to 
 credit an account is to indicate that the sum must be 
 repaid by the business to the person or department 
 represented by that account, or that the business 
 must show what it has done with the property in- 
 trusted to it on that account, or that the business 
 force represented by that account has conferred upon 
 the business a benefit. Thus, to credit Jones is to 
 indicate that the business owes him or that he has 
 paid something which he owed to the business; to 
 credit real estate is to indicate that the property has 
 
22 ACCOUNTING AND AUDITING 
 
 surrendered to the business a certain amount of 
 value; and to credit interest account is to indicate 
 that the force in business which requires men to pay 
 for the use of others' money has brought in income. 
 To summarize this principle, then, we may say that 
 when any transaction has occurred such that some 
 person or department of the business or business 
 force is responsible for property, whether for the 
 receipt and care of that property or for the loss of 
 that property, we should debit the account represent- 
 ing that person or department or force; when a trans- 
 action is such that any person or department of the 
 business has conferred a benefit on the business as a 
 whole — which is, of course, a creditable thing to do, 
 — we should credit the account representing that per- 
 son, department, or force. 
 
 With this general statement as a starting point, 
 we may now pass on to illustrate the principle with 
 a good many detailed cases and see how it works out 
 in practice. 
 
 If we sell goods on trust, we wish to record on 
 our books the fact that someone is responsible to 
 make payment to us for their value. It is inevitable, 
 therefore, that we shall debit someone, for a debit 
 means that the person named in the title of the 
 account is responsible or accountable to the business. 
 It is customary in naming an account to indicate 
 clearly who or what is connected with the responsi- 
 bility indicated by that account. For instance, in the 
 case just mentioned, we must give to the account a 
 name which wUl indicate not merely the fact that 
 this money is owed by a person, but also in what 
 capacity that person owes the money. It may be 
 
DEBIT AND CREDIT 23 
 
 some other capacity than that of a private individual. 
 If John Jones, for instance, buys goods as a trustee, 
 we should debit not John Jones, but *^John Jones, 
 Trustee,^' to indicate that the claim is not against 
 him as an individual but against him as a representa- 
 tive of someone else. If, on the other hand, he 
 makes the purchase for a society, and has its author- 
 ity to make such a purchase, we should debit the 
 society itself; for to that society we may look for 
 payment. If, again, the purchase is made by John 
 Jones for the firm of John Jones & Company, care 
 must be taken that the debit is made not to ^^John 
 Jones," but to ^'John Jones & Company," for he 
 personally is liable only in case the firm of John 
 Jones & Company fails to pay. The books should 
 show the legal relation between the business for 
 which they are kept and the outside world. 
 
 The relations of a business are much more ex- 
 tensive, however, than merely with outsiders. Of 
 course, looking at the thing in the simplest point of 
 view, the total property of a concern less the claims 
 against it is the present worth of the business as a 
 whole; but if we have no figures on our books other 
 than the total of the property and the claims against 
 outsiders (less the claims which outsiders have 
 against the business), though we may know what the 
 business is worth, we shall not know where to look 
 to find that value. Some of it may be in cash, some 
 of it in merchandise, some of it in notes, some of it 
 in real estate, and some of it, as we have seen, in 
 claims against outsiders. If the books are to show 
 the facts, they ought to show not only what claims 
 we have against outsiders, which are, of course, the 
 
24 ACCOUNTING AND AUDITING 
 
 same as property, but also what kinds of property 
 there are in the business and what is the value of 
 each kind. 
 
 This can be done only if we keep an account with 
 each kind of property, indicating for every entry 
 the value connected with each transaction. That is 
 to say, accounts should show how much cash is on 
 hand, what is the value of real estate, what is the 
 value of merchandise, what is the face value of prom- 
 issory notes, etc. It happens that these facts can 
 be very easily recorded by treating various depart- 
 ments of the business itself as if thay were actually 
 individuals outside the business. For instance, if 
 we treat the cashier's department as if it were an 
 outsider, or as if the cashier were an outsider who 
 had relations with the business, we can show the 
 amount of cash received, for we can charge or debit 
 cash account as responsible for all money entrusted 
 to the cashier exactly as we should charge an out- 
 sider for money paid to him; and if we credit cash 
 account for all money paid out, just as we should 
 credit an outside person who supplied us with cash, 
 the total credit will represent the payments. The 
 difference between the two sides will show the 
 amount of cash that ought to be on hand. In other 
 words, though the cash drawer is a part of the busi- 
 ness, we can best get the figures that we want by 
 treating it on the books as if it were an outside 
 person. 
 
 Similarly, if we debit merchandise account for aU 
 goods purchased, treating it as if it represented an 
 outside warehouse which we had entrusted with 
 goods, our total debits to merchandise account will 
 
DEBIT AND CEEDIT 25 
 
 show the amount of purchases and by so much the 
 amount which the warehouse must be able to ac- 
 count for to the business as a whole; and if we credit 
 merchandise account, representing the warehouse, 
 exactly as if it were outside, the total credits to mer- 
 chandise account will represent the amount which 
 the warehouse has surrendered. The balance will 
 be, if we have debited and credited all goods at the 
 same price, the balance of merchandise that should 
 remain in the warehouse. So we can, by treating 
 departments of the business as if they were responsi- 
 ble for property exactly as outsiders are responsible, 
 secure figures which shall show in detail the distri- 
 bution of the property of the business through its 
 various departments. When, therefore, as assumed 
 a moment ago, we debit John Jones, or John Jones, 
 Trustee, or John Jones & Company, for the sale of 
 goods, we should also credit Merchandise; for the 
 warehouse, represented by the merchandise account, 
 has given up to the business merchandise which has 
 now passed over to John Jones. So, in effect, what 
 has happened is that whereas previously merchan- 
 dise account, representing the warehouse, was re- 
 sponsible to us for certain value in merchandise, 
 now that responsibility has been taken by John 
 Jones and the warehouse has given it up. The books 
 show this exactly as it has happened. There is no 
 longer a responsibility, so far as this merchandise is 
 concerned, on the warehouse account, but one 
 attaches to the account of John Jones. 
 
 One class of accounts representing relations 
 within the business still remains. Sometimes we 
 make payments or receive property in return not 
 
26 ACCOUNTING AND AUDITING 
 
 for other property, such as exchange of merchandise 
 for cash, but on account of some force in business 
 which causes profit or loss. For instance, if we 
 borrow money we are pledged to pay interest for its 
 use. When we pay that interest we pay it not for a 
 thing which can be seen or touched, but merely be- 
 cause there is in our civilization a force which re- 
 quires us to make a payment for the use of other 
 people's property. This payment of interest has 
 not affected the amount we owe on the original loan. 
 If we borrow $1,000 with an agreement to pay six 
 per cent, interest, we pay at the end of two months, 
 when the money becomes due, $1,010, of which $1,000 
 is a repayment of the original sum and the $10 repre- 
 sents no repayment but a mere compensation for the 
 use of the $1,000. Obviously, this $10 cannot be deb- 
 ited to any of the accounts that we have previously 
 considered. It cannot be debited to the man who lent 
 us the money, for he is under no obligation to return 
 it or to account for it. We have owed it to him be- 
 cause of using his thousand dollars, and when we pay 
 it we simply meet our obligation. To debit it to him 
 would be to tell a falsehood on our books, for it would 
 imply that he is now responsible to account for that 
 $10, and he is not. We cannot, on the other hand, 
 debit that $10 to any property account, such as those 
 discussed in the last paragraph, for that $10 does 
 not to us represent any property; it is not cash, nor 
 merchandise, nor real estate, nor notes. It has sim- 
 ply disappeared in consequence of the fact that men 
 must pay for the use of other people 's property. The 
 same sort of thing is true with regard to payments 
 of rent, of taxes, of wages, of postage; indeed, it is 
 
DEBIT AND CREDIT 27 
 
 true of all payments for which we do not get prop- 
 erty in exchange. 
 
 If we did not care at the end of the year to know 
 anything more about our profit or loss than the 
 amount of such profit or loss, th^re would be no need 
 of keeping record of these payments, for, as has 
 already been indicated, the difference between our 
 property and claims at the beginning of the year and 
 the property and claims at the end of the year indi- 
 cates the profit; but if we wish to know from what 
 sources our profits have come, and for what reasons 
 we have suffered certain losses or certain expenses, 
 it is necessary for us to keep a record through the year 
 of the particular forces which have brought income 
 or have caused us to suffer loss and expense. We 
 can keep such records by a process similar to that 
 of keeping account of our property. Remembering 
 that ** debit" means that the account named and 
 debited is responsible, we see that to debit one of 
 these force accounts such as Interest is to hold that 
 force responsible or accountable for the loss of prop- 
 erty. Although it is not true that those forces can 
 usually return to us the property debited, it is true 
 that those forces are responsible for the loss in the 
 sense in which we commonly use ** responsible" in 
 everyday talk. We commonly say that the cold 
 weather is responsible for prevalent sickness, or 
 trusts are responsible for high prices. We can very 
 well use ^'responsibility" in this sense for bookkeep- 
 ing purposes ; and so we make record of the fact that 
 a loss of cash is due to that force in business called 
 * interest," and we debit Interest even though we 
 do not expect that force to return the money. In 
 
28 ACCOUNTING AND AUDITING 
 
 other words, a debit to Interest in this fashion is 
 simply a record of the explanation of the loss of 
 cash, and all debits and credits to such accounts are 
 of the nature of explanations. As has already been 
 suggested, we desire to know at the end of the year 
 not only what our profit or loss has actually been, 
 but what were the sources of profit and the causes of 
 loss. 
 
 Obviously, if we had done nothing throughout 
 the year but exchange property of one sort for prop- 
 erty of another and of the same value, we should 
 neither have made profit nor suffered loss. If profits 
 or losses have resulted, something different from 
 mere exchange at the same price has occurred. We 
 desire to know not only what exchanges have taken 
 place, but also why there has been a difference of 
 value between the property given and the property 
 received. Accounts can furnish us just the desired 
 explanations. Under the head of Interest, for in- 
 stance, they can give figures showing how much cash 
 went out and came in for interest, which is not a 
 tangible thing — though the use of the money bor- 
 rowed or lent may have made possible a profit which 
 will be registered finally in some property account. 
 Similarly, if we have bought merchandise at one price 
 and sold it at another, the difference between the two 
 prices may be shown in some explanation account. 
 
 It will be noted that these explanation accounts 
 never represent value. They show only an amount 
 of change in values. When we paid cash for interest, 
 we were giving something of tangible value in return 
 for a thing which for that particular moment of 
 exchange brought nothing in return — though its use 
 
DEBIT AND CEEDIT 29 
 
 in the past may have brought profit registered in 
 some other account. In the case of a purchase and a 
 sale of merchandise, as we have seen, Merchandise 
 should have been debited for the goods purchased, 
 at the cost price, and credited for the goods sold, at 
 the selling price; the difference between these two 
 amounts will be the profit which must be recorded in 
 some explanation account. Let us say that cash was 
 paid for merchandise bought, and was received for 
 that sold. We can show the meaning of the explana- 
 tion account by supposing both purchase and sale 
 to take place at the same time. Our entries then 
 will be — 
 
 Merchandise, Dr., $3,000 
 
 To Cash, Cr., $3,000 
 
 Cash, Dr., 3,500 
 
 To Merchandise, Cr., 3,000 
 
 To Profit & Loss, Cr., 500 
 
 These three accounts show that merchandise to 
 the amount of $3,000 was received and charged to the 
 warehouse, and later the warehouse surrendered 
 $3,000 worth of merchandise and. was accordingly 
 credited; that cash to the amount of $3,000 was paid 
 out, and later cash to the amount of $3,500 came in 
 and was debited to the cashier's department; and, 
 finally, that the difference between the $3,000 cash 
 going out and the $8,500 cash coming in is explained 
 by the profit and loss account representing gains and 
 losses from the forces of business. In practice, it is 
 common to keep a good many separate accounts for 
 profit and loss, each indicating some special sort of 
 gain or loss, such as interest, rent, insurance, taxes, 
 wages, postage, commissions, stationery, printing, 
 
30 A.CCOUXTING AND AUDITING 
 
 cartage, freight, etc. Some of these represent ex- 
 pense, and are usually debited as responsible; and 
 others represent earnings, and are usually credited 
 as conferring benefit on the business — a creditable 
 thing to do. 
 
 We have seen, then, three kinds of accounts — 
 first, with persons, partnerships, corporations and 
 others, who are entirely outside of the business and 
 have relations of responsibility or accountability with 
 it, in which they are responsible to the business or it 
 is responsible to them; these are usually called per- 
 sonal accounts: second, accounts representing vari- 
 ous departments of the business which contain prop- 
 erty belonging to the business, such as merchandise, 
 real estate, cash, bills receivable, etc. ; these are usu- 
 ally called property accounts: these two classes to- 
 gether are usually called real accounts: ^ third, ac- 
 counts representing forces which cause profit or loss, 
 explanatory of changes in value, such as interest, in- 
 surance, taxes, etc. ; these are usually called nominal 
 accounts, for they represent forces, or names, rather 
 than things. 
 
 When one stops to think of it, one sees that it is 
 impossible ever to have a debit without the need, if 
 the books are to be carefully kept, of a credit some- 
 where to correspond. We have seen that all transac- 
 tions are either mere exchanges of one kind of prop- 
 erty for another, or payments or receipts of prop- 
 erty because of one of the forces in business which 
 calls one to get or give more or less than the exact 
 equivalent. If we do not exchange dollar for dollar, 
 which, of course, yields no profit or loss, we are giv- 
 ing more or less, and therefore, getting profit or suf- 
 
DEBIT AND CREDIT 31 
 
 fering loss; and one of the purposes of our account- 
 ing is to show not only what we get and give, but 
 why we get and give it. If there has been an in- 
 crease or a decrease, some one of the forces which 
 causes increase or decrease has been at work, and 
 our books should show which cause was responsible 
 for the loss or creditable for the gain. It is neces- 
 sary, therefore, that when anything is debited as re- 
 sponsible for value, something else shall be to the 
 same amount credited for furnishing either the value 
 which was exchanged or the force which caused the 
 increase in value; and it is similarly necessary that 
 when anything is credited as yielding value, some- 
 thing else shall be debited as either taking guardian- 
 ship or explaining the origin of the loss. For in- 
 stance, if we credit Cash for a payment of money, we 
 must debit the person receiving the money, the 
 account representing the property purchased with 
 the money, "or the account showing the money lost; 
 if we fail to do this we have not recorded all the facts 
 worth knowing. Similarly, if we debit Cash for 
 money received, we must credit the person furnish- 
 ing the cash, the property account which gave up the 
 property sold for the cash, or the nominal account 
 which explains through what force the cash was 
 earned. This is the origin of double-entry bookkeep- 
 ing. This is all that is meant by double-entry book- 
 keeping — namely, that for every debit there is a 
 credit of the same amount to some one or more ac- 
 counts ; otherwise, the origin of the debit has not been 
 shown and the books fail to record all they should. 
 Single-entry bookkeeping, on the other hand, at- 
 tempts to record usually only the relations of the busi- 
 
3!^ ACCOUNTma AND AUDITIKG 
 
 ness with outsiders, and gives no information about 
 the sources of profit or loss — and sometimes gives 
 practically none about the kinds of property in the 
 business. Since practically all business records which 
 profess to seek accuracy must, from the nature of the 
 case, be kept by double entry in order to tell all the 
 facts, it is to double entry that we shall devote our 
 attention here. 
 
 Let us summarize, finally, our conclusions with 
 regard to debit and credit. To debit is to indicate 
 that the account named, which must represent per- 
 sons, property, or a force, is held by the business 
 responsible for the amount of value indicated by the 
 entry. It does not necessarily mean, however, that 
 the amount is to be repaid; for in the case of a per- 
 sonal account, a previous credit may have indicated 
 that the money was already owed and this debit now 
 show^s merely that the matter is closed, and in the 
 case of a nominal account, the business does not ex- 
 pect the value to be returned because it is recog- 
 nized as one of the definite expenses or losses to be 
 offset against gains at the end of the year. A credit, 
 on the other hand, is an acknowledgment that the 
 account named has conferred certain benefits for 
 which it is creditable. It is not true, necessarily, 
 that the business must ever pay for those benefits; 
 for a credit to a personal account may simply offset 
 a debit previously made, and indicate only that a 
 debt incurred toward the business has now been paid, 
 or, in the case of a nominal account, it may indicate 
 that this force has brought into the business certain 
 income which the business will keep as its own profit. 
 
CHAPTER ni 
 
 THE METHOD OF IJNTRY 
 
 It would be possible to keep books in the form of 
 a diary written in narrative form, just as it is pos- 
 sible for a person to make detailed financial state- 
 ments by word of mouth. It is obvious, however, 
 that, though the facts might be all contained in such 
 a narrative, drawing conclusions from those facts 
 would be extremely difficult. If, moreover, one 
 should happen to miss some important fact in draw- 
 ing one's conclusions or in making a settlement with 
 an outsider, the record might just as well be faulty 
 as to be correct, for an item missed is, for the pur- 
 pose in hand, an item lost. It is essential, then, that 
 the figures shall be brought together so that all 
 items relating to the same thing may be added to- 
 gether or subtracted one from another to produce 
 a correct total or balance. The ultimate destina- 
 tion of all figures in bookkeeping, then, is a book 
 in which the items may be classified according to 
 their relations. This book is in practice always 
 called the * ledger," and it is so arranged that each 
 account has a page (or several pages, or a portion 
 of a page) to itself, and all debits are written in the 
 left half of the space and all credits in the right. 
 The ledger must recognize the principle, stated in 
 the last chapter, that the debit shall be to a title 
 
 A & A-3 33 
 
34 ACCOUNTING AND AUDITING^ 
 
 expressing the exact relation to the business, and 
 not confuse ^^John Jones'' v/ith ^'John Jones, 
 Trustee,'' or with ''John Jones & Company." There 
 may then be three accounts in the ledger all of which 
 represent the relations of the business with John 
 Jones, but each will represent him in a capacity 
 somewhat different from any of the others. By an 
 ''account" we always mean the items to be brought 
 together in the ledger, and hence if for any reason 
 we wish to distinguish items which are apparently 
 of the same sort, we may open separate accounts in 
 the ledger lest they be confused; but always the title 
 finally chosen for any account should be used 
 throughout all the books for all items to be carried 
 to that account in the ledger. 
 
 Since the ultimate destination of all figures is 
 the ledger, we must arrange our books in such 
 fashion that we shall at the same time make clear 
 the meaning of the original record, which is good 
 legal evidence of facts, and keep the items in such 
 form that they can be easily transferred to the 
 ledger without risk of omission or confusion. This 
 is usually accomplished by making every entry in 
 two parts: one is a statement in rough diary form 
 giving the history of the transaction so that it shall 
 be clear to everyone reading it even though he is 
 unacquainted with the transaction itself; the other 
 is a brief summary which gives the names of the 
 accounts to be debited, the names of the accounts to 
 be, credited, and the amounts for each. In the old 
 days, these two portions of an entry were custom- 
 arily kept in separate books, the first of which was 
 
THE METHOD OF ENTHY 35 
 
 commonly called the '^daj book," and the second 
 the '^journal.'' As a consequence, the brief sum- 
 mary formerly kept in the journal has come to be 
 called the ^'journalization." Its purpose is to 
 serve as a medium to assist in transferring from the 
 diary form of the original record to the classifica- 
 tion in the ledger, i. e., in '^ posting." This journaliza- 
 tion would be entirely unnecessary if it were not 
 for the fact that often a transaction is so compli- 
 cated that, in attempting to transfer items to the 
 ledger, i. e., to post, from the diary form, one is in 
 great danger of omitting some item from either the 
 debit or the credit side, or of neglecting some por- 
 tion of a divided item. For instance, if we give cash 
 to pay a bill and to pay a note at the same time, 
 the entry may include a debit to our creditor for 
 the amount of the bill, a debit to Bills Payable for 
 the amount of the note, a debit to Interest for the 
 interest on the note, a credit to Cash for the amount 
 of cash paid, and a credit to Discount for the amount 
 of discount allowed on the bill; that i^, though on the 
 face of it we have only to debit Bills Payable and 
 the creditor, and to credit Cash, we have really in ad- 
 dition to get upon our ledger a debit to Interest and 
 a credit to Discount. It would be practically impos- 
 sible for any bookkeeper to make such postings from 
 a simple diary form of statement and keep up the 
 process hour after hour without many errors of 
 commission or omission. The security against this 
 is journalization of entries in summary form. Such 
 a transaction as that just described might be en- 
 tered in a modern journal as foUows: 
 
36 ACCOUNTTT^G AND AUDITING 
 
 Paid John Doe today his bill of N ovember 18, less 2% 
 discount, and our note dated October 18, with in- 
 terest, at 6%. 
 John Doe $200 
 
 Bills Payable 300 
 
 Interest 3 
 
 To Cash $499 
 
 Discount 4 
 
 As a matter of universal custom, debits are writ- 
 ten in the journal in left columns, and credits in 
 right. 
 
 The form of entry just illustrated makes it pos- 
 sible to keep all details of business transactions in 
 a form not only clear for a statement, but, at the 
 same time, if the amounts stand out prominently, 
 ready for use in posting to the ledger; so far, they 
 are quite as good as any bookkeeping forms need to 
 be. In reality, however, many devices have been in- 
 vented for simplifying the labor of making and find- 
 ing and interpreting entries and of posting from the 
 journalization to the ledger. For instance, it is a 
 great convenience to have all cash items together, 
 not only in the ledger but in the books of original 
 entry, so that all explanations of just what was done 
 with cash and why it was received shall appear 
 together. This is usually done by providing a book 
 into which nothing shall go but cash transactions. 
 Similarly, it is convenient to have together in one 
 book all sales of merchandise, and this is the cus- 
 tom in all but small businesses. The title of such a 
 book is usually the *^ sales book.'' Purchases are 
 very commonly also kept in a book by themselves, 
 which may be called the "invoice book'' or the 
 ** purchase book." 
 
THE METHOD OF ENTEY 37 
 
 It can be readily seen that if items of one sort 
 are kept together, as in a cash book, a sales book, 
 and a purchase book, the labor of posting may be 
 very much simplified. When we make entries in 
 the journal form just described. Cash must be debited 
 by a posting to the ledger for each cash receipt and 
 must be credited by a posting to the ledger for each 
 cash payment ; and at the same time a credit posting 
 must be made to some other account for each debit 
 to Cash, and a debit posting must be made to some 
 other account for each credit to Cash. In other 
 words, fifty receipts of cash would mean one hun- 
 dred postings — fifty debits to Cash and fifty credits 
 to other accounts ; and fifty pajments of cash would 
 mean one hundred postings — fifty debits to other 
 accounts and fifty credits to Cash. "When, on the 
 other hand, we keep all cash items in a book 
 by themselves, we do not need to post to the ledger 
 each individual debit and credit to Cash, but may 
 hold back the postings to Cash in the general ledger 
 as long as we like, provided only we realize all the 
 time that the total of all cash receipts is a cash debit 
 and the total of all cash payments is a cash credit 
 w^hich ultimately must be considered in judging the 
 business. Indeed, if we like, we may wait until the 
 end of the month before we post any item to Cash, 
 and then we may post to each side of Cash the total 
 for the month of all items on that side, instead of 
 the fifty or more separate items to each side. We 
 still have, however, to post the other half of all cash 
 entries, — that is, the debits to other accounts, to ex- 
 plain why cash w^ent out, and the credits to other ac- 
 counts to explain why cash came in. We have not 
 
38 ACCOUNTING AND AUDITING 
 
 reduced the labor of posting^ any account but 
 Cash, but we have reduced that from say fifty 
 postings a month to one. Similarly, if all our Mer- 
 chandise debits are in the purchase book, though we 
 must credit in the ledger each seller with what we 
 have received from him, we do not need to post the 
 debit to Merchandise item by item but may hold 
 back those postings until the end of the month, or 
 such time as we please, and then post them in total 
 as the footings of the page or pages of the purchase 
 book. With the sales book, similarly, the total of 
 the book is the credit to Merchandise, and it may be 
 "posted in a lump sum; but the debits to customers 
 must be posted item by item. 
 
 It is obvious that with a separate book for cash, 
 for purchases, and for sales, our original book of 
 record, the journal, has shrunk to rather insignifi- 
 cant dimensions. The journal still serves an im- 
 portant function because items of interest, discounts, 
 transfers from one account to another, and all other 
 transactions which are not directly cash or merchan- 
 dise, must go upon its pages. 
 
 It is now worth while to observe the forms which 
 are in common use. The journal, nowadays rather 
 insignificant in size, though very important with re- 
 gard to the kind of items which it contains, may be 
 of numerous forms, equally good in theory, but each 
 good or bad according to the needs of the particular 
 'business in which it is used. There is, in fact, no 
 such thing as an absolutely right or absolutely wrong 
 form anywhere in bookkeeping. Any form is right 
 which states clearly the transaction. The choice be- 
 tween forms is determined by the ease with which 
 
THE METHOD OF EI^TEY 39 
 
 each can be handled, and that is determined not 
 merely by its adaptation to speed in making trans- 
 fers or postings to the ledger, but by its provisions 
 against confusion. The form given above, on 
 page 36, in which we have first the detailed descrip- 
 tion of the transaction and then the journalization, 
 is logically the best, for the journalization or sum- 
 mary statement arises out of the detailed description 
 of the transaction. In practice, however, it is usu- 
 ally found a little less convenient to handle than the 
 reverse form, in which the journalization is stated 
 first. The difference lies simply in the fact that 
 items to be posted stand out more distinctly at the 
 beginning of an entry than when they follow an ex- 
 planation. Some bookkeepers may find the first 
 form for their particular eyes more easy to work 
 from. Another form very convenient is one in which 
 the journalization stands in a column parallel to the 
 explanation. This form often saves the rewriting 
 of figures and of names, for the journalization may 
 follow line for line the explanation to which it be- 
 longs. Its defect is sometimes awkwardness of ar- 
 rangement. An illustration of the second form will 
 be found on page 75, and one of the third form on 
 page 41. It should be clearly understood that there 
 is no difference in desirability between these forms 
 except as one of them may prove for any particular 
 bookkeeper easier for him to work from. Usually, 
 in all forms, a blank line, or a line used only for the 
 date, is left between entries. This arrangement 
 makes clear to the eye just how much is comprised 
 in each entry. 
 
 It was common many years ago, and some book- 
 
40 ACCOUNTING AND AUDITING 
 
 keepers still keep up the custom, to use the term 
 *^ Sundries" on a journal whenever more than one 
 item appears on either debit or credit side of an 
 entry. If, for instance, we have a debit to custom- 
 ers and a credit to Merchandise, the entry would 
 normally be made to read: 
 
 Sundries 
 
 To Merchandise 500.00 
 
 David Hume 250.00 
 
 Edward Gibbon 250.00 
 
 This means that the debit is not to one account 
 but to two, and that the equality between debits and 
 credits must be looked for not between the credit 
 and any one debit, but between the credit and a 
 group of debits. The same sort of thing would be 
 true if the matter were reversed. Indeed, the entry 
 may read even '* Sundries to Sundries," when on 
 both sides appears more than one item. Such, for 
 instance, would be the case if we had given cash as 
 well as merchandise to Hume and Gibbon, as follows : 
 
 Sundries 
 
 To Sundries 
 David Hume 600 
 
 Edward Gibbon 600 
 
 Cash 600 
 
 Merchandise 500 
 
 The details would, of course, be explained in the 
 day-book portion of the entry, indicating how much 
 cash and how much merchandise was given to each. 
 
 An illustration of the parallel-coliunn form of 
 journal, without the use of the term ^^ Sundries," is 
 given below. It may well be compared with the 
 original form given on page 36. 
 
THE METHOD OF ENTEY 
 [Journal — Parallel-column form] 
 
 John Doe 
 Bills Payable 
 Interest 
 To Cash 
 To Discount 
 
 DEC. 18. 
 His bill of Nov. 18 
 Our note of Oct. 18 
 On note of Oct. 18 
 Paid as above 
 Less 2% on the bill 
 
 200 
 
 300 
 3 
 
 41 
 
 499 
 4 
 
 It is obvious that wlien we turn to the cash book, 
 which, as was just indicated, contains only cash 
 items, it is unnecessary to provide a complete jour- 
 nalization. The fact that the item appears upon the 
 cash book sufficiently indicates that Cash is either 
 debited or credited. If we divide the cash book it- 
 self into two parts, using left pages, as the book lies 
 open, for debits to Cash, and right pages for credits 
 to Cash, we have by the mere choice of pages indi- 
 cated which are cash receipts and which cash pay- 
 ments. The only journalization necessary, then, is 
 an indication of what account is to be credited when 
 Cash is debited, and what account is to be debited 
 when Cash is credited. The journalization is now so 
 simple that we have only to make a statement of the 
 origin of the receipt and the purpose of the expendi- 
 ture. In order to avoid the possibility of abuse of 
 the cash book, misrepresenting the amount of cash 
 by inserting items out of place, it is desirable to use 
 only one line for each entry. Then there will be an 
 amount carried out in the money column for each 
 line, and the possibility of inserting amounts falsely 
 for the purpose of manipulating the cash balance is 
 removed. Many defaulters have taken advantage 
 of loop-holes left in carelessly kept cash books to 
 make insertions which covered up amounts ab- 
 stracted. Only when entries are confined to one line 
 
42 
 
 ACCOUNTING AND AUDITING 
 
 can one see at a glance that nothing is perverted. 
 The f omi of a double-entry cash book is shown below. 
 Since receipts are always written on left pages, as 
 the book lies open, and disbursements on right 
 pages, the balance on hand is readily shown by sub- 
 traction of totals. 
 
 [Cash Book] 
 
 EECEIPTS. 
 
 Jan. 
 
 3 
 
 
 John Jones 
 
 8 
 
 
 Eichard Hoe 
 
 12 
 
 
 Bills Receivable 
 Stationery 
 
 15 
 
 
 Peter Smith 
 
 22 
 
 
 Bills Payable 
 
 28 
 
 
 Freight 
 Cash, Dr. 
 
 Jan. 
 
 John Doe 
 Henry Esmond 
 Dombey & Son 
 Bills Payable 
 Stalky & Co. 
 Rent 
 
 Commission 
 Cash, Cr. 
 
 Bill Dec. 26 paid 
 
 On account 
 
 Note of Wm. Brown No. 14 Paid 
 
 Envelopes 
 
 Bill Jan. 5 paid 
 
 Borrowed on our note with interest 
 
 Fr 't on ship 't to Rice & Co. repaid 
 
 [Cash Book] 
 DISBURSEMENTS. 
 
 Paid his bill Dee. 26 
 
 '' '' '' Jan. 1 
 
 ** their '' Jan. 7 
 Paid our note of Nov. 15 
 
 '' their bill of Jan. 11 
 Rent for month of January 
 On sales made by Samuel Sanders 
 
 540 
 
 00 
 
 .273 
 
 50 
 
 5000 
 
 00 
 
 5 
 
 25 
 
 1125 
 
 00 
 
 1000 
 
 00 
 
 12 
 
 75 
 
 1 7956150 
 
 725 
 370 
 851 
 1500 
 110 
 125 
 41 
 
 3723 
 
 65 
 
 The purchase booli and the sales book are com- 
 monly similar to each other in form. The only 
 difference between them is that the purchase book 
 contains credits to all creditors and debits to IVCer- 
 chandise, whereas the sales book contains debits to 
 all customers and credits to Merchandise. All that 
 is necessary in the way of a record for each transac- 
 tion is a statement of the creditor's or customer's 
 name, a statement of the terms of purchase, and a 
 list of the goods with the amounts. These amounts 
 are carried out into the money columns with all dis- 
 counts subtracted before the final extension, and at 
 
THE METHOD OF ENTEY 
 
 43 
 
 the end of the week, month, or other desired inter- 
 val, the total is taken to be posted to Merchandise. 
 The precaution that no discounts shall be allowed 
 to get into the extension columns is important; for, 
 otherwise, the total for Merchandise, which is the 
 total of the column, would include not only the net 
 amount of the bill, but the amount of discount, and 
 sometimes the full amount of the bill before the dis- 
 count was taken off. This would magnify the debit 
 or credit to Merchandise and throw the books out 
 of balance and out of accord with the truth. A 
 common form is shown below. 
 
 John Nicholson 
 
 Peter Ibbetson 
 
 Thomas Jones 
 
 Merchandise, Cr. 
 
 [Sales Book] 
 
 Jan. 2. 
 
 Terms 30 d. 
 
 100 lbs. Coffee 
 40 lbs. Tea 
 50 lbs. Flour 
 20 lbs. Chocolate 
 
 330 lbs. Sugar 
 
 Discount 5% 
 
 Terms 6% 10 d. 
 5% 30 d. 
 500 gal. Molasses 
 1500 lbs. Sugar 
 
 Terms 30 d. 
 10 bbls. Flour 
 50 lbs. Coffee 
 200 lbs. Tea 
 
 25 
 
 25 
 
 00 
 
 
 
 50 
 
 20 
 
 00 
 
 
 
 00 
 
 300 
 
 00 
 
 
 
 36 
 
 7 
 
 20 
 
 
 
 05 
 
 16 
 
 50 
 
 
 
 
 368 
 
 70 
 
 
 
 18 
 
 43 
 
 350 
 
 27 
 
 50 
 
 250 
 
 00 
 
 
 / 
 
 04i 
 
 67 
 
 50 
 
 317 
 
 50 
 
 00 
 
 60 
 
 00 
 
 
 
 25 
 
 12 
 
 50 
 
 
 
 50 
 
 100 
 
 00 
 
 172 
 
 50 
 
 
 
 
 840 
 
 27 
 
 Two purposes are to be served in making entries 
 in books. The first is to have a complete record of 
 the transaction which, in any matter of dispute, may 
 be used as good evidence in a court of law; the second 
 is, as has been suggested, to make easy the arrange- 
 
44 ACCOUNTING AND AUDITING 
 
 ment of items in the ledger so that they shall show 
 the balance for any account. We have been con- 
 cerned so far chiefly with the second of these pur- 
 poses. It remains to note that the first is even more 
 important. Many bookkeepers spend a good deal of 
 time in trying to interpret their own entries because 
 they have forgotten the circumstances under which 
 the entries were made, and have left their record 
 in such form that many important elements in the 
 transaction are not shown. A record to be satisfac- 
 tory should show about every transaction absolutely 
 every detail that can ever be a matter of consequence 
 to know. If, for instance, a transaction is a sale of 
 goods on an order, the entry should show the date of 
 the sale, the date of the order, the person from whom 
 the order was received, the number of the order, the 
 amount of each kind of goods with the specific name 
 or quality, the price agreed upon, with any discounts 
 that may have been offered, and, if the goods are 
 shipped away, an indication of the method of ship- 
 ment, — such 'as the number of the packing-case or 
 the initials and number and destination of the car, 
 and, if the goods were consigned to anyone different 
 from the customer who orders them, the name of 
 such consignee. Similarly, if money is received in 
 payment of a note, the entry should indicate just 
 what note it is meant to pay, and, if the notes are not 
 listed by number in a separate book, the entry should 
 show the date of the note, the maker, the endorsers, 
 the time, the amount, and the interest, if any. If 
 the entry is based upon any calculation, such as a 
 percentage of discount, it is advisable to indicate the 
 calculation on the entry itself in order that it may 
 
THE METHOD OF ENTRY 45 
 
 bear upon its face evidence of its own correctness. 
 Otherwise, if questions ever arise as to the correct- 
 ness of the calculation, all must be done over; and in 
 the end it is cheaper to write the calculation in each 
 entry than it is to recalculate the many entries which 
 commonly require examination. 
 
 Errors are bound to occur from time to time, and, 
 therefore, care should be taken that the corrections 
 do not cast suspicion on the genuineness of the rec- 
 ord. A posting error may be corrected by scratch- 
 ing, for since the ledger is not a book of original entry 
 and is legal evidence only so far as it is assumed to 
 be a proper transcript of the original entry, erasures 
 are not serious. We should not, on the other hand, 
 ever erase a figure in an original entry unless that 
 figure is sufficiently proved by its context. For in- 
 stance, if we, in making an entry crediting a per- 
 sonal account for goods purchased, put a wrong price 
 and then scratch not only the price but the extension 
 of the amount and the total of the bill, we have 
 opened to suspicion the whole entry. In the nature 
 of the case, there can be no evidence that the change 
 was not made at a later date for the purpose of com- 
 mitting fraud. If, on the other hand, the error is 
 discovered before the extension has been made and 
 only the price is scratched, the fact that the exten- 
 sion is unchanged and that the total amount of the 
 bill is unchanged is evidence of the correctness of 
 the price, for only that price could have produced 
 the final result. Similarly, even though we have 
 made an error in an extension, if the price is correct 
 and the total amount of the bill is correct, it is ob- 
 vious that the scratching of the extension is of no 
 
46 ACCOUNTIKG AND AUDITING 
 
 account; for if the other items in that bill are un- 
 scratched, a subtraction of the other items from the 
 total proves the correctness of that extension. If, 
 finally, an error is made in entering the total of the 
 bill, it may be corrected by scratching, because if the 
 individual items of the bill remain unscratched the 
 total is vouched for by simple addition. Usually 
 when a change must be made it is wiser to leave the 
 original figure standing, to draw a line through it 
 and write the correct figure above, than to erase it 
 entirely; for if the original figure standing there is 
 obviously incorrect and the figure above is the only 
 substitute for it, we see at a glance why the change 
 was made and accept it without question. If the 
 original figure had been erased, however, no one 
 could tell what was there originally, or why the 
 change was made. In cases where it is impossible 
 for the context to prove the correctness of the figure 
 put in after an erasure, corrections should be made 
 not by any erasure but by a new or counter entry. 
 
 Whatever error is made in an original entry, if 
 only the debits are equal to the credits, a proper 
 counter entry will correct it. If, for instance, we 
 credit Cash for more than was paid, we may, by 
 entering the amount of error on the other side of 
 the cash book as if cash was received, produce the 
 balance of truth. If we charge too much for mer- 
 chandise sold, we can make a correcting entry h^ 
 debiting Merchandise and crediting the customei 
 for the difference. If we debit too much to Interest, 
 consequently crediting Cash too much, we may credit 
 Interest and debit Cash for the amount' of error. The 
 method of making such corrections is usually to mark 
 
^HE METHOD OP ENTRlf 47 
 
 the original entry very plainly, sometimes in red ink 
 — unless one objects to advertising one's errors con- 
 spicuously, — with some such words as these: '* Er- 
 ror; for correction see p. 27, Jan. 10." Then in the 
 first available space one should make a new entry, 
 debiting and crediting the proper accounts not for 
 the original corrected figures, but for the amount 
 of alteration necessary to produce, with the original 
 incorrect entry, the true result. The explanation 
 should be somewhat as follows: '*To correct error 
 of p. 17, Dec. 21, 5c per yd. overcharge in price, to 
 Andrew Jackson." When this new entry has been 
 posted, the balance of the accounts concerned is as it 
 should be. 
 
 Suppose, for instance, we have credited Bills Re- 
 ceivable when we should have credited Bills Payable. 
 The erroneous entry reads, perhaps, as follows : 
 
 Cash 1000 
 
 To Bills Receivable 1000 
 
 Since the Cash is correct it will not be affected by 
 the new entry, which should read as follows : 
 
 Bills Eeceivable 1000 
 
 To Bills Payable 1000 
 
 This debit to Bills Receivable will correct the er- 
 roneous credit, and the credit to Bills Payable will 
 accomplish what should have been done in the first 
 ]»lace. 
 
 The substance of this chapter may be summar- 
 ized briefly. Entries should be made in what are 
 called books of original entrj^ in such form that full 
 information about every transaction is shown clearly. 
 
48 ACCOUNTING AND AUDITING 
 
 and the arrangement of the entry should be such 
 that it is easy to transfer the desired figures from 
 that record directly to the ledger, — which contains 
 a summary, classified by accounts, for all transac- 
 tions. Original entries are commonly made in a 
 cash book containing only cash transactions, a pur- 
 chase book containing only purchases, a sales book 
 containing only sales, and a journal containing every 
 transaction which cannot go into any one of these 
 three other books. The cash book, purchase book, 
 and sales book, serve not only as a convenient means 
 of posting cash and merchandise in totals at inter- 
 vals, but also of posting proper debits and credits 
 to the other accounts concerned in the transactions 
 with cash and merchandise; that is to say, we use 
 the cash book, for instance, not only for debits and 
 credits to Cash, but for credits and debits to the 
 other accounts concerned when Cash is debited and 
 credited. The ledger, on the other hand, is not a 
 book of original entry, and has no legal value except 
 as it is taken to represent a correct transcription of 
 original records, and its only function is to bring 
 together the items relating to the separate accounts. 
 No erasures should be made in any figure that cannot 
 be easily proved clearly correct from other figures 
 that are intact. Any necessary changes should be 
 thoroughly explained. 
 
CHAPTER IV 
 
 THE COMMON LEDGER ACCOUNTS 
 
 We have so far noted the distinction between 
 debit and credit, and the simple forms of entry. 
 Quite as important as proper debiting and crediting, 
 however, is proper choice of the account to which a 
 debit or a credit shall be made. We have seen that 
 accounts are of three classes — with persons, with 
 property, and with forces. It is obvious that if we 
 make the error of debiting to a force, which can 
 never repay, an amount that ought to be debited to 
 an individual, who must repay, our books are mis- 
 leading. If, again, we debit to a property account, 
 as if the value were on hand, what ought to have been 
 debited to a force account, as an explanation of loss, 
 we are overstating our possessions. If, again, we 
 credit one force account when we ought to credit 
 another, we may mislead; if, for instance, we credit 
 Interest — when he ought to credit Insurance — for 
 an amount allowed on the cancellation of an insur- 
 ance policy, though we have not misstated the 
 amount of our property we have misstated the source 
 from which some of our property has come; that is, 
 we have made the record indicate that we have 
 earned as a clear profit a sum which in reality was 
 merely a repa}niient of an insurance premium vainly 
 
 A & A-4 49 
 
so ACCOUNTING AND AUDITING 
 
 paid. Such an error misrepresents to us not only our 
 actual earnings by lending money, but also the ex- 
 pense of insurance; and if we are to use our figures 
 in drawing conclusions as to the subsequent conduct 
 of our business, we shall be misled unless the item 
 is small. This matter of deciding to what ledger 
 account each item shall be carried, therefore, is of 
 great importance. 
 
 It is worth while to examine with considerable 
 care the commonest of the ledger accounts and de- 
 termine just what each should represent. It is to 
 be noted, however, that the important matter is not 
 that any hard and fast rules shall be followed, but 
 only that the bookkeeper himself shall know what 
 the account on his own ledger means in the case of 
 his own business. Names are of no consequence 
 anywhere if only the people who use the names 
 always know exactly what is meant by the name 
 used. It would matter not at all, for instance, if all 
 English-speaking people were to agree that what 
 previously has been called an *^ apple'' should here- 
 after be called a ^Hable," and that what previously 
 had been called a *Hable" should hereafter be called 
 an *' apple." To read, then, that a man ate a table 
 and wrote at an apple would confuse no one, and a 
 man indeed may in his own memoranda kept for pri- 
 vate purposes transpose these two terms with per- 
 fect freedom and without danger of confusion if he 
 only remembers exactly what he means by each. So 
 in bookkeeping the title of an account is of no conse- 
 quence if only those who are to use it know what use 
 is made of it under that title; but since accounts are 
 commonly read by others than the makers, it is wise 
 
I'HE COMMON LEDGER ACCOUNTS 5l 
 
 to follow common practice lest there be misunder- 
 standings. Above all else, since accounts are likely 
 to be called into court, unusual uses of terms may lay 
 one open to suspicion of attempt at fraud, and should 
 be avoided. 
 
 The most obvious account with which all business 
 is concerned is Cash. (Hereafter, when a common 
 noun, like ^^cash,'' is used with a capital letter, it 
 will be understood that the name indicates not the 
 thing itself but the name of the ledger account which 
 is to represent it.) To Cash is usually carried not 
 only actual money in hand, such as silver, gold, and 
 legal paper money, but also checks and money orders. 
 Checks and money orders are included because they 
 are supposed to be convertible at sight into the actual 
 legal money; and, therefore, it is not worth while to 
 distinguish on the books between them and currency. 
 As a matter of fact checks are not usually turned 
 into cash but are deposited in banks, where they go 
 to swell the cash balance without any handling of 
 specie and bills. Bank balances, also, are usually 
 considered as cash because bills can be paid with 
 them as readily — usually more readily — than with 
 the actual money; and although some business houses 
 keep a separate account for bank balances, most 
 houses make no such distinction. When it is desired 
 to make such distinction, it is easy to provide a 
 special column in the cash book for bank balances as 
 distinguished from legal money. Two items which 
 might readily be confused with cash but should not 
 appear on the cash account are promissory notes and 
 drafts. These are only orders or promises to pay, 
 and cannot in any proper sense be deemed cash until 
 
52 ACCOUNTING AND AUDITING 
 
 the pajonent has actually been made. It is true in 
 a sense that a bank check is only an order to pay, 
 but since the order is on a bank whose business it is 
 to make payments on the orders of its depositors, 
 the normal condition is one in which the check is as 
 good as money and is as readily used in making pay- 
 ments. ' The courts, moreover, have given checks 
 special protection so that they may be considered 
 money, and a man who issues a check without money 
 behind it is guilty of obtaining money under false 
 pretenses, which is an offence with a very heavy pen- 
 alty attached. Inability or i^nwillingness to pay 
 notes or drafts, on the other hand, is not legally an 
 offence: the only penalty is a loss of credit; and, 
 therefore, such evidences of debt are nothing more 
 than claims similar in nature to debts due where no 
 document has been given. 
 
 The account representing promissory notes is 
 Bills Eeceivable. This account does not include 
 claims, against customers or others, unless evidence 
 has been given in the form of written promises to 
 pay money when due. Of course, if money is owed 
 to a business by a customer, the books must some- 
 where show the debit to that customer, and such a 
 debit to him indicates that he has not made payment; 
 but if he has given written promise to pay, in the 
 form of a promissory note, he has made payment of 
 the original debt. He has given the business an 
 equivalent for the goods purchased, and the business 
 will collect from him, if he is solvent, not for the 
 goods but for the note. If collection must be made 
 through the courts, the business holding the note 
 does not have to show just what is the origin of the 
 
THE COMMON LEDGEE ACCOUNTS 53 
 
 obligation, but must sue on the note, for the note is 
 itself evidence that the obligation exists — but it is at 
 the same time evidence that the original debt no 
 longer exists. In other words, the note is itself prop- 
 erty which has paid for the merchandise. The busi- 
 ness, then, has no longer any claim against its cus- 
 tomer for the goods sold him, and must not have any 
 debit against him on its books. So Bills Receivable 
 represents property as distinguished from claims; 
 and this is true in part because promissory notes may 
 be bought and sold and transferred from hand to 
 hand just as can merchandise or cash. The purpose 
 in maintaining an account on the ledger with such 
 notes is to show exactly how much of this kind of 
 property — ^promises as distinguished from money, 
 and property as distinguished from claims — is in the 
 possession of the business. 
 
 To this account are carried also drafts after they 
 have been accepted by those upon whom they were 
 drawn. The common transaction for a draft is that 
 in which a man to whom money is owed draws a 
 paper ordering the man who owes him to pay, usually 
 to a third person, the sum of money owed. The per- 
 son who is ordered to pay is under no legal obligation 
 to make payment in this way unless he chooses. If 
 he is willing to pay, he indicates his willingness by 
 writing the word ^^ accepted" and signing his name 
 across the face of the draft. Until he has done this, 
 the order to pay is nothing but worthless paper, — 
 unless, indeed, it is what is called a sight draft de- 
 manding immediate payment, and even then, of 
 course, the person ordered to pay is under no obliga- 
 tion to make payment in this form unless he is so 
 
64 ACCOUNTING AND AUDITING 
 
 inclined. It is not customary, therefore, to make 
 any entry on books, except by way of memorandum, 
 when a draft is drawn ordering somebody to pay to 
 a third person for the benefit of the business. As 
 soon as such a draft is accepted, however, the drawee, 
 or person ordered to pay, has given his written 
 promise to make payment in due season, and this is 
 exactly identical in nature with a promissory note 
 which he might have drawn in the ordinary form. 
 Since, then, there is no distinction in nature between 
 an accepted draft and a promissory note, such drafts 
 are always included with the notes as making up the 
 body of Bills Eeceivable. 
 
 Bills Receivable should be debited for only the 
 face of notes and drafts held. This account should 
 represent property and ought, theoretically, to re- 
 main unchanged for any one note so long as that 
 note is unpaid. When a note bears interest, how- 
 ever, the claim which the holder of the note has 
 against the signer is not m^rely for what is called the 
 face of the note-— that is, the amount written in as 
 dollars and cents — ^but also for an additional sum, 
 or interest, which is a certain percentage of the face 
 value. It would be possible to let Bills Receivable 
 represent not only the face of such notes but also the 
 amount of accrued interest. To do so, however, 
 would mean that if we wished Bills Receivable to 
 represent the true value of notes at all times, we 
 should be obliged every day to figure interest on all 
 interest-bearing notes that we held and add that as a 
 debit to Bills Receivable. This would involve a large 
 amount of labor in businesses handling many notes. 
 A simpler method is to debit Bills Receivable for 
 
THE COMMON LEDGER ACCOUNTS 55 
 
 only the face value of notes, and to make record of 
 the interest only at the time that interest is involved 
 in some transaction, — or whenever the books are 
 used in figuring profits at the end of an earning 
 period, as at the end of the fiscal year. So far as 
 the books are concerned, then, in this matter of Bills 
 Receivable there would appear no difference between 
 a case in which a note was received bearing interest 
 and payable in six months, and one in which a note 
 had been held for three months without bearing in- 
 terest, even though the note had been made three 
 months before the time it came into the hands of 
 this business. To summarize Bills Receivable, then, 
 we may say that the balance of this account repre- 
 sents simply the face value of written promises held 
 by the business, either so-called promissory notes or 
 accepted drafts. 
 
 In this connection, before we pass on to Bills 
 Payable, which is the converse of Bills Receivable, 
 it is well to note the relation of Interest to Bills Re- 
 ceivable. Many persons unfamiliar with business 
 find difficulty in realizing what is the actual value of 
 a note, assuming the maker of the note to be solvent, 
 as distinguished from its face value. One thing is 
 necessary to understand at the start, viz., that a note 
 is a promise to pay a definite sum of money, neither 
 more nor less, and at a definite time. If the note 
 reads, '^Two months from date I promise to pay to 
 John Doe $5,000," it is a claim enforceable two 
 months from date for $5,000 and for no more. If the 
 maker of the note had promised to pay $5,000 and 
 interest, the note would have read ** $5,000 and inter- 
 est." Without a direct stipulation that interest is 
 
66 ACCOUNTING AND AUDITING 
 
 to be added on the expiration of the time named, no 
 interest can be demanded. Yet it is a commonplace 
 of business experien(ie that one cannot use other 
 people's money without paying for it in one form or 
 another. If, then, the maker of a note has not prom- 
 ised to pay interest, the note is not until the day of 
 maturity worth the amount written on its face. A 
 note payable two months in the future is one requir- 
 ing the owner to wait two months for payment. No 
 one in a business transaction would accept such a 
 $5,000 note as a $5,000 payment. Such a note would 
 be accepted, when interest is at six per cent., for only 
 $4,950, for the discount is $50 for two months. Under 
 one condition, however, it would be taken at face 
 value, — i. e., in case the $5,000 payment itself is not 
 due for two months. If, for instance, I have bought 
 goods in a trade where it is customary to allow pur- 
 chasers two months in which to make payments, and 
 I pay for those goods with a note payable in two 
 months, I am making proper payment; for the money 
 named in the note becomes due on the day when I 
 should pay for the goods. Even here, however, if 
 the firm receiving that note from me in payment of 
 their goods now wishes to make use of that note in 
 its business — if, for instance, it wishes to borrow 
 money on that note from a bank, — it cannot expect 
 to sell the note for $5,000, for whoever lends the 
 money will be forced to wait two months for its pay- 
 ment and then he can collect not $5,000 with interest, 
 but only $5,000 straight. The value of that note 
 today, then, is not $5,000, but only $5,000 less dis- 
 count, and the discount is equivalent to the interest 
 
THE COMMON LEDGEE ACCOUNTS 57 
 
 for two months.* If now we take the case of a note 
 bearing interest, we shall find the circumstances very 
 different. Suppose I buy goods in a trade in which 
 payment is expected at once. If it is inconvenient 
 for me to make such cash payment and my credit is 
 good, I can probably persuade those from whom I 
 buy to accept my note promising to pay the $5,000 in 
 two months, provided I make the note to read ^*with 
 interest." They will then have a claim against me 
 at the end of that time not only for the original 
 $5,000, which I should normally have paid at the time 
 of purchase, but for compensation in the nature of 
 interest for the delay which they have suffered in 
 making the collection. If they do not wish to wait, 
 before using the money, until the two months have 
 expired, they can sell that note to someone else who 
 will pay for it in cash; and the value of that note to 
 the purchaser will be not only the full face value 
 written on the note on the day of issue, but more to 
 the extent of the interest for each day by which its 
 maturity or date of payment has approached. This 
 difference between notes bearing interest and notes 
 not bearing interest may well be indicated by parallel 
 columns showing for five dates the values of each. 
 It will be seen there that both are increasing in 
 value, — one approaching its face value because the 
 
 * In practice the discount would be $50, or 1 per cent of the face of 
 the note. This is called "bank discount." In theory, the amount of 
 discount is not the interest of $5,000 for two months, but something 
 less than that, for not $5,000 is lent. True, or theoretical, discount is 
 used in valuing bonds, leases, insurance premiums, etc. The method 
 is to divide the face of the obligation by the sum which one dollar will 
 amount to at interest for the required time. This quotient will show 
 how many dollars will be required to produce the face of the obligation. 
 If, here, we divide $5,000 by 1.01, we get $4,950.49%. If this were put 
 at interest, it would amount to just $5,000 at 'the end of two months. 
 
88 ACCOUNTING AND AUDITING 
 
 time of payment of the specified amount is approach- 
 ing, the other exceeding its face value because it will 
 ultimately call for an amount in excess of the face 
 value by the interest for the time elapsed. We will 
 assume both notes to be for $5,000, payable in four 
 months, dated January 1, when interest is 6 per cent. 
 
 Not bearing interest Bearing interest 
 
 Jan. 1 $4,900.00 $5,000.00 
 
 Feb. 1 4,925.00 5,025.00 
 
 March 1 4,950.00 5,050.00 
 
 April 1 4,975.00 5,075.00 
 
 May 1 5,000.00 5,100.00 
 
 A note bearing interest will not usually specify 
 the rate unless no legal rate happens to be estab- 
 lished in that locality or unless it is to bear a rate 
 different from the legal. The discount rate, for a 
 note not bearing interest, is a matter of custom; but 
 it is never specified in the note itself, for such a note 
 has no concern with discount — it is a promise to pay 
 a fixed sum, and that sum only, at a fixed date, and 
 its discounted value is a matter for agreement be- 
 tween buyer and seller only. The deduction from the 
 face value of a note is called discount, and the addi- 
 tion to the value of a note is called interest; but in 
 nature the two are identical. Discount is taken out 
 at the start as a decrease in value below face value ; 
 interest is added at the end as an increase in value. 
 The discussion of the treatment of interest on the 
 hooks had best be postponed until we come to con- 
 sider so-called force or nominal accounts. 
 
 Just as Bills Eeceivable is treated so as to repre- 
 sent only written promises owned by the business 
 on whose book^ they appear, Bills Paj^able should, 
 
THE COMMON LEDGER ACCOUNTS 59 
 
 represent only written promises issued by the firm 
 on whose books they appear; so that John Jones's 
 Bills Receivable may be identical with John Smith's 
 Bills Payable, and the same note is to one a bill re- 
 ceivable and to the other a bill payable. Bills Pay- 
 able, like Bills Receivable, moreover, does not in- 
 clude claims for debt unless a definite written prom- 
 ise to pay has been given, and it includes accepted 
 drafts, — in this case, drafts accepted by the firm and 
 ordering it to pay to others. 
 
 Most of the other property accounts are of a na- 
 ture so simple that seldom question arises as to a 
 choice of titles. To Real Estate, for instance, would 
 be charged purchases of land and buildings. To 
 Machinery and Plant would be charged expenditures 
 for purchases of equipment for manufacturing. To 
 Furniture and Fixtures would usually be charged the 
 equipment for an office or a store. Akin to these, 
 though having some elements usually different from 
 them, is Merchandise, which, as ordinarily kept, has 
 peculiarities which it wilkbe well to discuss only after 
 we have given some attention to nominal accounts. 
 
 The most obvious account representing what we 
 have called explanation, or nominal, accounts, is 
 Wages. This represents the obvious fact that we can- 
 not expect other men to work for us without compen- 
 sation, and the debit to that account indicates for how 
 much of our outgo that force in human nature is re- 
 sponsible. This account may be divided into sev- 
 eral portions — for instance, one subdivision may be 
 for salaries of managers, as distinguished from the 
 wages of day laborers, — but in nature the itema are 
 similar. It is difficult to conceive of Wages as any- 
 
60 ACCOUNTING AND AUDITING 
 
 thing but purely nominal, for at best it explains why 
 a shrinkage has occurred in assets. It is true, of 
 course, that return is expected for the wages ex- 
 pended, but that return does not come back into 
 Wages unless one is engaged in the nefarious busi- 
 ness of hiring people and then letting them out to 
 someone else at a higher price; in all other cases the 
 return for wages paid appears not in Wages but in 
 a credit to some other account representing the in- 
 crease in the value of property, such as Merchandise, 
 or Real Estate. 
 
 Similar to Wages as nominal accounts indicating 
 expense are Printing, Postage, Insurance, Taxes, etc., 
 all of which might be, in a business attempting only 
 very simple accounting, charged to one general ac- 
 count which might be called '^Expense." As soon as 
 a business has passed beyond a very simple state, one 
 linds usually that these various elements of expense 
 may be profitably distinguished in separate accounts* 
 
 Nominal accounts are of value quite as mu(5h in 
 distinguishing sources of profit as in measuring the 
 force of causes of loss. For instance, if we are com- 
 mission merchants engaged in the selling of goods 
 for others, the commissions which we collect would 
 naturally be credited to an account representing that 
 department of our activity. Items of that sort would 
 be carried to Commission, — though for a firm which 
 employed agents to sell its goods that same title 
 would be used for an account which represented an 
 expense of selling. Similar to Commission in this 
 respect would be Rent for a firm renting property, 
 but Rent on the books of a firm hiring property would 
 
THE COMMON LEDGER ACCOUNTS 6t 
 
 be an expense account. Nominal accounts, then, may 
 represent either gains or losses. 
 
 A nominal account which may have a balance first 
 on one side and then on the other is Interest. Al- 
 though it is true that any one firm is likely to be 
 usually either a borrower or a lender, every firm is 
 likely to have interest items upon both sides of the 
 account merely in the handling of notes and drafts. 
 For instance, in the case used as an illustration on 
 page 56, the firm accepting a promissory note must 
 debit Bills Eeceivable for the full face of that note, 
 or $5,000. If the note does not bear interest, how- 
 ever, and the firm sells that note to somebody else 
 a month later, it will get not $5,000, but consid- 
 erably less, possibly $4,975. That is to say, since 
 the other firm taking the note must wait a month 
 before the $5,000 called for by the note can be col- 
 lected, it will subtract from the face of the note 
 enough to compensate it for accepting the note so far 
 in advance of the time when it shall be paid. This 
 other firm will take out interest for one month, or 
 $25. The firm which originally received this note 
 from its customer has already debited Bills Receiv- 
 able $5,000 and has credited the customer $5,000. 
 On having the note discounted, however, it must 
 credit Bills Receivable $5,000, for that department of 
 the business has surrendered the note charged to it 
 at $5,000, and it will debit Cash $4,975 and Interest 
 $25 (which explains or holds Interest responsible for 
 the loss of $25). This was a case in which though 
 no interest was actually specified or paid as such, the 
 Interest entry had to be made. The second firm ac- 
 cepting this note will be allowing $4,975 for a note 
 
6^ ACCOUNTING AND AIJDITINa 
 
 of which the face value is $5,000, and $5,000 will he 
 received by it at the time the note becomes due. The 
 entry on its books when it accepts the note, there- 
 fore, will be to debit Bills Receivable $5,000, to credit 
 Cash (if they paid cash) $4,975, and to credit Interest 
 $25. That is to say, though the note is worth on its 
 face value $5,000, the firm allows to the others from 
 whom it takes the note only the actual value of^ 
 $4,975, and pays accordingly. The difference be- 
 tween the face value and the amount which it allows 
 for the note is a profit due to the fact that it is will- 
 ing to wait one month for payment, and this profit is 
 properly recorded under the head of Interest because 
 the force which Interest represents has brought in 
 that gain. If the note bears interest, on the other 
 hand, when that interest is collected Interest must 
 be credited. 
 
 Recognizing the fact that Interest is debited for 
 all losses on account of interest and credited for all 
 gains on account of interest, the only complication 
 arises in determining in each case whether the inter- 
 est should be entered now or only at a later date. 
 Of course in the case last worked out the profit is not 
 really made until the note is paid; that is, $4,975 was 
 allowed for the note, we will say, on December 1, but 
 the $5,000 was not collected until January 1. In one 
 sense, therefore, it is true that the profit should be 
 entered only on January 1; but in the meantime the 
 books would be failing to show the fact that there 
 was a $25 discrepancy between the face value of the^ 
 note recorded in the Bills Receivable account and the 
 $4,975 paid in cash; and such discrepancies are not to 
 be allowed* upon the books. Indeed, the purpose of 
 
THE COMMON- LEDGER ACCOUNTS 63 
 
 double entry is to explain always day by day the 
 origin of any figures of profit and loss. Although it 
 is true, therefore, that the interest is not properly 
 gained until January 1, yet since the transaction in 
 all its outward forms is really complete on December 
 1, in the sense that the promise to pay the extra $25 
 was received in the form of the note on December 1, 
 that is the desirable time to make the entry; for so 
 far as the books are concerned it is the promise rather 
 than the performance which determines the amount 
 of money to be entered on the books. When, on the 
 other hand, the note bears interest, it is true that the 
 promise to pay interest is made on the earlier date, 
 just as it is in the last case discussed, but the promise 
 is not expressed in terms of dollars and cents. The 
 note reads, **I promise to pay $5,000 with interest;" 
 but as the amount of interest is not entered on the 
 face of the note and is not properly to be included 
 in Bills Eeceivable, it is not yet to be credited to 
 Interest, and that portion of the interest remains off 
 the books until actually paid. In other words, the 
 entry to Interest is made at the time that the trans- 
 action takes a definite form in dollars and cents, and 
 is entered on the books as such whether the payment 
 is made at that time or later. As will be shown in 
 another connection, this method does not cause the 
 books to misrepresent facts with regard to Interest; 
 for, in any proper plan of accounting, whenever the 
 books are closed or the profit and loss for the year is 
 determined, allowances are made for all accrued 
 items which have not yet been entered upon the 
 books. 
 
64 ACCOUNTING AND AUDITING 
 
 We have now discussed property or real accounts 
 and force or nominal accounts. We have remaining 
 one account which, as commonly kept, is both real 
 and nominal. The suggestion was made in the sec- 
 ond chapter that if we debit Merchandise for all pur- 
 chases at cost and credit Merchandise for all sales 
 at selling price, the balance between them will not 
 represent goods on hand, for the debits and credits 
 were not at the same prices, but will include a cer- 
 tain amount of profits — ^if profits have been made. 
 How much profit will be included in such a balance 
 must be determined by figures not included in the 
 account itself. Under this plan of keeping Mer- 
 chandise account, therefore, we are not getting quite 
 the results we usually expect to get from either prop- 
 erty accounts or force accounts, for the balance is 
 neither straight property nor straight profits. We 
 can determine the profit, however, by taking account 
 of stock and relating the valuation to the purchases 
 and the sales. The method of doing this will be 
 described later in this chapter. 
 
 Before going further in our discussion of the use 
 of particular accounts it is worth while to pause to 
 work out a number of practical cases and see how 
 the various accounts are to be debited and credited. 
 Then, with a better notion of just how each account 
 looks and what it stands for, we may analyze it fur- 
 ther and see its real significance. Let us assume a 
 business buying and selling merchandise, receiving 
 and giving notes, paying and collecting bills, and in- 
 dicate for it the commonest transactions and the 
 ways by which those transactions would get upon its 
 books of account. The most profitable way of doing 
 
THE COMMON" LEDGEB, ACCOUNTS 65 
 
 this for the present is to assume that all items go 
 upon the journal, and not to attempt at this time 
 to distinguish in use between journal, cash book, 
 sales book, and purchase book. We shall thus have 
 all parts of each transaction before us at once. After 
 we have once made these entries in journal form, we 
 may then split them among the separate books and 
 show how they w^ould appear upon a ledger. 
 
 Let us suppose that Laurence Sterne begins busi- 
 ness January 1 w^ith the following capital: cash, 
 $15,000; store building, $15,000; a promissory note of 
 George Eliot, for $1,000, dated January 1, payable 
 in two months; a promissory note of George Evans, 
 for $2,000, dated December 1, payable in two months; 
 a promissory note of George H. Lewes, for $500, 
 dated December 16, payable in one month; a prom- 
 issory note of George Meredith, for $1,500, dated No- 
 vember 1, payable on demand with interest. For 
 this opening of business an entry would need to be 
 made so as to provide debits and credits to several 
 accounts. In the first place, we must realize that the 
 proprietor is, for the books of the business, an out- 
 sider. The books are not his books, except as he 
 chances to own the business. On them he will be 
 credited for what he puts in and debited for what he 
 takes out — just as anyone else would be debited and 
 credited. 
 
 Cash would Ibe debited because the cash drawer or 
 the cashier is responsible. Real Estate would bq 
 debited because that department of the business, or 
 the property itself, if one prefers to put it that way, 
 is responsible for that amount of value. Bills Re- 
 ceivable would be debited for $5,000, because the 
 
 A & A-5 
 
ee ACCOUNTING AND AUDITING 
 
 total face value of these notes amounts to that sum, 
 and the bills receivable account should represent 
 face values only. The proprietor, Laurence Sterne, 
 however, cannot be credited properly with the full 
 face of the notes, for although these notes will bring 
 in a total of $5,000, and, indeed, more, since the last 
 of them bears interest, he is not turning over to the 
 business property worth $5,000 on the day that the 
 business is opened: the business must wait two 
 months to collect the $1,000 ultimately due on the 
 first note ; it must wait one month to collect the $2,000 
 on the second note; it must wait fifteen days to col- 
 lect the $500 due on the third note. Obviously, if a 
 man is going to debit his business or the business is 
 going to credit him with an investment, the facts are 
 stated properly only when he is credited on the books 
 of the business for the amount invested on the day 
 of investment. When the year is over, an attempt 
 will be made from the books to determine just what 
 the business has earned from each one of its sources 
 of income, including interest, and just what it has 
 lost from each one of its causes of expense. Clearly, 
 then, to credit the proprietor with funds which can- 
 not be realized by the business until a date later than 
 the time of credit is to cause the business to lose the 
 use of the money and possibly even to suffer an ex- 
 pense on account of interest for the time which it 
 has to wait to realize upon the investment. We shall 
 see in this case that nine days later the business is 
 obliged to borrow money for operating uses. It 
 would not have to do so if the proprietor had turned 
 into it cash or notes on which payment could be im- 
 mediately demanded. Three of the notes are payable 
 
THE COMMON LEDGER ACCOUNTS 67 
 
 only in the future. The business, therefore, should 
 give the proprietor credit for his investment of notes 
 only for theii? present worth, which is the face 
 value less the discount. Let us figure the dis- 
 count on each of these notes. It must be observed, 
 in the first place, that when a note does not bear in- 
 terest we are concerned, when figuring its present 
 worth, not at all with the length of time which it 
 has run, but only with the length of time which it 
 has yet to run. For instance, if the note is payable 
 two months in the future, we have to wait two months 
 for collection, and neither the amount that it will 
 call for nor the time is affected by the past history of 
 that note, — that is, we do not care whether it was 
 dated July 1 to become due March 1, or dated De- 
 cember 31 to become due March 1. Our period of 
 waiting is no longer in one case than in the other, 
 and our discount is determined solely by looking into 
 the future. We need to know the date of the note 
 only in order that we may add its time to that date 
 ^nd determine its maturity. When, on the other 
 hand, a note bears interest, we are concerned only 
 with its past history, for, since it bears interest, the 
 future takes care of itself, and we wish to know only 
 how much/has accumulated and remains unpaid of 
 the interest for which it is a good claim. In the cases 
 in hand, therefore, since the note of George Eliot is 
 dated today, payable in two months, it is worth less 
 than the face value by the amount of the discount 
 for two months, or, at six per cent., $10. Since the 
 note of George Evans was dated December 1, payable 
 in two months, it will become due February 1, and 
 today it is subject to discount for one month, or, at 
 
68 ACCOtJNTIKG AND AUDITING 
 
 six per cent., $10. Since the note of George H. Lewes 
 was dated December 16, payable in one month, it will 
 become due January 16, and must be discounted for 
 fifteen days, or, at six per cent., $1.25. The sum of 
 these discounts is $21.25. This sum, if we wished to 
 make a separate entry for it, would be debited to the 
 proprietor and credited to Interest, for the business, 
 by agreeing to wait for its money, will receive in the 
 end more than the sum credited to the proprietor, and 
 the difference will have been earned by the force of 
 interest. Since the note of George Meredith, dated 
 November 1, bears interest, the interest accrued up 
 to January 1 will be, at six per cent., for two months, 
 $15; and this $15 the business buys when it takes the 
 note. So Interest should be debited as responsible 
 for this expenditure of money. We may combine 
 these two entries, however. The $21.25 discount, 
 to be credited to Interest on the first three notes, may 
 be reduced by the $15 to be debited to Interest, leav- 
 ing a net sum, creditable to Interest and chargeable 
 to the proprietor, of $6.25; the proprietor's credit, 
 therefore, is less than the face of the notes by this 
 amount. Since Bills Receivable should include only 
 the face values of notes, this $6.25 does not affect 
 that account. 
 
 Although under some refined systems of book- 
 keeping the interest accrued on the Meredith note 
 would be carried to an account indicating in its title 
 exactly its purpose, such, for instance, as Interest 
 Accrued, in a simple type of bookkeeping we may 
 carry this item directly to Interest, recognizing that 
 here Interest represents an asset. This does not in- 
 troduce confusion into the books, however, for when 
 
THE COMMON LEDGER ACCOUNTS 69 
 
 the interest is paid Interest will be credited, and the 
 correspondence of debit and credit will wipe out the 
 item, showing that on the purchase the business made 
 neither profit nor loss; and it is true that on this 
 item the business has not yet earned anything on 
 account of interest, for the business has paid for the 
 interest claim by crediting the proprietor. When the 
 interest is collected, however, so much of the credit 
 as offsets the debit will apply to balance the account, 
 and any excess will represent our profits from hold- 
 ing the note. We shall see this worked out later. 
 So far as the discounts are concernei, on the other 
 hand, the $21.25 should properly be credited to In- 
 terest account because this sum will be an earning 
 of the business. That is to say, we allow the pro- 
 prietor credit for his investment, including the face 
 of the notes less the discount subtracted, but when 
 the notes are paid the full face of those notes will be 
 collected in cash, and the difference between the 
 amount allowed the proprietor, which was the face 
 less interest, and the amount actually collected, 
 which will be the full face, is exactly what the busi- 
 ness has earned through the force of interest. This 
 earning ought to be credited to Interest, and this 
 method leaves it so credited. It is obviously unnec- 
 essary, though it would be quite harmless, to credit 
 the proprietor for the interest accrued on the last 
 note — namely, $15, debiting Interest for the same 
 amount, — and then to debit the proprietor with the 
 amount of discount on the first three notes — namely, 
 $21.25, crediting Interest for the same amount. This 
 would represent the facts just as they are, but 
 it would involve two entries and two postings both 
 
70 ACCOUNTING AND AUDITING 
 
 to the proprietor and to Interest; whereas the desired 
 result is produced just as well by combining the two 
 into one entry and subtracting the difference between 
 the discount and the interest from the amount which 
 otherwise would be credited to the proprietor — giving 
 $35,000 less $6.25, — and crediting Interest with the 
 same difference, or $6.25. The full entry for the in- 
 vestment would appear upon the books in simple 
 journal form as follows : 
 
 Cash 
 
 $15,000 
 
 
 Eeal Estate 
 
 15,000 
 
 
 Bills Receivable 
 
 5,000 
 
 
 To Laurence Sterne 
 
 
 $34,993.75 
 
 Interest 
 
 
 6.25 
 
 Laurence Sterne begins business this day. 
 He invests cash and real estate as indicated 
 above, and notes as follows; 
 of George Eliot, dated Jan. 1, tv^o months, 
 
 face 1,000, discount 10.00 
 
 George Evans, dated Dec. 1, two 
 
 months, face 2,000, discount 10.00 
 
 George H. Lewes, dated Dec. 16, two 
 
 months, 500, discount 1.25 
 
 total discount 21.25 
 
 George Meredith, dated November 1, on 
 demand, with int., 1,500, interest 15.00 
 
 net discount 6.25 
 
 Suppose our next transaction is the purchase of 
 office and store f umitiu-e for $500 in cash. The entry 
 will have to debit Furniture and Fixtures for the 
 fuU amount paid, because, if we conceive that furni- 
 ture to be on hand as property, the department of the 
 business which has charge of it is responsible for its 
 care, or, if we conceive that furniture to be consumed 
 in the processes of the business, the account must 
 indicate a responsibility for consuming that amount 
 
THE COMMON LEDGER ACCOUNTS 71 
 
 of value. For our present purpose, then, we do not 
 need to decide whether the account shall represent 
 ]oroperty supposed to remain on hand, or property 
 to be consumed in the conduct of the business; in 
 either case a responsibility is taken and the account 
 should be debited. Cash, on the other hand, repre- 
 senting the cash drawer or the cashier's department, 
 has yielded up a part of its property to enable us to 
 secure the property, which is a creditable thing to do, 
 and, consequently. Cash must be credited to indicate 
 a surrender of property previously charged to it. 
 The journal entry will be as follows: 
 
 1 
 
 Furniture and Fixtures 500.00 
 
 To Cash 500.00 
 
 Bought office and store furniture 
 
 Next let us pay $15 for postage. It is possible to 
 have one account, usually called ^* Expense," to in- 
 clude a large number of expense items of various 
 sorts, but usually it is desirable to divide such ex- 
 pense among a number of separate accounts. One 
 of these, usually worth while to maintain by itself, 
 is Postage. In this case, therefore, we must debit 
 Postage to indicate that one of the causes of shrink- 
 age of property is the need of having matter carried 
 through the mails, and to indicate for just how much 
 of our shrinkage of assets this account is responsible. 
 We must at the same time, as in the last case, credit 
 Cash, for the cash drawer has surrendered a part of 
 its property to enable us to secure the postage equip- 
 ment necessary. The entry , would be made as 
 follows; 
 
72 ACCOUNTING AND AUDITING 
 
 Postage 15.00 
 
 To Cash 15.00 
 
 Stamps and envelopes bought 
 
 Next we may buy stationery, office books of ac- 
 count, etc., for cash. The account representing such 
 things must be debited as responsible for the outgo, 
 and, as before. Cash must be credited. The entry will 
 be as follows: 
 
 Stationery 125.00 
 
 To Cash 125.00 
 
 Office books, stationery, ink, etc., bought 
 
 On the second day of the month we buy merchan- 
 dise of Charles Dickens, for which we agree to make 
 payment in ten days, to the amount of $4,000, and we 
 buy merchandise from Charles Reade to the amount 
 of $3,000, to whom we pay cash. It would be possible 
 to combine these two transactions into one entry, in 
 which case Merchandise would be debited $7,000, be- 
 cause the merchandise department of the business is 
 now responsible for this amount of property, Charles 
 Dickens would be credited $4,000 because he has en- 
 trusted the business with this amount of value, and 
 Cash would be credited, as previously, with $3,000. 
 It might be desirable, however, to open an account 
 with Charles Reade in the ledger in spite of the fact 
 that immediate payment is made to him. The 
 ledger, it will be remembered, is a book in which all 
 items pertaining to the same matter are classified 
 under one account. A ledger, of course, is indexed, 
 and it is possible always, therefore, to find an item 
 in the books by turning to the corresponding ledger 
 
THE COMMON LEDGEE ACCOUNTS 73 
 
 account as indicated by the index. If, on the other 
 hand, the item does not get into the ledger at all, 
 there is no convenient means of finding it, for no 
 other book is susceptible of convenient indexing. If 
 it is probable, therefore, that we shall have other 
 transactions with Charles Reade of sufficient impor- 
 tance to make it worth while to keep his affairs in- 
 dexed, it is worth while to open an account with him 
 and credit him, just as we credit Charles Dickens, 
 for the goods furnished, and then immediately debit 
 him for the cash payment. We will assume here, 
 however, that we are not to open an account with 
 Charles Reade, and that we are to make separate 
 entries for each purchase. One of these entries will 
 debit Merchandise and credit Dickens, and the other 
 will debit Merchandise and credit Cash. They are 
 shown below. 
 
 2 
 
 Merchandise 4000.00 
 
 To Charles Dickens 4000.00 
 
 The following bill of goods on 10 days' time, 
 
 purchased of him: [details should be 
 
 shown; or, if the bills are numbered and 
 
 filed, the number only is necessary] 
 
 2 
 Merchandise 3000.00 
 
 To Cash 
 [Explanation similar to that for the sale to 
 Charles Dickens] 
 
 On the third of the month we pay $65 for freight. 
 It is often worth while to maintain a separate ac- 
 count for freight in order that we may add the total 
 to the sum of our merchandise cost at the end of a 
 period and yet in the interval know what is our 
 amount of expense in this connection. Our entry 
 
U ACCOUNTIIsrG AND AUDITING 
 
 will be, of course, a debit to Freight and a credit to 
 Cash, for Freight is responsible for the loss of assets. 
 
 3 
 
 Freight 65.00 
 
 To Cash 65.00 
 
 Freight paid on goods rec'd today 
 
 We next day pay our telephone bill for three 
 months in advance. It might be worth while to open 
 a special account for telegraph, telephone and mes- 
 senger service, but it is assumed here that the amount 
 of such expense is so small that it is not worth while 
 to keep a separate account of it, and its payment, 
 therefore, is charged to the miscellaneous expense 
 account called by the simple title. We debit Expense 
 and credit Cash in the form of the entry shown below. 
 
 4 
 
 Expense 25.00 
 
 To Cash 25.00 
 
 Telephone bill paid to April 1 
 
 On the fourth of the month we buy horses and 
 wagon for delivery service, and pay cash, $500. This 
 is obviously of the nature of an expense item. It is 
 desirable, however, to keep it in an account by itself 
 for the simple reason that when we come to make up 
 our accounts at the end of the year we shall, unless 
 we have had bad luck, find that the value is chiefly 
 remaining and in only small part consumed during 
 the year. These items, then, though of the nature 
 of expense, are chiefly property and are expense only 
 so far as their value is reduced by use during the 
 year. It is much simpler to debit this payment to 
 an account by itself, and at the end of the year tp 
 
THE COMMON LEDGER ACCOUNTS 75 
 
 consider only a part as consumed, than to debit it to 
 Expense and at the end of the year make allowance 
 for most of it remaining unconsumed. It may be 
 well to have an account entitled '^Delivery Equip- 
 ment." To such an account will be carried charges 
 not only for the horses and wagon, but also for har- 
 ness, stable furnishings, etc. The entry will be as 
 below: 
 
 4 
 
 Delivery Equipment 500.00 
 
 " To Cash 500.00 
 
 Horses and wagon bought for cash 
 
 We next pay $30 for advertising. This should be 
 debited to Expense and credited to Cash unless it is 
 desirable, because of the amount of this kind of ex- 
 penditure, to keep a separate account for advertising. 
 In the entry as shown below this has been done. 
 
 4 
 
 Advertising 30.00 
 
 To Cash 30.00 
 
 Paid for advertising in directory 10.00 
 
 in Journal 15.00 
 
 in Bulletin 5.00 
 
 On January 5 we seU goods to Anthony Trollope 
 to the amount of $700, with the understanding that 
 payment is to be made in thirty days. Our books 
 must show that we hold Anthony Trollope re- 
 sponsible for payment, and he must be debited; and 
 at the same time we must show that the warehouse 
 has given up $700 worth of goods, and, accordingly, 
 is to be credited for that amount. The entry is shown 
 below. 
 
76 ACCOUNTING AND AUDITING 
 
 5 
 
 Anthony Trollope ' . 700.00 
 
 To Cash • 700.00 
 
 Sold him, on 30 days, as follows : 
 [Details] 
 
 We on the same day buy goods of Alexander Pope 
 and pay cash. Let us assume in this case that we 
 wish to have an account in our ledger with Pope 
 in order that we may have in one place a record of 
 all purchases made from him and payments made to 
 him. We must then debit Merchandise and credit 
 Pope for the full amount, $6,000, and then by another 
 entry debit Pope and credit Cash by the same 
 amount. 
 
 5 
 Merchandise 6000.00 
 
 To Alexander Pope 6000.00 
 
 Bought of him as below: 
 [Details] 
 
 5 
 Alexander Pope 6000.00 
 
 To Cash 6000.00 
 
 In payment of merchandise bought of him 
 today X 
 
 On the 8th we pay wages of $25 to the bookkeeper, 
 $15 each to three clerks, and $10 to the driver. This 
 transaction might be entered in either of two ways. 
 If we desire to keep on our books a record of all re- 
 lations with our employees in such form that we 
 may learn just when wages were due each employee 
 and when he was paid, we should carry these items 
 through the ledger by making an entry first to credit 
 each with his wages, and then another entry to debit 
 each for the cash paid. In such a case the first entry 
 would be a debit to Wages, $80, and a credit to the 
 
THE COMMOlSr LEDGER ACCOUNTS "S^? 
 
 five persons concerned at the amount belonging to 
 each. Then, on payment, each would be debited by 
 the amount previously credited, and Cash would be 
 credited for the total. This method shows, when all 
 wages have been paid, that no sums are due to any 
 of the employees, for the debits and the credits to 
 each cancel; but we have in the end a balance of 
 debit to Wages and of credit to Cash, and this repre- 
 sents the actual fact, — a loss of cash because of the 
 fact, shown by the debit to Wages, that men will 
 not work for nothing. If, on the other hand, we do 
 not care to have a ledger account with each clerk, 
 because payments are always made promptly, we 
 should omit both the debits and the credits to em- 
 ployees and make the simple entry debiting Wages 
 and crediting Cash. This is the method in the entry 
 given below. 
 
 8 
 
 Wages 80.00 
 
 To Cash 80.00 
 
 One week's wages, Jan. 1 to Jan, 6, as follows : 
 [The detail may give the items or refer to the 
 pay roll] 
 
 On January 9 we buy goods of Walter Scott, pay- 
 ment to be made in ten days, for $7,000. This, as in 
 the case of earlier purchases, is a debit to Mer- 
 chandise and a credit to the seller, as is shown below. 
 
 Merchandise 7000.00 
 
 To Walter Scott 7000.00 
 
 His invoice No. 4 
 
 [This assumes that the invoice is numbered 
 and filed for reference] 
 
78 ACCOUNTIN^G AND AUDITING 
 
 On the same day a bank messenger brings us a 
 draft which Charles Dickens has drawn on ns order- 
 ing us to pay to a third party, three days after we 
 see the draft, the amount of our bill for the purchase 
 of January 2. We find that since the goods were 
 bought on an agreement to pay for them in ten days, 
 payment ought to be made on the 12th, and as this 
 draft, if accepted by us, will be payable three days 
 from today, we agree to make payment, and we write 
 the word '^accepted" across the face of the draft, 
 with the date, and our signature. As soon as we 
 have done this we no longer owe Charles Dickens for 
 the goods. We have made payment by signing this 
 draft and promising to give cash on the day desig- 
 nated. If we default in payment, he will bring suit 
 not for payment on the goods, but for payment of 
 the draft. Our books must show this fact, and, there- 
 fore, we must debit Charles Dickens for the payment 
 made, namely, $4,000, and credit Bills Payable. 
 
 Novices at bookkeeping more often have trouble 
 with Bills Payable than with any other account. The 
 case before us may well illustrate the proper treat- 
 ment of that account. It is obvious that Charles 
 Dickens must be debited, for we are holding him re- 
 sponsible to free us on his books from the debt due 
 on account of the goods; he is responsible for our 
 acceptance of the draft. Something must be credited, 
 moreover, at the time we debit Dickens. This sug- 
 gests that Bills Payable should receive the credit 
 because we issue to him a promise to pay, and Bills 
 Payable is meant to represent all promises for pay- 
 ment in the form of any written document. It ought 
 to be possible, however, to determine whether Bills 
 
THE COMMON LEDGEE ACCOUNTS 79 
 
 Payable shall be debited or credited without know- 
 ing the other half of the entry. In this case, just 
 what has been done for the business, and by what! 
 Bills Payable, as a ledger account, represents some- 
 thing which has stepped in and paid our debt, tem- 
 porarily, for us. We ought to make settlement with 
 Dickens on the so-called book account — or sum due 
 for the charge against us on his books, — ^but we are 
 released from that responsibility by the fact that we 
 have accepted a draft. In other words, something 
 has stepped in between Charles Dickens and us and 
 set us free from that responsibility on the book ac- 
 count. Whatever has so set us free is entitled to 
 credit for the operation and is, of course, therefore 
 to be credited. So we credit Bills Payable just as 
 we should credit any individual who should come in 
 and take this burden off our hands. This is exactly 
 the sort of thing which always leads to a credit to 
 this account. It will be found always when a note is 
 issued or a draft is accepted that the paper signed 
 has relieved the business of some responsibility or 
 has raised funds for it, — as happens in the next trans- 
 action. We must, therefore, always credit the ac- 
 count as performing this service, just as we should 
 credit an individual or Cash or any other account 
 which performs a service for us. The entry f oUows : 
 
 9 
 
 Charles Dickens 4000.00 
 
 To Bills Payable - 4000.00 
 
 Accepted his draft for the amount of his 
 invoice credited January 2 
 
 The next day, finding need for more money to 
 run pur business, we make out a note promising to 
 
80 ACCOUNTING AND AUDITING 
 
 pay to our bank $5,000 in thirty days. This we take 
 to our bank and get discounted. The bank will give 
 us, however, not $5,000, of course, because as the note 
 does not bear interest it demands the payment of 
 only $5,000 at the expiration of thirty days; conse- 
 quently, the bank will now deduct the discount, which 
 is $25 at six per cent., and give us $4,975 in exchange. 
 Our entry must indicate the fact that the face of the 
 note is $5,000, and must therefore credit Bills Pay- 
 able for that amount. Cash, however, is increased 
 only by the proceeds of the note, or $4,975, and there- 
 fore must be debited for only that sum. The cause of 
 the discrepancy between the face of the note and the 
 amount of cash realized is the force represented by 
 the account entitled Interest, and therefore we debit 
 Interest for that amount. The entry is shown below. 
 
 10 
 
 Cash 4975.00 
 
 Interest 25.00 
 
 To Bills Payable 5000.00 
 
 Discounted our note, 30 days, at 
 National City Bank 
 
 On the same day we receive from George Mere- 
 dith $1,517.25 in payment of his note invested by the 
 proprietor at the opening of business. Since the note 
 has run two months and nine days, the amount of 
 interest will be $17.25. We must debit Cash for the 
 total amount received, because the cash drawer or 
 cashier's department is responsible. "We must credit 
 Bills Receivable by the face of the note, because the 
 department of the business to which notes were en- 
 trusted (or, if one wishes so to consider it, the drawer 
 in the safe in which such notes are kept) has sur- 
 
THE COMMON LEDGER ACCOUNTS ^1 
 
 rendered that amount of value, or has produced that 
 amount of value. We credit Interest $17.25, be- 
 cause the force which that account represents has 
 produced this increase of property, — a creditable 
 thing to do. The entry is shown below. 
 
 10 
 Cash 1617.25 
 
 To Bills Eeceivabl 1500.00 
 
 Interest 17.25 
 
 Eeceived payment on George Meredith's 
 note, received Jan. 1, with interest 
 
 It is interesting to note here that when this note 
 was received by the business, on January 1, Interest 
 was in effect debited $15.00. (On reference to the 
 entry it will be seen that the $15.00 was subtracted 
 from the $21.25, which otherwise would have been 
 credited to Interest.) This $15.00, we saw then, was 
 accrued interest purchased as an asset. Interest was 
 debited because Interest is responsible, — not there 
 responsible for a loss, but responsible to collect the 
 money. Now we find Interest credited $17.25. Ob- 
 viously $15.00 of the $17.25 is merely acquittal of 
 the responsibility to collect, and the rest is benefit 
 conferred on the business, — clear gain. Is the $2.25, 
 left as clear gain, correct? The business held the 
 note nine days, and, at six per cent., it ought to earn 
 a sixth of a mill a day for every dollar, or $2.25 for 
 the nine days on $1,500. Since this is just what our 
 books show, we have proved the correctness of our 
 debits and credits to Interest on this score. 
 
 On the 11th we buy goods of John Dryden and 
 pay cash, $6,000. We do not wish to open an ac- 
 count with John Drvden on the ledger because we do 
 
 A & A-6 
 
82 ACCOUNTING AND AUDITING 
 
 not expect to have other transactions with him. Be- 
 low is the entry. 
 
 11 
 
 Merchandise 6000.00 
 
 To Cash 6000.00 
 
 Bought of John Dry den for cash, as below : 
 [Details] 
 
 On the 12th we wish to raise more money, and 
 consequently discount at our bank George Evans's 
 note invested by the proprietor. Since this note was 
 dated December 1, to run two months, it will become 
 due February 1, and today it is worth less than its 
 face by the discount for twenty days. The amount 
 of discount is $6.67. We get in cash, therefore, 
 $1,993.33 and must debit Cash for that amount. Since 
 that force in business which we call interest is re- 
 sponsible for the deduction of $6.67 from the face 
 of the note. Interest should be debited; and Bills Ee- 
 ceivable, which has produced the cash, should be 
 credited for the face, as always, or $2,000. The entry 
 is shown below. 
 
 12 
 
 Cash 1993.33 
 
 Interest 6.67 
 
 To Bills Eeceivahle 2000.00 
 
 Bills Eeceivahle No. 2 discounted 
 
 It will be remembered that when we took the note 
 Interest was credited for $10.00 (though this amount 
 was combined with others to make a net credit for 
 four notes of only $6.25). The present debit of $6.67 
 leaves a net credit of $3.33. This is exactly correct, 
 for it shows that we have earned $3.33 by holding 
 the note a third of a month. The note was worth 
 
THE commo:n^ ledger accounts 83 
 
 $1,990 when we took it, and is now worth $1,993.33. 
 On the same day we pay the draft accepted by us 
 on the 9th. Since this is now a bill payable, we debit 
 Bills Payable and credit Cash. The reason for this 
 debit to Bills Payable is obvious : we are now obliged 
 to give up $4,000 in cash because of the claim out- 
 standing against us which originated in this bill 
 payable. We credited Bills Payable for stepping in 
 between us and our debt at the time we accepted 
 the draft, and now that the bill payable must be met 
 we debit it for causing the outgo. The two items 
 on that account balance each other. Always when 
 a bill payable is met the account is, of course, debited 
 as responsible for the loss of property. The entry 
 will appear as shown below. 
 
 Bills Payable 4000.00 
 
 To Cash 4000.00 
 
 Paid our acceptance of Jan. 9 
 
 On the 13th we sell goods to Jonathan Swift, 
 payable in ten days, for $575. The entry is as fol- 
 lows : 
 
 13 
 
 Jonathan Swift 575.00 
 
 To Merchandise 575.00 
 
 Sold him goods as follows, on 10 days 
 [Details] 
 
 On the 15th we sell goods to Richard Steele, to be 
 paid for in ten days, for $200. The entry is as below. 
 
 15 
 
 Eichard Steele 200.00 
 
 To Merchandise 000.00 
 
 [Details] 
 
M ACCOUNTING AND AtlDITINO 
 
 On the 16th the note of G. H. Lewes, invested in 
 the business by the proprietor on January 1, is paid. 
 Since cash comes in, cash account is debited; and 
 since the origin of this receipt lies in property sur- 
 rendered by the bills receivable drawer in the safe, 
 Bills Receivable is credited, as shown below. The 
 business has made a profit by holding the note, for 
 it allowed the proprietor only $498.75 on Jan. 1; the 
 discount was then credited, however, and so only the 
 face needs now to be entered. 
 
 16 
 
 Cash 500.00 
 
 To Bills Receivable 500.00 
 
 Note of G. H. Lewes, dated Dec. 16, paid 
 
 On the same day we sell to Joseph Addison in ex- 
 change for his note, payable in thirty days, $600 
 worth of goods. If for any reason we wish Addison's 
 account to appear on the ledger, we should debit him 
 and credit Merchandise, and then by a second en- 
 try we should debit Bills Receivable and credit him. 
 We will assume in this case, however, that we have 
 no use for Addison's account in the ledger, and there- 
 fore merely debit Bills Receivable because the safe 
 is responsible for that amount of property, and credit 
 Merchandise for surrendering that amount of value. 
 If the goods are to be paid for under ordinary cir- 
 cumstances in thirty days, and his note reads as pay- 
 able in thirty days, no discount is to be considered. 
 If, however, the goods ought to be paid for in ten 
 days, and the note reads as payable in thirty days, he 
 should pay the difference of discount in cash. We 
 
THE COMMON LEDGEE ACCOUNTS 85 
 
 will assume in this case that thirty days is a normal 
 time for payment of the goods and that, therefor,e, 
 the note is an exact equivalent. The entry is shown 
 below. 
 
 16 
 
 Bills Eeceivable 600.00 
 
 To Merchandise 600.00 
 
 Sold goods to Jos. Addison, for his note, 
 30 days 
 [Details] 
 
 On January 17 we sell goods to George Berkeley 
 for cash, $300, as indicated below: 
 
 17 
 
 Cash 300.00 
 
 To Merchandise 300.00 
 
 Sold goods to George Berkeley, for cash 
 [Details] 
 
 On the next day we issue our own note for thirty 
 days, bearing interest, and borrow its face value at 
 a banli for $4,000. It will be seen that here, since the 
 note itself bears interest, there is no discount to be 
 subtracted, for at payment a larger sum than $4,000 
 must be paid exactly equivalent to the interest 
 charge for the lapse of time. We have, therefore, 
 merely to debit Cash and credit Bills Payable, for 
 Bills Payable has rendered the business the service 
 of raising for it this amount of cash. On payment, 
 however, since we must pay more than $4,000, we will 
 debit Interest and Bills Payable and credit Cash. 
 The entry for the issue of the note is shown below. 
 
86 ACCOUNTING AND AUDITING 
 
 18 
 
 CaBh 4000.00 
 
 To Bills Payable 4000.00 
 
 Issued our note for $4000, with interest, 
 and borrowed on it at the National City 
 Bank, 30 days i 
 
 On the 19th we pay Walter Scott in full, as is 
 shown by the following entry: 
 
 Walter Scott 7000.00 
 
 To Cash 7000.00 
 
 Paid him his bill of Jan. 9 
 
 On the same day we pay insurance to the amount 
 of $100. This might be debited to Expense, except 
 as it is desirable to keep all insurance costs by them- 
 selves imtil the end of the year. The latter is what 
 is done in the entry below. 
 
 19 
 
 Insurance 100.00 
 
 To Cash 100.00 
 
 Policy No. 64,510, 3 yrs., on stock of goods 
 
 On the 2^d we pay $300 for remodeling our ofi&ces. 
 If it is supposed that this remodeling constitutes 
 permanent improvement, it will be charged to Real 
 Estate. If, on the other hand, it is supposed to be 
 merely temporary, as a part of the expense of con- 
 ducting the business, it must be charged to Expense 
 or to some subdivision of that account. We here 
 suppose it to be a permanent improvement, and 
 therefore enter it as shown below: 
 
THE COMMON LEDGER ACCOUNTS 87 
 
 _ 22 
 
 Eeal Estate 300.00 
 
 To Cash 300.00 
 
 Bill of Star Building Co. for remodeling 
 offices 
 
 On the same day we let to a tenant one of our re- 
 modeled offices, and he pays three months' rent in 
 advance, to the amount of $100. It is obvious that 
 Cash must be debited as responsible for the money, 
 and some accoimt representing earnings, of a differ- 
 ent sort from those ordinarily made in the common 
 conduct of the business, must be credited. That is 
 to say, it is worth while to distinguish between the 
 profits made on merchandise sold, and the profits 
 arising from such things as interest, commission, and 
 rents. It would ordinarily be desirable to credit this 
 item to Rent, as shown below: 
 
 22 
 Cash 100.00 
 
 To Eent 100.00 
 
 Three months^ rent paid in advance 
 for office, by Edmund Burke 
 
 On January 23 Jonathan Swift's bill is paid, as 
 shown below: 
 
 23 
 Cash 576.00 
 
 To J. Swift 
 In payment of his bill of Jan. 13 
 
 On the same day we pay for coal, $100. Though 
 this might be carried to Expense, if the coal con- 
 sumption is large it will be desirable to compare the 
 cost this year with subsequent years and, therefore, 
 to charge this to an account by itself, as is shown 
 below: 
 
88 ACCOUNTING AND AUDITING 
 
 23 
 Fuel 100.00 
 
 To Cash 100.00 
 
 [Explanation should specify dealer, kind, 
 and amount, or the bill as filed] 
 
 On the 24th we subscribe and pay $100 for the 
 benefit of sufferers by a flood in a distant part of 
 the country. This is no part of expense in the or- 
 dinary sense, and may be charged either to the pro- 
 prietor, if he is supposed to make the subscription 
 on his own behalf, or to Profit and Loss, if the sub- 
 scription is made by the business. In the latter case, 
 as is assumed below, we simply hold responsible for 
 a loss of assets the general balance of income for the 
 year. This, if profit is made, is reduced by this 
 amount, or, if a loss is suffered, is increased to the 
 same extent. The entry is as follows: 
 
 24 
 
 Profit & Loss 100.00 
 
 To Cash * 100.00 
 
 Subscription to flood sufferers * 
 
 We sell goods for cash, as show^n below: 
 
 24 
 Cash - 1200.00 
 
 To Merchandise 1200.00 
 
 [The detail should indicate the name of the 
 purchaser for any large item, as well as the 
 goods sold.] 
 
 On the next day we draw a draft on Anthony 
 Trollope, payable in ten days, to our ,own order, for 
 the amount of his bill due February 4. If this draft 
 is not accepted by Trollope it is nothing but a piece 
 of valueless paper, and, therefore, we cannot make 
 any debit or credit until we know its fate. We make 
 
THE COMMO]^ LEDGER ACCOUNTS 89 
 
 a memorandum of its drawing but can at the present 
 time do nothing else. 
 
 On the same day a bill for dry goods purchased 
 by the proprietor's wife is paid out of the cash 
 drawer. This is chargeable, of course, to his account, 
 as shown below: 
 
 25 
 Laurence Sterne , 75.00 
 
 To Cash 75.00 
 
 Dry goods bill paid for Mrs. Sterne 
 
 Richard Steele's bill is paid in cash, as indicated 
 below: 
 
 25 
 
 Cash 200.00 
 
 To Richard Steele 200.00 
 
 Bill of Jan. 15 paid 
 
 On December 26 we receive notice that the draft 
 drawn on TroUope has been accepted. This is now 
 Troll ope 's promise to pay and is, therefore, for us 
 a bill receivable, and TroUope has met his obligation 
 to pay for the goods sold him on January, 5. We ac- 
 cordingly debit Bills Receivable, for the bills receiv- 
 able drawer or file is responsible for the property, 
 and credit TroUope for giving this property to the 
 business, as shown below: 
 
 Bills Receivable 700.00 
 
 To A. TroUope 700.00 
 
 Our draft on him, for his bill of Jan. 5, 
 accepted by him 
 
 On the 27th we discount at our bank the draft 
 which we received the preceding day accepted by 
 Anthony TroUope. Since this is his promise to pay. 
 
90 ACCOUNTING AND AUDITING 
 
 and we guarantee its payment on discounting it at 
 the bank — ^just as we do any promissory note, — the 
 bank, if our credit is good, will lend us money upon 
 it. We receive cash for the face value less the dis- 
 count for the time remaining before maturity. Since 
 this loss of discount is due to that force in business 
 which is represented by Interest, that account is 
 debited for 93 cents. Cash is debited for the net pro- 
 ceeds, and Bills Receivable, which has now surren- 
 dered this amount of value, is credited for the full 
 face. It is obvious that TroUope's name does not 
 need to appear here as either debited or credited, for 
 he was properly credited when he accepted the draft. 
 The entry for this transaction follows. 
 
 700.00 
 
 On January 29 the proprietor draws for his own 
 use $150 in cash. This cash withdrawal should be 
 debited to the proprietor exactly as any other pay- 
 ment of cash to an individual should be debited to 
 that individual's account. It must be clearly under- 
 stood that the books are kept for the business as 
 an entity independent of the proprietor. The pro- 
 prietor is liable for any debts of the business and he 
 will take any profits accruing to it; but so long as 
 we are keeping books for the business we must not 
 confuse its affairs with the proprietor's personal af- 
 fairs. The balance of the proprietor's account should 
 at all times show how much he now has invested in 
 
 27 
 
 
 Cash 
 Interest 
 
 To Bills Receivable 
 Discounted TroUope's acceptance received 
 yesterday 
 
 699.07 
 .93 
 
THE C0MM0:N' LEDGEE ACCOTJNTS 91 
 
 the business. It may be desirable to keep two ac- 
 counts for the proprietor, one of which shall con- 
 tain his capital investment and the other a record of 
 his personal drawings out of the probable profits. 
 Ordinarily, unless there are complications due to 
 partnership, it makes absolutely no difference 
 whether the capital and withdrawal accounts are 
 combined or not, for the combined balance of the 
 two accounts is the net investment; but when a 
 partnership agreement provides for interest on capi- 
 tal and on imdrawn salaries, it may be essential to 
 know what portion of a partner's total credit is upon 
 investment and what portion is upon salary. We 
 here, having only a single proprietorship, charge this 
 withdrawal to the proprietor's capital account. 
 
 29 
 
 Laurence Sterne 150.00 
 
 To Cash 150.00 
 
 Cash drawn for personal use 
 
 On the 30th we buy goods of Dickens, and sell 
 goods to Swift and Steele. Combining the sales, we 
 get the following entries: 
 
 30 
 
 Merchandise 1000.00 
 
 To Charles Dickens ' . 1000.00 
 
 [Details] 
 
 30 
 
 Jonathan Swift 500.00 
 
 Eichard Steele 500.00 
 
 To Merchandise 1000.00 
 
 [Details] 
 
 We are now in a position to study a little more 
 deeply the significance of some of these accounts, 
 
92 ACCOUNTING AND AUDITING 
 
 and to note a few accounts that are new to us. Let 
 us review summarily the old ones as we go on. 
 
 Cash, as we have seen, represents money, checks, 
 and money orders, but does not represent notes and 
 drafts. Since Cash is debited for all such items re- 
 ceived, and is credited for all such items paid, and 
 since no more can have been paid out than has been 
 received. Cash must always have the balance on the 
 debit side if it has any balance at all. An apparent 
 exception to this, in books which treat bank balances 
 as* if they were cash, is when a bank account has been 
 overdrawn. In such a case the payments appear to 
 be in excess of the receipts. Theoretically, this is 
 true; but its occurrence is bad bookkeeping, for the 
 moment a bank account has been overdrawn, whether 
 with the consent of the bank officials or not, an entry 
 should be made on the receipts side of the cash book, 
 crediting the bank and debiting Cash for the amount 
 of the overdraft. Such an overdraft is distinctly a 
 loan from the bank and should be entered as such. 
 The business is liable for its repayment just as much 
 as it is liable for any other debt, and such a debt 
 should appear upon the books. 
 
 Similarly, Bills Receivable, which represents 
 notes and drafts collectible, can have a balance on 
 the debit side only. Bills Eeceivable is debited for 
 all notes and drafts received, and is credited for all 
 notes and drafts surrendered or collected, and since 
 no more can have been surrendered or collected in 
 cash or other property than the debits called for, 
 it is impossible that the credits to Bills Receivable 
 should ever exceed the debits, and the amount of 
 debit balance must always equal the face value of 
 
THE COMMON LEDGER ACCOUNTS 93 
 
 the notes on hand. An apparent exception to this is 
 in connection with notes bearing interest, for then 
 we collect a sum which, by the amount of the interest, 
 is larger than the face. It is to be noted, however, 
 that this excess payment is no part of the Bills Re- 
 ceivable proper, but is simply a payment for interest, 
 and should be credited to Interest. So it remains 
 true that Bills Receivable account cannot have been 
 credited for more than its debits, and its balance will 
 be the face value of notes on hand. 
 
 Bills Payable account, representing the promises 
 of the business to pay either on promissory notes or 
 on drafts, will be credited for all notes issued and 
 debited for all notes paid; and since not more can 
 have been paid upon Bills Payable than the face of 
 the notes themselves calls for, the balance will al- 
 ways be on the credit side, and the amount of the 
 balance will always be the face of all notes still out- 
 standing. It is true, of course, that sometimes a note 
 calls for the payment of a larger sum than that in- 
 dicated on its face, for interest may be included; in 
 such case, however, it must be recognized that the 
 excess payment is interest pure and simple, and must 
 be debited to Interest; so it still remains true that 
 not more can have been paid on Bills Payable proper 
 than the total of the Bills Payable credits, and the 
 balance is the amount outstanding. 
 
 All pure property accounts must have the balance 
 on the debit side, if any balance at all remains; for 
 since each such account is debited originally for the 
 value of the property belonging to the department 
 of the business represented by the account, and since 
 each is credited for what is surrendered by that de- 
 
94 ACCOUNTING AND AUDITING 
 
 partment, any balance must represent the amount 
 of property on hand. If any elements of profit are 
 connected with property accounts — such as we have 
 seen in the case of Merchandise, — the profit makes 
 the account to a certain extent nominal, and its treat- 
 ment at the end of the year must be in part that 
 accorded to nominal accounts. Normally, however, 
 property accounts are not supposed to have profit 
 connected with them, though most of them need, an- 
 nually or oftener, to be credited for depreciation in 
 case repairs have not kept the property up to its 
 original value. This credit subtracted from the debit 
 standing originally on the books should show the net 
 value of the property on hand, which is the debit 
 balance remaining. 
 
 Of property accounts having some admixture of 
 profits. Merchandise is the most common and there- 
 fore best worth detailed study. We saw that it is 
 partly a real account, representing property, and 
 partly a nominal account, representing profit or loss. 
 This introduces some complication and awkwardness 
 of interpretation. Let us examine it further. Mer- 
 chandise may have a balance on either side because 
 it is commonly debited for merchandise bought at 
 the cost price, and is commonly credited for mer- 
 chandise sold at the selliug price. The difference 
 between the tw^o prices may be so great as to throw 
 the balance on the credit side even though a con- 
 siderable amount of merchandise is still on hand. 
 Before we can know whether this account properly 
 represents an earning or a loss, then, we must take 
 into account the amount of merchandise on hand. 
 Let us try out a number of cases of this sort. 
 
THE COMMON LEDGER ACCOUNTS 95 
 
 Suppose the amount of merchandise on hand at 
 the beginning of the year cost $15,000, and that $40,- 
 000 worth was bought during the year. This gives 
 a total debit of $55,000. Suppose next that the mer- 
 chandise sold and credited amounts to $50,000. Ap- 
 parently we have a debit balance of $5,000 which, if 
 we were to treat Merchandise as we ordinarily treat 
 property accounts, would indicate $5,000 worth of 
 merchandise on hand. If, however, our selling price 
 has been much higher than the buying price, it is 
 obvious that the $50,000 worth sold cost us a good 
 deal less than $50,000, — how much less we cannot tell 
 by any figures before us. If, now, we learn that we 
 have $20,000 worth of goods, figured at cost price, 
 still remaining, the goods sold cost us $35,000; and 
 we know this because we know that of the $55,000 
 debited to Merchandise ($15,000 worth on hand at 
 the beginning of the year and $40,000 worth pur- 
 chased later), we have $20,000 still remaining, so that 
 $35,000 worth must have been sold. If the $35,000 
 worth sold brought us $50,000, as the credits to Mer- 
 chandise indicate, the gain is $15,000. 
 
 Now let us change our supposition. Suppose, 
 though we are beginning the year as before, with 
 $15,000, and purchased during the year as before 
 $40,000, and sold during the year as before $50,000, 
 the amount now on hand is $5,000. It is obvious 
 that we have made no profit; this is shown by sub- 
 tracting the $5,000 now on hand from the $55,000 
 total debits, leaving $50,000 as the cost of the goods 
 sold. This compared with the credits indicates that 
 we really got only cost price for sales. 
 
 Let us try another case. Suppose the debits to 
 
96 ACCOUNTING AND AUDITING 
 
 be $55,000 ^s before, the credits to be now but $20,- 
 000, and the inventory to be $40,000. It is obvious 
 in this ease that the profits are $5,000; for the amount 
 on hand, $40,000, subtracted from the total debits, 
 $55,000, leaves $15,000, at cost price, for the goods 
 sold; and since the sales amounted to $20,000 and 
 the cost of the sales to $15,000, the balance is $5,000 
 profit. 
 
 The same result would have been attained each 
 time if, instead of subtracting the inventory from the 
 debits, we had added it to the credits; for the credits 
 then would have represented what we have received 
 for our sales plus what we have yet on hand, which 
 ultimately is to be credited. The difference between 
 what it cost us to secure the merchandise and what 
 the merchandise is worth, both sold and in stock, is 
 the profit. 
 
 Let us take one case more, and use the second 
 method. Supposing the debits to be as before, $55,- 
 000, let us assume the sales to be $60,000 and the 
 goods remaining on hand to be $15,000. Here the 
 profit will be $20,000, because our sales have already 
 realized $5,000 more than the total cost of all mer- 
 chandise, and we have $15,000 yet on hand; the two 
 added give us $20,000 profit. Eeverting to our for- 
 mer method for this case, we get figures as follows : 
 our present stock of $15,000, subtracted from our 
 debits, $55,000, leaves us $40,000 for the cost of the 
 goods sold; as they brought $60,000, our profit is 
 $20,000. Neither method, it is to be noted, counts 
 profit on future sales, for we are figuring the in- 
 ventory only at cost price, and we are doing this 
 only because we must figure it on some basis in order 
 
THE COMMON LEDGER ACCOUNTS 97 
 
 to determine what has been the profit on the goods 
 sold. If the inventory of $15,000 should prove next 
 year to bring in nothing, it would still be true that 
 our profits this year have been $20,000. This year's 
 profits are entirely independent of the inventory of 
 $15,000 put upon the goods now on hand. The $15,- 
 000 is used only in order that we may determine how 
 many of the total goods debited to Merchandise have 
 been utilized in getting the $60,000 worth of sales, 
 and the profit of $20,000 really comes from compar- 
 ing the $40,000 of cost of sales with the $60,000 of 
 results from sales. 
 
 Another method of treating Merchandise, which 
 proves well worth while in large businesses, may be 
 noted here. It does not get rid of the requirement 
 of an inventory; no method can do that unless cost 
 can be figured exactly on all articles sold, for only 
 when we have either the cost of goods sold or the 
 cost of the goods remaining on hand can we learn 
 our profit from sales. By this method, separate ac- 
 counts are kept f Qr each of the three relations which 
 Merchandise has with the business as a whole. One 
 account. Inventory, represents the inventory, or re- 
 sult of taking account of stock, at the beginning of 
 the year; this is kept constant through the year 
 because no other debits and no credits are made to 
 it. Another account. Purchases, shows purchases; 
 and to this account are debited at the purchase or 
 cost price all purchases made during the year. This 
 would be a property account if it were credited for 
 all sales of goods at the purchase price, for then the 
 difference between the debits and the credits to this 
 account would show what value in goods bought since 
 
 A & A-7 
 
98 ACCOUNTING AND AUDITING 
 
 the beginning of the year is still on hand. A diffi- 
 culty is that it is usually impossible, at least in any 
 businesses but those of few sales, to figure on all 
 items of sales the actual cost. Consequently it is 
 usual under this plan to make no credits to the pur- 
 chases account except when goods purchased are re- 
 turned. Sales are credited to a separate account 
 bearing that name, and are always entered at the sell- 
 ing price. Under this plan, then, profit is learned by 
 adding the inventory at the end of the year to the 
 sales, and from this sum subtracting the sum of the 
 inventory at the beginning of the year and the pur- 
 chases. We are not then much better off as regards 
 the profit on merchandise than under the plan of a 
 single account for merchandise, discussed in the pre- 
 ceding paragraph. The real value of this three-account 
 treatment of merchandise is that with it we know 
 the magnitude of our business as indicated by the 
 total amount of purchases and the total amount of 
 sales. Under the single account for merchandise, if 
 we debit Merchandise when goods are bought and 
 then return some of these goods, we must credit 
 Merchandise for the return at the cost price; but we 
 commonly also must credit merchandise sales to the 
 single merchandise account at selling price. Our 
 credits to Merchandise, then, comprise two sets of 
 items : one is returned purchases at cost, the other is 
 sales at selling price. This total credit does not 
 properly indicate the magnitude of our sales, and, 
 consequently, our merchandise account is not a 
 proper index of the magnitude of our business. Simi- 
 larly, we debit Merchandise not only for goods pur- 
 chased at cost price, but for sales returned at selling 
 
THE COMMOI^ LEDGER ACCOUNTS 99 
 
 price, and hence the debit to Merchandise does not 
 indicate the volume of our purchases. Only so far 
 as the three separate accounts for Merchandise avoid 
 this difficulty is the three-account system for mer- 
 chandise better than the old-fashioned method of a 
 single account. 
 
 We have to conclude, therefore, that in any case 
 our Merchandise account is not quite one thing or an- 
 other. It is not quite a real account and not quite a 
 nominal account, but it may be made either of these. 
 Whenever we take account of stock, we can remove 
 from Merchandise the profit made on sales and trans- 
 fer it to another account; the balance is then the cor- 
 rect property valuation. This awkwardness in Mer- 
 chandise seems unfortunate, but it chances that it is 
 due not at all to bookkeeping defects, but to a mere 
 defect of fact. If the managers of the business can- 
 not learn what has been the actual cost of sales, be- 
 cause of the expense of keeping and classifying the 
 records, it is not to be expected that accounting 
 can show in Merchandise, or any accounts represent- 
 ing merchandise, just what is the stock of goods on 
 hand. It is only where it is possible to keep record of 
 sales, and look up the cost price of all such sales, that 
 merchandise account can be made exactly either a 
 property account or a profit account. If such a record 
 of the cost of sales were made, the books could al- 
 ways be kept in accordance with the facts. If Pur- 
 chases was then credited every day with the total 
 cost of goods sold, the debit balance of Purchases 
 would always be the purchases added since the be- 
 ginning of the year and now on hand ; and this sum, 
 added to the inventory at the beginning of the year, 
 
100 ACCOUNTING AND AUDITING 
 
 would be the total stock of goods on hand; or, if 
 more had been sold than was purchased after the be- 
 ginning of the year, the credit excess when carried 
 to Inventory (as at the beginning of the year) would 
 leave as a balance a sum equal to the stock of goods 
 on hand. The sales account, similarly, would be deb- 
 ited for all sales at cost — because, of course, the sales 
 would be responsible at cost for the goods disposed 
 of, — and would show as a balance, since it is credited 
 with all sales at selling price, the gross profit on sales. 
 
 It is obvious that Wages, Printing, Postage, In- 
 surance, Taxes, etc., all of which represent varieties 
 of expense, will have a balance on the debit side, 
 for they are responsible for outgoes. If, on the other 
 hand, we find that one of our workmen has been en- 
 gaged in something for his employer's personal use, 
 though his name appears on the pay-roll as if he were 
 engaged in the regular work of the business, we cor- 
 rect the error by debiting the proprietor and credit- 
 ing Wages. If some of our stationery originally 
 charged to Stationery is sold, Stationery will, of 
 course, be credited for the amount. Eepayment of 
 insurance premium on the cancellation of a policy 
 will be credited to Insurance. Credits to these ac- 
 counts are rare, however. 
 
 Commission, representing both commissions al- 
 lowed and commissions earned, may have a balance 
 on either side, for the amounts earned may exceed 
 or fall below those allowed. If Commission shows 
 a credit balance, it is obvious that since it is credited 
 for earnings — because to earn commissions is a 
 creditable thing, — and is debited for commissions in- 
 curred — since Commission is responsible for the out- 
 
THE COMMON LEDGER ACCOUNTS 101 
 
 go, — a credit balance shows a net profit on that score; 
 and a debit balance shows a net loss on that score. 
 
 Interest, similarly, may have a balance on either 
 side. A credit balance represents net earnings of in- 
 terest over interest charges incurred, and a debit bal- 
 ance represents excess of interest allowed to others 
 over interest earned. 
 
 The three general types of accounts have been 
 illustrated in the particular accoimts just described; 
 but if it were not possible to bring together the vari- 
 ous elements of a business and make a summary of 
 all operations and relations, it would be difficult at 
 the end of the year to record on the books any very 
 clear statement of the results as a whole. As a 
 means of bringing together the various nominal ac- 
 counts, a profit and loss account is always kept. To 
 this, ultimately, the balances, of the other nominal 
 accounts are carried. Indeed, Profit and Loss may 
 serve another purpose than merely to summarize the 
 transactions of an earning period. Throughout the 
 com-se of any year there are likely to be some losses 
 and gains of an unusual and rather trivial nature for 
 which it is not worth while to keep any special ac- 
 counts. Such losses and gains would be carried, 
 whenever they occurred, to Profit and Loss, and there 
 remain to be combined with all the others at the end 
 of the year. Obviously, Profit and Loss should, in 
 closing the business at the end of the year, be debited 
 for all nominal accounts having a debit balance at 
 that time, — such, for instance, as wages, rent paid 
 in excess of that earned, interest paid in excess of 
 that earned, commissions paid in excess of that 
 earned, postage, stationery, etc.; and should be 
 
102 ACCOUNTING AND AUDITING 
 
 credited by the earnings from merchandise, interest 
 when earned in excess of allowances, etc. Profit and 
 Loss may, of course, show the balance on either side. 
 An excess of credits means that this account explains 
 the fact that our assets have increased, by profits, 
 over what they were at the beginning of the period. 
 Since we debit property accounts and credit some ex- 
 planation account (and Profit and Loss is simply the 
 total balance of all explanation accounts) for all 
 profits made during the year, the balance shown to 
 the credit of this account at the end of the year 
 measures the increase of assets. A debit balance to 
 Profit and Loss, on the contrary, indicates net shrink- 
 age of assets, for we have debited some explanation 
 account and credited some property account for all 
 sums disbursed as expenses or losses. If the busi- 
 ness is a corporation and suffers a loss on operations 
 for the year. Profit and Loss will remain with a debit 
 balance at the end of the year; for if stockholders 
 are not assessed to make up this deficit, there is no 
 way of offsetting this loss on the books by charg- 
 ing it against any other account. A debit balance, 
 then, means simply that the capital of the corpora- 
 tion has been depleted by the amount shown. 
 
 So far we have been considering only accounts 
 which are of practically universal use. It is well now 
 to observe some which, though common, are not 
 necessarily found in all lines of business. It is com- 
 mon in many lines of business, as already indicated, 
 to provide that when bills are paid early a discount 
 may be subtracted from the full billed price. Some- 
 times these discounts are carried directly to Mer- 
 chandise; that is, if the discounts are taken by cus- 
 
THE COMMON LEDGER ACCOUNTS 103 
 
 tomers on goods sold, since the original credit to Mer- 
 chandise is larger than the amount finally paid, Mer- 
 chandise is debited for the amount of discount; so 
 that the net result is the same as if Merchandise 
 had been originally credited for the proper figure. 
 This serves the purpose very well in most particulars, 
 but it does not indicate what is the actual amount of 
 discount allowed in the course of the year, for the 
 figures are buried in Merchandise; and when it is de- 
 sirable to compare discounts allowed this year with 
 those allowed last year, this method gives no in- 
 formation. It is obvious, of course, that if we are 
 selling to a poorer class of customers this year than 
 last year, they probably will be less able to pay their 
 bills promptly, and the amount of discount which 
 they take will be smaller. When the amount of goods 
 sold is the same, therefore, an increase in the amount 
 of discount allowed indicates a better class of custom; 
 and as this figure may be found easily only when dis- 
 counts are carried to an account which contains 
 nothing else, it is worth while to keep merchandise 
 discounts separate during the year and carry them 
 at the end of the year into Merchandise — as a final 
 correction of prices, — or directly into Profit and Loss. 
 Another method of accomplishing the same end, but 
 on a more scientific basis, will be discussed later. 
 The method described here, however, is the common 
 method of business. 
 
 Another special account, which one would wish 
 never to have occasion to use, is for bad debts. When 
 it is finally known that an account will never be col- 
 lected, though from one point of view it is still de- 
 sirable that the books shall show that the money is 
 
104 ACCOUNTING AND AUDITING 
 
 owed, from another point of view it is desirable to 
 eliminate the account altogether; for smns due to the 
 business ought to be counted as assets in calculating 
 the present worth of the business at the end of the 
 year. If bad debts are allowed to remain upon the 
 books, there is great danger that the assets will ap- 
 pear overstated. A method of keeping record of the 
 fact that the debt was not paid, and yet of removing 
 the accoimt from the assets, is to maintain an ac- 
 count entitled Bad Debts. Whenever an account is 
 known to be bad a debit is made to Bad Debts and a 
 credit to the account concerned. This closes the bad 
 account and leaves Bad Debts with a balance which 
 is of the nature of an explanation to be closed into 
 the profit and loss account at the end of the year. If 
 by any chance the debt should finally be paid, en- 
 tries may be made to indicate the fact by simply 
 debiting once more the original account and crediting 
 Bad Debts, and then debiting Cash and crediting the 
 original account for the amount paid. This puts 
 everything where it would have been if the account 
 had never been erroneously thought bad. This is 
 better than crediting Bad Debts directly with the 
 cash, for then the original account still looks as if it 
 had never been paid*. 
 
 A similar account for items thought possibly to 
 be bad, though not yet abandoned, is sometimes called 
 Suspense. To this account are debited items which 
 the proprietors no longer wish to carry as good 
 claims and yet are not willing to charge as losses. 
 The method of handling this account would be the 
 same as that for Bad Debts except that at the end of 
 the year a certain percentage of such accounts, pos- 
 
THE COMMOlSr LEDGER ACCOUNTS 105 
 
 sibly one-half, one-third, or one-fourth, would be 
 considered as good — on the assumption not so much 
 that one-half of each account would be paid, as that 
 an amount equivalent to one-half of the total would 
 probably be paid in full. 
 
 Sometimes one finds in bookkeeping an accoimt 
 bearing the same name as that just described, but 
 with an entirely different purpose. If it is a little 
 uncertain at a time money is spent what will be the 
 ultimate result of that expenditure, one is in doubt 
 what to debit. Perhaps the company is engaged in 
 rebuilding parts of its plant, and it is not sure while 
 the work is in progress how much of the expendi- 
 ture is for repairs, which ought to be considered as 
 a part of expenses, and how much is for actual ad- 
 ditions, which ought to be charged to Real Estate. 
 By the device of a suspense account, to which all 
 such expenses may be temporarily charged, it is pos- 
 sible to postpone the final decision as to the amounts 
 to be charged to Repairs and to Real Estate until the 
 work is completed. Then an entry debiting Real 
 Estate and Repairs and crediting Suspense will rep- 
 resent the facts properly upon the books. 
 
 An entirely new class of accounts unlike any we 
 have been discussing up to this point are so-called 
 reserve accounts. It is obvious that if, at the end 
 of the year. Profit and Loss shows a balance on the 
 credit^ side, the business has earned something dur- 
 ing the year in excess of its expenses. If all this 
 credit balance is distributed as dividends. Profit and 
 Loss will have no balance at the beginning of the new 
 year; for on the distribution of dividends Profit and 
 Loss will be debited and Cash will be credited. If, on 
 
106 ACCOUNTING AND AUDITING 
 
 the other hand, the directors or partners decide not 
 to distribute all the earnings as dividends, Profit and 
 Loss will have a balance representing undivided 
 profits. Several dispositions of these undivided 
 profits are possible. It is common to leave them 
 standing just as they are on the ledger. When left 
 in this fashion, it is of course possible that they may 
 be distributed in another year, for it may chance that 
 the later earnings are a little less than in the past 
 and the surplus earnings accumulated may be used 
 to make up the dividend to an amount as large as that 
 previously distributed. If, on the other hand, it is 
 the policy of the managers to keep out of each year's 
 profits a certain portion as a safety fund for possible 
 losses through bad debts, through depreciation of ma- 
 chinery, through changes of fashion — ^throwing out 
 of use goods and machinery to make such goods, — it 
 may be desirable to label, so to speak, a certain part 
 of the accumulated profits so that they shall be under- 
 stood as intended to be maintained unimpaired in the 
 business and never, or at least not for some years, 
 distributed as dividends. The way to accomplish this 
 on the books is to make an entry debiting Profit and 
 Loss and crediting a special account (that is, simply 
 transferring the balance), and thus to convert the old 
 profit and loss balance into a new profit and loss 
 balance which appears on the books with a name in- 
 dicating its specific purpose, — such as Permanent 
 Surplus. In such cases it is clear that, just as Profit 
 and Loss is a nominal account explaining that a cer- 
 tain amount of the assets of the business has come 
 from profit-yielding operations, so the reserve ac- 
 count is nominal and indicates that a certain amount 
 
THE COMMON LEDGER ACCOUNTS 107 
 
 of assets, consisting of accumulated profits, is in- 
 tended for a specific purpose other than distribution 
 as dividends. A large business may maintain several 
 different reserve accounts of the sort described. For 
 instance, it may have so many buildings and so much 
 machinery scattered about in many places that the 
 managers believe it can more cheaply get along with- 
 out fire insurance and run the risk of fire losses than 
 pay insurance to insurance companies. In that case, 
 the part of wisdom would be to set apart out of each 
 year's apparent profits a certain reserve to cover 
 the possibility of loss by fire. If the company has 
 good luck, this reserve will be constantly growing and 
 will represent earnings found to be unnecessary for 
 replacement of buildings. If in any year a fire oc- 
 curs, this account will be debited for the amount re- 
 quired to replace the buildings destroyed. Again, it 
 is a common thing for machinery to become out of 
 date by the discovery of new processes which will 
 produce goods more cheaply than the old machinery 
 can do. Many companies, to protect themselves 
 against loss through the occurrence of this sort of 
 thing, establish regularly a reserve for obsolescence 
 of machinery. This appears, of course, as a credit on 
 the books — a specially labeled profit and loss credit 
 balance. 
 
CHAPTER V , 
 
 THE PRACTICAL OPERATIONS OF BOOKKEEPING 
 
 We saw in the last chapter a good many illustra- 
 tions of the method of making entries through the 
 journal, and we saw in the preceding chapter that, 
 by means of books which are specialized forms of the 
 journal, we may post certain common items, like cash 
 and merchandise, in totals at the end of each month 
 or week instead of individually, item by item. Let 
 us review these special books and then examine the 
 actual methods of dealing with them. 
 
 When we use a cash book and one page is made to 
 include all the debits to Cash — with, of course, credits 
 to other accounts, — and the other page to include 
 credits to Cash — with debits to other accounts, any 
 number of items may be posted as a debit or a credit 
 to Cash in one lump sum, and so the total nimaber of 
 postings for each side of the book is only one greater 
 than the number of items. If, for instance, there are 
 one hundred items of Cash receipts, there will be 
 one hundred credits to the accounts representing the 
 source of the cash, and there will be only one debit 
 to Cash — which is a total of all the receipts; and the 
 one debit to Cash will be the amount of the credits 
 to all the other accounts. However great the number 
 of items, if we can keep all our Cash debits in one 
 place, we need only one Cash debit to offset all the 
 
 109 
 
110 ACCOUNTING AND AUDITING 
 
 credit items. The same thing is true on the other side 
 of the cash book, on the purchase book, and on the 
 sales book. So, although we started with a consid- 
 eration of the only proper bookkeeping method as 
 that of double entry, we have found that the double 
 entry is double not in the sense that it requires two 
 entries or even two postings for each transaction, but 
 only in the sense that it has debits equal to credits. 
 
 It is well to note a number of things with regard 
 to the manner of making postings to the ledger. It is 
 desirable, of course, to indicate on the book of original 
 entry whenever a posting has been made, for other- 
 wise an unintentional second posting of the amount 
 might throw the ledger out of accord with the facts. 
 The usual method of indicating the fact that the work 
 has been done is to make a check mark; but since 
 there is advantage in having in the journal a record 
 of the page of the ledger to which the posting was 
 made (in order that in looking the matter up again 
 one may turn to it readily), the number of the ledger 
 page, or ^ ledger folio," is commonly used as the 
 check mark. Similarly, in the ledger it is desirable to 
 have for reference an indication of the page from 
 which the entry came, and in ledger rulings a column 
 is provided for that purpose. Care should be taken 
 in making postings that, even though the bookkeeper 
 knows the number of the ledger folio to which he will 
 transfer the item, he does not write that number in 
 the column for check marks until after the posting 
 is actually made; for otherwise, if by any chance he 
 is interrupted in the process, the check mark may 
 mislead him and possibly the item will not get upon 
 
PRACTICAL OPEEATIONS OF BOOKKEEPING 111 
 
 the ledger until after a long search in quest of the un- 
 known error. 
 
 Now that we have our original entries cut up and 
 distributed among four books, we may find oc- 
 casionally that various parts of what is really one 
 transaction must be split among several books. It is 
 a convenience to have all items belonging to one 
 transaction in one place. If that convenience is very 
 great, it may be worth while to make the full entry in 
 the journal, even though cash be involved, and then 
 make another entry in the cash book in order that 
 the amount of cash may appear among the cash re- 
 ceipts. When this is done, unless a precaution is 
 taken. Cash will be debited or credited twice — once 
 in the journal and once in the cash book. It is easy 
 to head off a second posting by checking this cash 
 item in the journal at the time the entry is made. 
 If the check used is a blank check, instead of the folio 
 number, this check will indicate that posting has not 
 been made and need not be made from this place and 
 that the entry appears elsewhere and will be posted 
 thence. Any entries may be introduced into any book, 
 for the sake of a comprehensive statement of the 
 transaction — even though duplicate entries are made 
 in other books, — provided only the blank check 13 
 used to head off duplicate postings. This principle 
 may be well illustrated by one treatment of a cash 
 sale. Some houses use a special cash-sales book, from 
 which the total is carried to the cash book as a debit 
 to Cash and a credit to Merchandise. The credit post- 
 ing to Merchandise may then be made, obviously, 
 either from the cash book, to which the total is trans- 
 ferred, or directly from the footing of the cash-sales 
 
112 ACCOUNTIN^G AND AUDITING 
 
 book itself. Even when this special sales book for 
 cash sales is not provided, however, it is desirable 
 that the entry shall be made on the cash book in order 
 that all cash items may be together, and it is desirable 
 that it shall be also upon the sales book in order that 
 we may have a complete record of sales. Unless we 
 take precaution to head off the possible double post- 
 ing — that is, both the debit to Cash and credit to Mer- 
 chandise from the cash book and the credit to Mer- 
 chandise and debit to Cash from the sales book, — we 
 shall have both of these accounts thrown out of ac- 
 cord with the facts. If, however, we make in both 
 books, at the time of entry, the blank check in the 
 check column, we provide that Cash shall be prop- 
 erly debited, because the amount will be included in 
 the footing of the page as a Cash debit for the period, 
 and that Merchandise shall be properly credited, be- 
 cause the sale will be included in the footing of the 
 sales book for the period; but since both items are 
 checked. Merchandise is not improperly credited 
 again from the cash book (as it naturally would be 
 if not checked), and Cash is not improperly debited 
 again from the sales book (as it naturally would be 
 if not checked) . This is shown on pages 122 and 125 
 for the sale to George Berkeley on January 17. The 
 item is checked in both sales book and cash book. 
 Cash gets a debit posting through the total for the 
 month on the cash book, and Merchandise gets a 
 credit posting through the total sales on the sales 
 book. A large number of uses of the blank check 
 may be worth while in such connections as this. We 
 might, for instance, give Laurence Sterne credit on 
 the journal (page 121) for his whole investment, 
 
MACTICAL OPEEATIOKS OF BOOKKEEPING 113 
 
 including cash; then if we check the cash item in 
 the journal and check the Laurence Sterne item in 
 the cash book (page 122), all will be as it should be. 
 This is not done, however, for there is no objection to 
 splitting the item between two books. 
 
 It is not necessary to add the columns of the jour- 
 nal, for the totals are not to be posted to any account. 
 When it happens, however, that the separate items 
 of debits and of credits are not identical, it may be 
 worth while to add the journal columns in order to 
 make sure that the total debits equal the total credits, 
 — which of course they ought to do. If, that is to 
 say, many entries are so complicated, like that on 
 page 70, that, though the sum of the debits equals 
 the sum of the credits, the debits and the credits are 
 not identical item for item, one cannot at a glance 
 make sure that the total debits equal the total credits 
 unless one takes the footings of the columns and 
 compares them. To test a page made up of such 
 items and to preserve the test by entering the totals 
 in the journal, as a footing of the page, gives satis- 
 faction not only to the bookkeeper but to anyone who 
 has occasion to use the book. Such a total is shown 
 on page 121. 
 
 We may note next that the custom has grown up 
 in bookkeeping of making occasional entries which 
 are distinctly false, but those entries are accompa- 
 nied by other entries which offset the intentional 
 error. The best illustration of this is on the cash 
 book when discounts are allowed. The method is the 
 same whether the discounts are those similar to in- 
 terest, such as we had in the transactions worked 
 
 out in detail in the last chapter, or are commercial 
 A & A-8 ■; 
 
U4 ACCOIJNTING AND AtJDITIK& 
 
 discounts allowed for early payment of bills. It is 
 obvious that when we discount a note at a bank and 
 receive the face of the note less the discount, the 
 transaction is quite the same as if the bank gave us 
 the face value of the note and then required us to 
 pay the discount in cash. To make an entry as if 
 that took place, then, is not essentially to falsify the 
 record. If that actually happened we should on the 
 credit or disbursement side of the cash book enter a 
 debit to Discount; that is, we should enter on the 
 credit side of the cash book the item '* Discount," 
 and this, of course, appearing on that side of the 
 cash book means that Discount is debited. We 
 should at the same time on the debit or receipts side 
 of the cash book enter ''Bills Payable" at the full 
 face of the note, and this appearing on that side of 
 the book is necessarily a credit to BiUs Payable.- 
 When these items have been posted, each account has 
 its proper balance of debit and credit; and the only 
 falsification lies in an overstatement of the total 
 amount of cash handled: for the receipts side of the 
 cash book shows a sum larger than was actually re- 
 ceived (by the amount of the discount) because we 
 have debited Cash for the full face of the note though 
 we have received less than that sum, and the dis- 
 bursements side of the book shows a sum including 
 the amount of the discount, though no cash was paid 
 out on that score. This exaggeration of the amount 
 of receipts and of disbursements does no harm, how- 
 ever, for since both sides are exaggerated alike the 
 balance between them is accurate. This device saves 
 the labor of splitting such entries between two books^. 
 for without it the discounts would have to go upon 
 
PEACTICAL OPERATIONS OF BOOKKEEPING llS 
 
 the journal. It is illustrated on pages 122 and 123 
 in the discounts for January 10, 12 and 27. 
 
 Bookkeeping recognizes no such thing as sub- 
 traction. It would be extremely awkward if it were 
 necessary to indicate in any place that a certain 
 figure were to be subtracted from the figure above 
 it, for then totals could not be taken without con- 
 stant precaution that a sum to be subtracted were 
 not added. It is often necessary, however, to pro- 
 duce the effect of a subtraction. This is alwavs done 
 by adding to the other side of an account the figures 
 to be subtracted. Suppose an account shows a total 
 of $5,000 on the credit side, and $4,000 on the debit 
 side. Subtraction gives us a balance of $1,000 credit. 
 If we were to subtract that $1,000 and bring down 
 our $4,000, we could then rule up the account as bal- 
 anced and carry the balance down to the re-opening 
 of the account. The same result is produced by 
 adding $1,000 on the debit side (for this gives $5,000 
 on each side — which produces an equality), and then 
 bringing down the $1,000 as the new balance on the 
 credit side. Such artificial insertions are usually 
 made in red ink; for they thus call conspicuously to 
 the attention of anyone reading the account the fact 
 that the item is not a proper debit due to some re- 
 sponsibility assumed, but is artificially inserted 
 merely to measure the excess of the other side. It is 
 obvious that one may as well compare two things by 
 adding to the smaller and seeing how much is re- 
 quired to make them equal, as by subtracting from 
 the larger. The common method of balancing is just 
 that: we see how big a thing is required to bring the 
 small side up to a level with the large, and we insert 
 
116 ACCOlTNTmG AND AUDITINa 
 
 it in red ink to call attention to the fact that it is only 
 the rneasure of the excess on the other side. Indeed, 
 this is what we commonly do in comparing things 
 with a yard stick. We measure the long and then 
 the short, and see how large a piece would need to be 
 added to the short piece to make up the length of the 
 long. It is true, then, that the amount brought down 
 on re-opening the account is not really the amount 
 written in red ink on the other side. What we bring 
 down is simply the excess on the big side, and it 
 chances that the size of that excess is measured by 
 the item written in red on the short side. As a work- 
 ing rule, however, we may say that an item written 
 in red is always brought down on the other side, — 
 but the reason is that the item simply measures an 
 excess on the same side. This method is illustrated 
 in the form of cash book shown on page 123. The 
 same method is used in balancing a ledger. 
 
 In a cash book the item of balances is usually the 
 only item which is not to be posted. A bookkeeper 
 in running his eye up the column reserved for check 
 marks, to see that no posting has been omitted, ob- 
 serves the blank space and has his attention arrested. 
 He must look to see why the omission occurs. It is 
 a convenience, therefore, to have a check in that 
 column to satisfy the eye that the work is finished; 
 at the same time it is worth while to use that check 
 as an indication that the bookkeeper has looked to see 
 that the balance brought down or carried over is the 
 same as that inserted in closing; and this observa- 
 tion he should always make before putting the check 
 mark into the column. As illustrated on pages 123 
 and 122, the last item on the credit side, $2,894.65, 
 
PKACTICAL OPEEATIONS OF BOOKKEEPING 117 
 
 which is the closing balance, is checked with the 
 February 1 opening balance on the debit side. 
 
 In modern practice it is common in posting to 
 omit from the ledger everything except the date, the 
 page nmnber of the book of original entry from 
 which the item is taken, and the amount. This has 
 the advantage of reducing labor to a minimum, but 
 there is a corresponding disadvantage lying in the 
 fact that there is nothing to indicate in the posting 
 just what is the nature of the transaction; and there- 
 fore it may be necessary often to look back to origi- 
 nal entries to see what happened. Even a slight in- 
 dication of what happened will usually sufl&ce as a 
 reminder of all that it is necessary for ordinary pur- 
 poses to know, and this can be easily given by a men- 
 tion of the other account concerned. If, then, in 
 posting we always indicate in the ledger the name of 
 that other account, such, for instance, as what was 
 debited when Bills Payable (page 79) was cred- 
 ited, we have in the ledger a complete summary of 
 each transaction. To do this, moreover, is not a seri- 
 ous task, for in books developed as most books are 
 nowadays it is likely to happen that most credits 
 to any account will be of the same nature — for in- 
 stance, Merchandise or Cash or Notes, — and, there- 
 fore, after the name of the other account has once 
 been written its duplication is indicated by simple 
 ditto marks. The labor is inconsiderable, and then if 
 any item of an unusual sort occurs it will be written 
 in full in the ledger and will catch the eye readily if 
 it is ever sought. 
 
 We have so far been concerned only with what 
 are called the *^ principal books," The work of 
 
118 ACCOUNTING AND AUDITING 
 
 making and of finding desired records may be very 
 much reduced if we keep certain memoranda in aux- 
 iliary books. These may not only relieve the prin- 
 cipal books of a great burden of detail, but may show 
 the information in a tabulated form convenient for 
 reference. A good illustration of such auxiliary 
 books is the so-called ^^bill book/' in which are 
 usually kept lists of all bills receivable and bills pay- 
 able. A separate book, or portion of a book, is kept 
 for each of these. The form of each of these books 
 supplies a large number of columns for a complete 
 record of all details concerning each note, — such, for 
 instance, as the maker, the indorsers, the date, the 
 time to run, the rate of interest, where the note is 
 payable, its maturity, and the amount. Usually a 
 dozen columns, one for each month, are provided for 
 the date of maturity, so that it is necessary to write 
 only the day of the month in the column for the 
 month. This is a great convenience, for since notes 
 mature usually not in the order of acquisition (be- 
 cause of different duration), it is something of a task, 
 where there are many notes, to go through the 
 list and pick out, without risk of error, all maturing 
 on any particular day. If carelessness occurs, some 
 notes fail of presentation or of payment at the proper 
 time. When, however, a column is provided for 
 each month of the year, and those notes maturing in 
 each month are indicated by numerals on the proper 
 line and in the proper column, one can at a glance 
 see just what are coming to maturity in each month. 
 If in a bill book all notes received and all notes is- 
 sued are given artificial numbers in consecutive 
 order, reference to them in the principal books — for 
 
PEACTICAL OPERATIONS OF BOOKKEEPING 119 
 
 instance, the joiu-nal when they are received and the 
 cash book when they are paid — ^may be made by 
 simply mentioning the nmnbers with the addition of 
 **B.E." or *'B.P." to indicate whether the notes are 
 bills receivable or bills payable. Then, if at any time 
 one wishes to trace one of these notes or identify it, 
 all the facts can be learned from the bill book. Thus, 
 on the cash book, **B. R. No. 17 paid" is all the ex- 
 planation necessary on the payment of the note 
 bearing that number. 
 
 A similar arrangement is commonly provided for 
 what are called ** accounts payable,'' that is, sums due 
 to creditors. Since commonly discounts are offered 
 for early payment of bills, it is a matter of much 
 importance that no bill be allowed to run over the 
 date of the highest rate of discount Sometimes the 
 rates run as high as seven or eight per cent, discount 
 in case the bill is paid in ten days. This is too large 
 an item to be neglected, and, consequently, every pre- 
 caution should be taken that such a bill be not for- 
 gotten. For an accounts payable book, therefore, 
 there may be wisely provided not only a column for 
 each month in the year, so that maturities may be 
 easily indicated opposite each bill, but even two, 
 three, or f oin* such columns to cover smaller intervals 
 of time. If two columns are provided for each 
 month, one will be headed **1 — 15," and the other, 
 **16 — 31;" if three columns are provided, the first 
 will read **1— 10," the second, ^^11— 20," the third, 
 **21 — 31;" if four are provided, the first will read 
 '^1— 7," the second, *^8— 15," the third, ^^16—23," 
 the fourth, **24 — 31." The same sort of thing may 
 be desirable for accounts receivable, that is, sums due 
 
120 ACCOUNTING AND AUDITING 
 
 from customers, though the need is not quite so great 
 in this case, for there is less likelihood of loss of 
 money by the neglect to know each day what bills 
 are maturing at that time. The maturity columns 
 in this book are serviceable mainly as a means of 
 watching customers' accounts and following them up 
 if bills are not paid promptly. 
 
 We will now see how the transactions worked out 
 in detail during the discussion of the preceding chap- 
 ter would be recorded under a system of bookkeeping 
 which utilizes not only a journal, but also a cash book, 
 a purchase book, and a sales book. [The reader who 
 wishes to understand clearly the use of these books 
 is recommended to turn back to these transactions, 
 beginning on page 70 and, taking them one by one, 
 make up his mind for each in what book it should be 
 entered and in just what form. Then he should 
 examine the form given in the following pages.] 
 
PEACTICAL OPERATIONS OF BOOKKEEPING 121 
 
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122 
 
 ACCOUNTING AND AUDITING 
 
 
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PEACTICAL OPEEATIONS OF BOOKKEEPING 123 
 
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124 
 
 ACCOUNTING AND AUDITING 
 
 80 
 
 82 
 83 
 V 
 80 
 25 
 
 Charles Dickens 
 
 100 doz. No. 62 
 200 '' No. 57 
 
 [PUECHA8E BOOK] 
 Jan. 2 
 
 10 days 
 
 14.00 
 13.00 
 
 Cash (Charles Keade) 
 
 [Details should be shown as above or 
 by invoice number] 
 5 
 Alexander Pope Cash 
 
 [Details] 
 
 9 
 Walter Scott 10 days 
 
 [Details] 
 
 11 
 Cash (John Dryden) 
 
 [Details] 
 
 30 
 Charles Dickens 10 days, 
 
 [Details] 
 
 31 
 
 Merchandise, Dr. Total for month 
 
 140000 
 260000 
 
 [Page 1 
 
 400000 
 
 300000 
 600000 
 700000 
 
 600000 
 100000 
 
 2700000 
 
 [The transaction for January 2 is exactly like 
 that for January 5, and yet the two are treated differ- 
 ently. The difference is due to the fact that we wish 
 the Pope sale to go upon the ledger, but do not care 
 to distinguish the. Reade sale from other miscel- 
 laneous sales.] 
 
PRACTICAL OPERATIONS OP BOOKKEEPING 125 
 
 81 
 
 84 
 85 
 
 [SALES BOOK] 
 Jan. 5 
 
 Anthony TroUope 
 
 50 doz. No. 65 
 
 13 
 
 Jonathan Swift 
 
 [Details should be shown] 
 15 
 Richard 'Steele 
 
 [Details] 
 
 30 days 
 14.00 
 
 10 days 
 10 days 
 
 Bills Beceivable 
 [Details] 
 
 Cash 
 
 Cash 
 
 [Details] 
 
 [Details] 
 
 Jonathan Swift 
 [Details] 
 
 Richard Steele 
 [Details] 
 
 16 
 17 
 24 
 30 
 30 
 31 
 
 (Joseph Addison) 
 (George Berkeley) 
 
 (Henry Fielding) 
 30 days 
 30 days 
 
 Merchandise, Cr. Total for month 
 
 [Pagk 1 
 
 70000 
 57500 
 20000 
 60000 
 30000 
 120000 
 50000 
 50000 
 
 457500 
 
 Let us now examine the posting of these items. 
 [The reader wishing to understand the method in 
 detail is recommended to take the items one by one, 
 as given in the books of original entry, pages 121- 
 125, and make up his mind for each, before looking 
 at the ledger form given, just what should be written 
 in each column of the ledger.] 
 
126 
 
 ACCOUI^TING AND AUDITIM 
 
 
 
 
 LAURENCE STERNE 
 
 
 [Pagel 
 
 Jan. 25 
 
 Cash 
 
 2 
 
 75 
 
 00 
 
 Jan. 1 
 
 Sundries 
 
 1 
 
 10993 
 
 75 
 
 29 
 
 
 2 
 
 150 
 
 00 
 
 
 Cash 
 
 1 
 
 15000 
 
 00 
 
 CASH 
 
 [Page 5 
 
 Jan. 31 Sundries 
 
 31092 25 Jan. 31 Sundries 
 
 28197 60 
 
 BILLS RECEIVABLE 
 
 [Page 8 
 
 Jan. 1 
 
 Sundries 
 
 1 
 
 16 
 
 Merchandise 
 
 1 
 
 26 
 
 Anthony Trollope 
 
 1 
 
 5000 00 
 
 Jan. 10 
 
 600 00 
 
 12 
 
 700 00 
 
 16 
 
 
 27 
 
 Cash 
 
 1500 
 2000 
 500 
 700 
 
 BILLS PAYABLE 
 
 [Page 12 
 
 Jan. 12 Cash 
 
 4000 00 
 
 Jan. 9 
 10 
 
 18 
 
 Charles Dickens 
 Cash 
 
 4000 
 5000 
 4000 
 
 Sundries 
 Cash 
 
 REAL ESTATE 
 
 [Page 16 
 
 Jan. 1 
 22 
 
 15000 
 300 
 
 
 
 
 INTEREST 
 
 
 
 [Page 18 
 
 Jan. 10 
 
 Cash 
 
 2 
 
 25 
 
 00 
 
 Jan. 1 
 
 Sundries 
 
 1 
 
 6 
 
 25 
 
 12 
 
 
 2 
 
 6 
 
 67 
 
 10 
 
 Cash 
 
 1 
 
 17 
 
 25 
 
 27 
 
 
 2 
 
 
 93 
 
 
 
 
 
 
 RENT 
 
 [Page 22 
 
 Jan. 22 Cash 
 
 100 00 
 
 MERCHANDISE 
 
 [Page 25 
 
 Jan. 31 Sundries 
 
 1 27000 00 f Jan. 31 Sundries 
 
 4575 00 
 
 EXPENSE 
 
 [Page 30 
 
 Jan. 4 Cash 
 
 2 25 00 
 
I>1ACTICAL OPERATIONS OF B00K:KEEHK'G WH 
 
 
 
 FURNITURE AND FIXTURES 
 
 
 [Page 15 
 
 Jan. 1 
 
 Cash 
 
 2 
 
 500 
 
 00 
 
 
 
 
 
 
 POSTAGE [P»«8 M 
 
 Jan. 1 
 
 Cash 
 
 2 
 
 15 
 
 00 
 
 
 
 
 
 
 STATIONERY [Page 41 
 
 Jan. 1 
 
 Cash 
 
 2 
 
 125 
 
 00 
 
 
 
 
 
 
 FREIGHT [Pa«e 44 
 
 Jan. 3 
 
 Cash 
 
 ' 
 
 65 
 
 00 
 
 
 
 
 
 
 DELIYERY EQUIPMENT [Page M 
 
 Jan. 4 
 
 Cash 
 
 2 
 
 500 
 
 00 
 
 
 
 
 
 
 ADVERTISING [Page 50 
 
 Jan. 4 
 
 Cash 
 
 2 
 
 30 
 
 90 
 
 
 
 1 
 
 
 
 WAGES [Page 52 
 
 Jam. S 
 
 Cash 
 
 2 
 
 80 
 
 00 
 
 
 
 
 
 
 INSURANCE [Page 58 
 
 Jan. 19 
 
 Cash 
 
 2 
 
 100 
 
 00 
 
 
 
 
 
 
 FUEL [Page 58 
 
 JaB. 2% 
 
 Cash 
 
 2 
 
 100 
 
 00 
 
 
 
 
 
 
ns 
 
 ACCOUNTING AND AUDITING 
 
 
 
 
 PROPl 
 
 T AND LOSS 
 
 
 [Page 60 , 
 
 Jan. 24 
 
 Cash 
 
 2 
 
 100 
 
 00 
 
 
 
 
 
 i 
 
 
 CHARLES DICKENS 
 
 
 [Page 80 
 
 Jan. 9 
 
 Bills Payable 
 
 1 
 
 4000 
 
 00 
 
 Jan. 2 
 30 
 
 Merchandise 
 
 } 
 
 4000 
 1000 
 
 00 
 00 
 
 
 ANTHONY TROLLOPE 
 
 
 [Page 81 
 
 Jan. 5 
 
 Merchandise 
 
 1 
 
 700 
 
 00 
 
 Jan. 26 
 
 Bills Receivable 
 
 1 
 
 700 
 
 00 
 
 
 ALEXANDER POPE 
 
 
 [Page 82 
 
 Jan. 5 
 
 Cash 
 
 2 
 
 6000 
 
 00 
 
 Jan. 5 
 
 Merchandise 
 
 1 
 
 6000 
 
 
 
 
 WALTER SCOTT 
 
 
 [Page 83 
 
 Jan. IS 
 
 Cash 
 
 2 
 
 7000 
 
 00 
 
 Jan. 9 
 
 Merchandise 
 
 1 
 
 7000 
 
 00 
 
 
 JONATHAN SWIFT 
 
 
 [Page 84 
 
 Jan. 13 
 80 
 
 Merchandise 
 
 1 
 1 
 
 575 
 600 
 
 00 
 00 
 
 Jan. 23 
 
 Cash 
 
 1 
 
 575 
 
 00 
 
 
 RICHARD STEELE 
 
 
 [Page 85 
 
 j„.« 
 
 Merchandise 
 
 1 
 1 
 
 200 
 
 500 
 
 00 
 00 
 
 Jan. 25 
 
 Cash 
 
 1 
 
 200 
 
 00 
 
 We have seen that it is possible to have any num- 
 ber of debits to Cash with only one posting to Cash. 
 It can readily be seen that if we provide a special 
 column in the cash book and into this carry all items 
 belonging to any one account which needs to be cred- 
 ited when Cash is debited, we can post all those 
 
PKACTICAL OPEEATIONS OF BOOKKEEPING 129 
 
 credits in one lump sum quite as easily as we post the 
 Cash debits. It often chances that a business is of 
 such a nature that a large portion of the receipts or 
 of the expenditures are of the same sort. A column 
 provided for the account concerned makes it possible 
 to reduce to a minimum the total number of postings 
 for all transactions. Let us suppose, for instance, 
 that of the cash expenditures one-half are chargeable 
 to Expense. If we provide a special column for ex- 
 penses so that all expense items shall be carried into 
 that column and all other items into the principal 
 column, we may then neglect the posting of all ex- 
 pense items until the end of the month. They have 
 been ''laid on the table," so to speak. The items 
 extended into the general column will be posted to 
 the ledger in the usual fashion, item by item; that is, 
 the first, perhaps, to Bills Payable, the next to one of 
 our creditors whom we have paid, the next to Freight, 
 the next to Stationery. Then if at the end of the 
 month we post the total of the special expense col- 
 umn to Expense, and carry that total into the general 
 column so that it is included in the total credit to 
 Cash, we have produced the desired result upon our 
 ledger. We simply hold up the expense postings 
 through the medium of a special column until the end 
 of the month and then take them in a lump sum. So 
 far as our cash expenditures are for expense, we are 
 by the device of the special (expense) column in the 
 special (cash) book providing that neither half of the 
 entry — that is, neither Cash nor Expense — need be 
 posted oftener than at convenient intervals, and then 
 only in lump sums. One posting for Expense and one 
 posting for Cash does all the work even though there 
 
 A & A-9 
 
ISO ACCOUNTING AND AUDITING 
 
 be five hundred sucli items. If, again, we assume 
 that of the remaining cash expenditures one-half are 
 for freight, and a special column is provided for 
 Freight, to be treated similarly to that for Expense, 
 we have reduced to one-fourth the items which must 
 be posted one by one. In other words, the cash, com- 
 prising one-half of all postings, the expense, com- 
 prising one-fourth of all postings, the freight, com- 
 prising one-eighth of all postings, are made in totals, 
 or three postings in all, and therefore the individual 
 postings need be but the remaining one-eight of the 
 total. This device of special columns in the cash 
 book is of almost universal use in businesses having 
 anything more than a small number of transactions. 
 The number of such columns is determined solely by 
 convenience. For the sake of showing the arrange- 
 ment of such a book, an illustration is given on page 
 131 showing, with slight changes, the entries for the 
 transactions given in the common cash book form on 
 page 123. In order to have several items to illustrate 
 the special column, various accounts kept separate in 
 the first form are in the new form combined in Ex- 
 pense. The arrangement of the debit side of the cash 
 book would be exactly similar except that the special 
 columns would be for the use of different accounts, for 
 the accounts which bring in cash are usually different 
 from those which cause it to go out. 
 
PEACTICAL OPERATION' S OF BOOKKEEPING 131 
 
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132 ACCOUNTING AND AUDITING 
 
 Blank checks are used in the ledger-folio column to 
 indicate that the work of posting is complete and 
 that the bookkeeper has looked to see that the exten- 
 sions for special-column items are in the proper 
 columns. 
 
 It is obvious that this device is equally service- 
 able for other books if it chances that the transac- 
 tions concerning any one account are numerous 
 enough to make a saving of labor. For instance, if 
 all our purchases are made of three firms it would be 
 worth while to arrange our purchase book so as to 
 provide one column for each of these firms. Then 
 any purchase from any one of the three would be ex- 
 tended into the column kept specially for that firm, 
 the total of the column would be posted at the end of 
 the month to the credit of that firm, and the total 
 of all columns would be posted at the end of the 
 month to the debit of Merchandise. In such a case, 
 then, four postings, one to Merchandise and one to 
 each of the three firms of whom we buy, would be 
 all that would be necessary for all the transactions 
 of any month. Let us next suppose, to take an ex- 
 treme case, that we buy from only three firms and 
 that we make all our sales to four firms. It would 
 then be possible with seven columns to get upon the 
 ledger all merchandise transactions for the month 
 with only nine postings — one to Merchandise debits, 
 one to Merchandise credits, four to customers, and 
 three to creditors — and this would be true however 
 many purchases and sales were made. 
 
 Let us now carry this principle one step further. 
 So far our discussion of the special column has been 
 concerned with entries which are divided into two 
 
PKACTICAL OPEEATIONS OF BOOKKEEPING 133 
 
 equal halves, that is, those in which one debit equals 
 one credit. One or both of these may be posted in 
 a lump sum with other items. The use of the special 
 column is possible also when one or both sides of the 
 entry are cut up into several parts. Suppose, for 
 instance, that in the case just assumed we are not 
 selling merchandise on our own behalf but as agents 
 for others. Let us assume, for the sake of simplicity, 
 that we guarantee the payment for all sales made. 
 In that case, whether we collect from our customers 
 or not, we are responsible to the people for whom we 
 sell. Finally, we assume that we never order goods 
 until we have received orders for them, and so each 
 purchase corresponds in every particular (except 
 commissions) with a sale. We debit our customers 
 at the maximum price and credit our creditors at that 
 price less our commission. By providing a special 
 column for commission and combining our purchase 
 book with our sales book, we can in one entry debit 
 the customer, credit the shipper, and credit Commis- 
 sion — all without repetition of a figure or a word and 
 with only eight postings for any number of transac- 
 tions, four for customers, three for creditors, and one 
 for Commission. Such a combined book might look 
 as follows: 
 
134 
 
 ACCOUNTING AND AUDITING 
 
 
 oo 
 
 CM— < 
 
 r~ -■=> ic r~ 
 
 POOJCOOC 
 
 
 
 CO O 
 
 w 
 
 . o o 
 
 q6TS 
 
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 ^^ 
 
 
 III 
 
 S a c g 
 
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 I 
 
 OOOUSOJ 
 
 
 
 1 
 
 — ^< 
 
PKACTICAL OPEEATIONS OF BOOKKEEPmG 135 
 
 Similarly, we may have in our journal special col- 
 umns for those accounts coming most frequently in 
 that book. When, for instance, we receive from our 
 customers notes in payment of their bills, and when 
 we give notes in payment of our own bills, the only 
 book on which the entry can be made simply is the 
 journal; for as neither cash nor merchandise is in- 
 volved in the transaction the entry cannot go. directly 
 upon the cash book, the purchase book, or the sales 
 book. If, therefore, we provide in our journal a 
 special column each for Bills Receivable debits and 
 for Bills Payable credits, we may avoid the necessity 
 of posting journal debits to either of those accounts 
 until the end of the month; then the total of the col- 
 umn for each kind of notes — debits to Bills Receiv- 
 able and credits to Bills Payable — can be posted each 
 as one lump sum. 
 
 Here is the obvious and common use of the special 
 coliunn. Its practicability in varying circumstances 
 can readily be seen. The only limitations upon its 
 use are two: first, if items are not of frequent occur- 
 rence in any book for any account, the handling of a 
 special column may make more work than it saves — 
 for it always involves some extra writing in the book 
 of original entry; second, if we provide a large num- 
 ber of special columns for accounts not of great fre- 
 quency our books become so bulky that time is lost 
 in passing over dead columns and in picking out the 
 exact column into which each entry should go. Illus- 
 trations are given below of a form of journal with 
 special columns for Bills Receivable and Bills Pay- 
 able. These assume settlement of items shown on 
 page 134 to be made by notes. In addition will be 
 
136 ACCOUNTING AND AUDITING 
 
 found another form used a number of years ago, 
 which is an excellent illustration of some of the pos- 
 sibilities of the special column. This is called the 
 columnar journal. It is a sort of combination cash 
 book, purchase book, sales book, and journal. The 
 Cash debit column is the same as the debit side of the 
 common cash book. The Cash credit column is the 
 same as the credit side of that book. The Merchan- 
 dise debit column is the same as the purchase book, 
 and the Merchandise credit column is the same as the 
 sales book. This form of journal is useful for a small 
 business having but few transactions. The illustra- 
 tions here are based on the transactions shown on 
 page 134, but assume that goods are purchased out- 
 right and that payment is made in cash for both pur- 
 chases and sales. 
 
PRACTICAL OPERATIONS OF BOOKKEEPING 137 
 
 
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 ACCOUNTING AND AUDITING 
 
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CHAPTER VI 
 
 DRAWING CONCLUSIONS FROM THE BOOKS 
 
 Since the purpose of all accounting is to present 
 the ultimate truth regarding values and profit and 
 loss, the most important thing of all is that the rec- 
 ord shall be summarized in a form bringing out 
 clearly the desired figures. The preparatory step 
 is, if possible, to prove the correctness of the record. 
 We have seen all along that debits must equal cred- 
 its, for whenever we have debited any account as re- 
 sponsible we have credited some other account as 
 conferring the responsibility. Since, then, we have 
 all along provided that debits shall equal credits in 
 our original entries, it must be true that, if oiu* post- 
 ing is correct, the total debits of our ledger must 
 equal the total credits of our ledger. The device to 
 test correctness is simple. It usually takes the form 
 of what is called a ''trial balance." In its simplest 
 type the trial balance is a sheet containing the names 
 of all ledger accounts and in debit and credit col- 
 umns opposite each name an extension of the amount 
 of the debit and credit total of that account. Then 
 the sum of all the debits of all accounts should 
 equal the sum of all the credits. To make such a 
 trial balance, however, is a little more than is neces- 
 sary. It is obvious that all accounts which have 
 been closed, so that they now show no excess of one 
 
 138 
 
140 ACCOUNTING AND AUDITING 
 
 side over the other, are by that fact akeady proved 
 to have debits equal to credits; and since our only 
 purpose in the trial balance is to test the equality 
 of debits and credits, we have no need of these ac- 
 counts on the trial balance. Similarly, if we wish, 
 we may omit all but balances on the accounts still 
 standing open; for as the balance is nothing but the 
 excess of one side over the other, in omitting all ex- 
 cept the balance we are simply omitting items 
 already proved to be equal. An adequate form of 
 trial balance, therefore, is the trial balance of ledger 
 balances. This is valuable, too, as a summary of 
 the business at the date of the trial balance. It 
 should be preserved for reference. Below will be 
 found two trial balances for the ledger shown on 
 pages 126-128. The first is the trial balance of ledger 
 totals, and the second is that for ledger balances. In 
 both, the numbers at the left of the names indicate, 
 for reference, the numbers of the ledger pages on 
 which the accounts are found. 
 
 One inexperienced in bookkeeping is surprised to 
 learn how frequently a trial balance fails at first to 
 show the desired equality of debits and credits. 
 Errors in posting are much harder to avoid than the 
 novice is likely to think. It is easy, for instance, to 
 post an item to the wrong side of an account. A 
 bookkeeper engaged in posting is shifting contin- 
 ually from one side to the other of his ledger, and 
 unless he watches himself very carefully or is think- 
 ing constantly of the meaning of every posting he 
 makes — which, as a matter of fact, he finds difficult 
 because of the monotony of the routine labor of post- 
 ing, — he is in danger of losing all adequate sense 
 
DEAWING CONCLUSIONS FROM BOOKS 141 
 [TRIAL BALANCE, JANUARY 31.— TOTAL DEBITS AND CREDITS] 
 
 Laurence Sterne 
 
 Cash 
 
 Bills Receivable 
 
 Bills Payable 
 
 Real Estate 
 
 Interest 
 
 Rent 
 
 Merchandise 
 
 Expense 
 
 Furniture & Fixtures 
 
 Postage 
 
 Stationery 
 
 Freight 
 
 Delivery Equipment 
 
 Advertising 
 
 Wages 
 
 Insurance 
 
 Fuel 
 
 Profit & Loss 
 
 Charles Dickens 
 
 Anthony Trollope 
 
 Alexander Pope 
 
 Walter Scott 
 
 Jonathan Swift 
 
 Richard Steele 
 
 225100 
 31092i2o 
 
 esoojoo 
 
 400000 
 
 1530000 
 
 3260 
 
 2600000 
 
 2500 
 
 60000 
 
 1500 
 
 12500 
 
 6500 
 
 50000 
 
 3000 
 
 8000 
 
 10000 
 
 10000 
 
 10000 
 
 400000 
 
 70000 
 
 600000 
 
 700000 
 
 107500 
 
 700 00 
 
 10406485 
 
 34993|75 
 
 2819760 
 
 470000 
 
 1300000 
 
 2350 
 
 10000 
 
 357500 
 
 500000 
 
 70000 
 
 600000 
 
 700000 
 
 67500 
 
 20000 
 
 10406485 
 
 [TRIAL BALANCE, JANUARY 31.— BALANCES] 
 
 Laurence Sterne 
 
 Cash 
 
 Bills Reeceivable 
 
 Bills Payable 
 
 Real Estate 
 
 Interest 
 
 Rent 
 
 Merchandise 
 
 Expense 
 
 Furniture & Fixtui 
 
 Postage 
 
 Stationery 
 
 Freight 
 
 Delivery Equipment 
 
 Advertising 
 
 Wages 
 
 Insurance 
 
 Fuel 
 
 Profit & Loss 
 
 Charles Dickens 
 
 Jonathan Swift 
 
 Richard Steele 
 
 289465 
 160000 
 
 1530000 
 910 
 
 2242500 
 
 25 
 500100 
 
 1500 
 12500 
 
 6500 
 60000 
 
 3000 
 
 8000 
 10000 
 10000 
 10000 
 
 50000 
 SOQlOO 
 
 34768 
 
 900000 
 10000 
 
 100000 
 
 75 
 
 4486875 44868175 
 
142 ACCOUNTING AND AUDITING 
 
 of what he is doing, and is likely to post to the credit 
 side an item which ought to go to the debit. 
 
 The detection of this sort of error through the 
 trial balance is sometimes easy. If the bookkeeper 
 has posted to the wrong side he has produced an 
 error in the ledger of double the amount posted; for, 
 by posting to the wrong side, he has not only made 
 one side larger than it ought to be, but he has neces- 
 sarily made the other side smaller than it ought to 
 be; and whenever we at the same time make one side 
 larger and the other smaller, we are establishing be- 
 tween the two a difference twice as great as the 
 amount of error. This may be illustrated by very 
 simple figures. Suppose we have to post 2+3+4 to 
 one side, and 6+2+1 to the other. These should give 
 equality, or 9 on each side of the trial balance. Sup- 
 pose, however, in making the last posting — which 
 would be, we will say, adding 1 to the credit side, — 
 we make the error of adding it to the debit side. 
 Then our debit side reads 2+3+4+1, and our 
 equation reads, since our 1 is now omitted from the 
 credit side by the error, 2+3+4+1=6+2; which is 
 a false equation by twice the sum of the original 
 error, or 10=8. When, therefore, a bookkeeper finds 
 in getting the total of his trial balance that one side 
 is larger than the other by a sum divisible by twQ, 
 he recognizes a possibility that the error arises from 
 a mistake in posting — or, what is quite as likely, a 
 mistake in drawing off figures from his ledger to the 
 trial balance — so that some amount is placed on the 
 wrong side. If the amount of discrepancy divided 
 by two is a peculiar figiu'e, such, for instance, as 
 $463.29, it is a matter of but a moment usually to see 
 
DRAWING CONCLUSIONS FROM BOOKS 143 
 
 whether that sum is among the figures involved in 
 the month's transactions either in the trial balance 
 itself or among the original entries. If that figure 
 appears, the posting should be examined to see that 
 it has not got upon the wrong side. 
 
 It is extremely easy for a bookkeeper to make a 
 slight error in addition. This will usually a:ffect 
 only one or two digits in a number, and therefore if 
 his trial balance fails of proof Hj sl discrepancy of 
 one or two figures— for instance, one side of the bal- 
 ance reading $164,213.20 and the other side $164,- 
 313.20, — he has three possibilities worth noting: first, 
 the error may be $50 on the wrong side in the original 
 entry — for the discrepancy is $100, and $50 is one- 
 half of it; or it may be in transferring from the ledger 
 to the trial balance an item of $50, so that it has got 
 upon the wrong side ; or he may have made an error of 
 1 in adding his totals on the ledger, in striking a bal- 
 ance from his ledger totals, or in adding the trial 
 balance itself. In the attempt to find the error he 
 will naturally look first at the places where it would 
 be most quickly discovered if it existed there; and, 
 therefore, he will first examine the footings of his 
 trial balance, then the transfers from the ledger to 
 the trial balance, next, the figuring of ledger bal- 
 ances themselves, and, finally, the additions of ledger 
 figures. If the error is still undiscovered he will 
 naturally turn next to the additions of sums posted 
 to the ledger in total; that is, the additions of his 
 purchase book or sales book or cash book. Obviously, 
 if in adding the figures of his sales book he has made 
 an error of $100, the amount posted as a debit to cus- 
 tomers will be correct because composed of the indi- 
 
144 ACCOUNTING AND AUDITING 
 
 vidual items, but the posting credited to Merchandise, 
 being derived from a false addition of the sums prop- 
 erly debited to customers, will be incorrect by the 
 amount of the error in addition. 
 
 A very common error in posting is due to the fact 
 that we can all remember figures better than we can 
 remember the order of those figures. Most of us 
 have had the experience at one time or another of 
 writing, for illustration, 623 when we meant 632. A 
 bookkeeper who is engaged for hours consecutively 
 in making postings, especially of large figures, is 
 likely to make a number of transpositions of this 
 sort unless he watches himself with extreme care. 
 It is an interesting fact that any transposition of fig- 
 ures will produce a discrepancy divisible by 9. The 
 difference between 34 and 43, for instance, is 9; be- 
 tween 27 and 72 is 45, which is divisible by 9; and 
 so on with any number of digits in any possible re- 
 arrangement. It is sometimes worth while, there- 
 fore, for a bookkeeper to make the test of dividing 
 his discrepancy by 9 to see whether possibly some 
 figure has been transposed. If he finds the prob- 
 ability here he may be helped to find the error, but 
 usually not, — ^though the probability may Suggest to 
 him where he had best look to see the mistake. In 
 case the discrepancy is divisible by 9, a relation can 
 be found between the amount of discrepancy and the 
 figures transposed; for instance, if the discrepancy 
 is 9, division by 9 gives 1, and this 1 indicates that 
 the difference between the figures transposed is 1, — 
 that is, 23 for 32 or vice versa, or 34 for 43, or 45 for 
 54, or 56 for 65, or 67 for 76; and the difference be- 
 tween 461 and 164 is 297, which divided by 9 gives 33, 
 
DEAWING CONCLUSIONS FROM BOOKS 145 
 
 indicating by its repetition of 3 (not necessary to 
 explain here) that the middle figure is not changed, 
 and by the 3 that the difference of transposed digits 
 is 3 (4 — 1) ; and the difference between 461 and 146 
 is 315, which divided by 9 gives 35, indicating that 
 the difference between the first two figures is ^3 and 
 between the last two figures is 5. This is of very little 
 avail to a bookkeeper with thousands of figures be- 
 fore him, however, except as a hint to watch for the 
 transposition of figures with the difference indicated. 
 We know that unless there has been some mistake 
 in adding figures to be posted, or in posting, or in 
 striking balances on the ledger, or in transferring fig- 
 ures to the trial balance, or in adding the trial bal- 
 ance, the trial balance debits must equal the trial bal- 
 ance credits, and it is worth while to find wherein lies 
 any discrepancy. We must not think because the dis- 
 crepancy is only a few cents that the error is trivial; 
 for obviously a dozen errors, some on one side 
 and some on the other, would produce a bal- 
 ance of error of merely the difference between 
 the debit errors and the credit errors. In other 
 words, the size of the discrepancy on the trial 
 balance gives no indication whatever of the num- 
 ber or size of the errors in the books. For in- 
 stance, an error of $5,000 omitted from the debit side, 
 another of $10,000 omitted from the credit side, an- 
 other of $15,000 omitted from the debit side, and 
 $9,999.99 omitted from the credit side, would give 
 a balance of error of just one cent; for the total debit 
 errors are $20,000 and the total credit errors $19,- 
 999.99. It is never safe, therefore, to proceed with 
 the books if the slightest error is disclosed in the trial 
 
 A. & A-10 
 
146 ACCOUNTING AND AUDITING 
 
 balance ; for the discrepancy indicates unknown error 
 or errors of unknown amount in the books of original 
 entry or somewhere between the original entries and 
 the trial balance footings. 
 
 One class of error may persist in the books in spite 
 of a trial balance which proves an equality of debits 
 and credits. If, for instance, we have by a careless 
 posting credited Robinson when we meant to credit 
 Brown, we have done nothing which affects the trial 
 balance. The trial balance does not indicate that 
 every figure has been carried to the proper account, 
 but only that every figure has been carried to the 
 correct side of some account. No one must rest in the 
 false assumption that his books are correct because 
 he has a good trial balance. The trial balance does 
 establish a strong presumption that the books are 
 correct, for an amount is much more likely to get 
 upon the wrong side or to be entered with an error 
 in the figures than wholly in the wrong part of the 
 ledger. Without a trial balance, on the other hand, 
 the assumption is that the books are not correct ; for 
 no bookkeeper can work without occasional error. 
 
 In one other case — very improbable, however — a 
 trial balance may show equality of debits and credits 
 and yet not prove the correctness of the books. Just 
 as errors may occur in determining balances or in 
 transferring to the trial balance, thus throwing out 
 the trial balance though no errors exist on the books 
 themselves, so such errors might happen by chance 
 to offset errors in the books; and thus an error of 
 $423.10, for instance, in the books might chance to 
 be exactly offset by an error on the other side of 
 $423.10 in striking balances or in drawing off the 
 
DRAWING CONCLUSIONS FEOM BOOKS Ul 
 
 trial balance. This occurrence, however, is very- 
 much against the law of chance. The chances are 
 several thousand to one against it in even a small 
 business, and perhaps a million to one against it in 
 a large business. Should such a thing occur it could 
 not continue long, however; for it is against all reason 
 that it should occur again another month, and a trial 
 balance that failed to show equality would soon dis- 
 close the error. 
 
 Sometimes a month's trial balance fails ^^to 
 come," that is, to show equality of debits and credits, 
 after a test of all the sorts known to bookkeepers. 
 These tests are intended merely to suggest probabil- 
 ities iwith regard to the error. When they fail, the 
 only hope lies in going back over the work of the 
 month, item by item. The desirable thing usually 
 is to go over, item by item, all the postings of the 
 month, rechecking them with care both in the books 
 of original entry and in the ledger. This checking is 
 usually done with a hard, fine pointed pencil, and the 
 check marks are placed in the double ruling where 
 they are not conspicuous. Great care should be taken 
 that no item is checked either in the book of original 
 entry or in the ledger until its counterpart in the 
 other has been found to be upon the right side and has 
 been found to be of the right amount. To check it in 
 the book of original entry before its counterpart has 
 been found is to run the risk that the whole purpose 
 of checking will fail. When all the work has been 
 checked up in this fashion, a survey of the books of 
 original entry and of the ledger should show at once 
 whether any item has been entered without posting, 
 and whether any posting has been made without a 
 
148 ACCOUNTING AND AUDITING 
 
 corresponding source in an original entry; and, of 
 course, if any entry is checked twice, or if, when on 
 the point of checking it, one finds that it has been 
 already checked, something is wrong at that point. 
 If this checking fails to disclose the error, the case 
 is discouraging. Most bookkeepers would at this 
 point begin all over at the very start as if they had 
 heretofore made no effort to find the error. 
 
 If still on a second round of discovery the error 
 is not found, the presumption is that it is in the books 
 of the preceding month; but still the human eye and 
 the human hand are so fallible that it is usually worth 
 while to try another device before going back. This 
 device should determine whether the error is in this 
 month's work. Since for each individual entry the 
 debits must equal the credits, the total debits for all 
 the accounts for any month must equal the total 
 credits for all the accounts for that month; and if we 
 were to take a trial balance for the items of this 
 month alone, regardless of any items on the ledger 
 prior to the beginning of this month, we ought to find 
 the debits equal to the credits; that is, if in a trial bal- 
 ance including only this month's items the debits do 
 not equal the credits, and there is no mistake in draw- 
 ing off the trial balance, the error is in the books for 
 this month. This fact is just what we wish to learn. 
 It is a comparatively simple matter to take a trial 
 balance for the items of this month. When the ledger 
 accounts are not numerous, this may usually be done 
 by simply making a new trial balance for the figures 
 added since the last balance was taken; but if the 
 number of accounts is very large, so that it is difii- 
 cult to see from the ledger just what items belong to 
 
DRAWING CONCLUSIONS FROM BOOKS 149 
 
 this month, it will be simpler to make new postings, 
 on independent sheets of paper, for the items of this 
 month alone and then take a trial balance of those in- 
 dependent ledger postings. If we have then a trial 
 balance which proves, it is obvious that the error 
 which we have been hunting for is not in the books of 
 original entry for this month. It is either in this 
 month's ledger figures, or it is of earUer date than 
 this month's transactions. If we add our new one- 
 month trial balance to last month's trial balance, so 
 as to produce a new one, a comparison with the faulty 
 balance will show in what accounts there is discrep- 
 ancy. Then study of the situation will show just 
 where is the trouble. 
 
 It is sometimes thought worth while to learn on 
 which side of the ledger an error disclosed by the trial 
 balance is to be found. If we use, in our trial bal- 
 ances, not the balances of open accounts, but the total 
 amounts of debits and credits for each open and 
 closed account, we can learn by subtracting one 
 month's totals from the preceding month's totals 
 what is the actual total of all ledger debits and of all 
 ledger credits posted for that month. The total of 
 the purchase book, the sales book, both sides of the 
 cash book, and either side of the journal, will indi- 
 cate the total amount of new debits which ought to 
 have been made to all accounts during the month; 
 that is, since from the purchase book we debit Mer- 
 chandise, from the sales book we debit customers, 
 from one side of the cash book we debit Cash and 
 from the other side debit recipients of cash, and from 
 the journal we debit all other items, the total of all 
 these must be the total debits of the month. Sim- 
 
150 ACCOUNTING AND AUDITING 
 
 ilarly, the total of the purchase book, the sales book, 
 the cash book, and either side of the journal, will be 
 the total necessary credits for the month; for we have 
 credited our creditors from the purchase book, have 
 credited Merchandise from the sales book, have cred- 
 ited Cash from the disbursements side of the cash 
 book and have credited sources of cash from the re- 
 ceipts side, and have credited miscellaneous accounts 
 from the credit column of the journal. We have now 
 a complete statement of what this month's debit post- 
 ings and credit postings ought to be, and what the 
 postings for each side actually are; so one can readily 
 see which side of the trial balance is in error. This 
 may reduce the labor of finding the particular fault. 
 Some firms keep their trial balances in double form, 
 showing both totals and balances. If totals are 
 entered in black and balances in red, confusion is 
 avoided. 
 
 We now assume that our books have been prop- 
 erly posted, and that the trial balance has been taken 
 to give us evidence that there^ is no error. We are 
 concerned next, then, to draw conclusions from the 
 records preserved upon the books. Eemembering 
 that we have three kinds of accounts, one represent- 
 ing property, another representing persons, and a 
 third representing known forces, we may, by treating 
 each of these classes of accounts as its nature war- 
 rants, determine just how much property is in the 
 business and how great are our profits and our losses. 
 As we saw long ago, the total of all personal accounts 
 showing a debit balance represents claims; the total 
 of all property accounts showing a debit balance rep- 
 resents property; and the total of all personal ac- 
 
DEAWING CONCLUSIONS FROM BOOKS 151 
 
 counts (excluding that of the proprietors) 'showing a 
 credit balance represents debts. So the sum of these 
 debits less these credits represents the total net assets 
 of the business. The account of the proprietors, 
 which is really a personal account, represents their 
 investment; but the business, though accountable to 
 the proprietors, is not responsible to repay them; it 
 needs merely to show what it has done with the value 
 entrusted to it. If the business has suffered a loss, 
 the net assets will not suffice to meet the liability to 
 the proprietors, and if it has earned profit, the assets 
 will more than meet that liability. The net invest- 
 ment of the proprietors, moreover, is shown as the 
 credit balance of their personal account. The total 
 of all personal accounts having a credit balance, then, 
 must be covered by all the assets, or the business has 
 suffered loss. Any excess is gain for the period 
 under consideration; for since the proprietors are 
 credited with their investment as it stood at the be- 
 ginning of the year (plus any investments made dur- 
 ing the year, and less any withdrawals of invest- 
 ments), the excess of total assets over the total lia- 
 bilities (including the proprietors' investment) 
 shows the amount of increase of assets, or net gain, 
 resulting from the operations of the business for the 
 period. Similarly, a deficiency in assets shows net 
 loss for the period. 
 
 The nominal accounts, on the other hand, since 
 they are debited for losses and expenses and are cred- 
 ited for earnings or gains, also must show this same 
 net gain or net loss for the earning period; for since 
 we have never debited or credited one of these nom- 
 inal accounts unless we were at the same time cred- 
 
162 ACCOUNTING AND AUDITING 
 
 iting or debiting some personal account or property- 
 account (except in the mere case of a transfer from 
 one nominal account to another, which does not affect 
 the total of them all), the net balance of all nominal 
 accounts must exactly equal the net balance of assets 
 and liabilities. Any excess of .assets over liabilities, 
 we have seen, indicates an increase of property, and 
 since nominal accounts were credited whenever there 
 were increases in property to explain, the net credit 
 to such nominal accounts must equal the excess of 
 assets over liabilities. Similarly, if the liabilities, in- 
 cluding the liability to the proprietors, are in excess 
 of the assets, it is because the business has lost prop- 
 erty through shrinkage or expense or bad debts; and 
 since all decreases in property were credited to the 
 proper accounts and at the same time debited to 
 nominal accounts by way of explanation, the net bal- 
 ance of debits shown by the combined nominal ac- 
 counts must exactly equal the net deficit of assets. 
 So our method of double entry is fulfilling its func- 
 tion by giving us at the end of the period an explana- 
 tion in nominal accounts of all changes in property 
 accounts. 
 
 This is best made clear in drawing conclusions at 
 the end of an earning period by arranging a table con- 
 taining six parallel columns to show the debits, the 
 credits, the assets, the liabilities, the losses, and the 
 gains. If each kind of property were always worth 
 exactly the amount of net debits standing to its ac- 
 count on the ledger, four columns would do as well 
 as six, for all debits to property accounts and per- 
 sonal accounts would be resources, all credits to per- 
 sonal accounts would be liabilities, all debits to nom- 
 
DEAWING CONCLUSIONS FROM BOOKS 1S3 
 
 inal accounts would be losses, and all credits to nom- 
 inal accounts would be gains; but as a matter of fact, 
 as we have seen in the treatment of Merchandise, 
 sometimes our debit to a property account does not 
 represent the present value of property on hand, for 
 there are likely to be increases and shrinkages in 
 value which have not yet been entered on the books. 
 Our Real Estate, for example, will nominally be deb- 
 ited for the value of real estate at the beginning of 
 the year, but if there is some depreciation, as is sure 
 to happen with regard to buildings on which there 
 have not been large repairs, we are not quite repre- 
 senting facts as they are if we leave the value on our 
 books at the end of the year as it was brought down 
 at the beginning of the year. This amount of depre- 
 ciation is clearly a loss, and we should indicate it not 
 only by bringing down a new valuation on that ac- 
 count, but also by entering the difference or shrink- 
 age among the losses. Since the basis for our judg- 
 ment of values and of profit and loss is the trial bal- 
 ance, it is well to incorporate the trial balance in this 
 statement; and, therefore, it is usually convenient to 
 use a six-column form, as shown below. The figures 
 used for illustration are taken from the trial balance 
 on page 141. The statement is immediately followed 
 by a detailed explanation of its construction and 
 meaning. 
 
 We have here but one month's transactions, but 
 for illustration of the method of determining profits 
 they will do as well as would figures for a longer 
 period. We will proceed to extend the debit and 
 credit trial balance columns into (1) the resource and 
 liability columns and (2) the loss and gain columns, 
 
164 
 
 ACCOUNTING AND AUDITING 
 
 8S 
 
 iS^I^ 
 
 ^^ 
 
 ^8888888^8: 
 
 C5|iH iH «0 COOO 
 
 [2 8 
 
 '^g 
 
 ^ 
 
 ^8 § 
 
 § 
 
 OOCO ^ 
 
 "to OO «5 
 
 5:> 
 
 § 88 1 ^81^ 
 
 On *Q 
 
 
 M 
 
 00 
 
 1 
 
 S8 8S 888888888888 
 
 COCO 
 (MrH 
 
 SOS iCiOQiOtOOQOOQQQ 
 (NC^lOr-iCOCOOCOQOOOO 
 CO Tt< iO r-( iO tHi-HiH lOiO 
 
 i-H (M 
 
 
 ow 
 
 
 
 <D L* .S 
 
 o. S ^ "S "S --a ^ 
 
 bfiPV. 
 
 O « 
 
 o ^ 
 
 S^fi£i£p<g:5i££6 
 
 
 "^'^^SS^^^gSSJ^^J^SSg^SI^S^ 
 
DKAWING CONCLUSIONS FEOM BOOKS 155 
 
 making all necessary allowances for depreciation, 
 losses and profits. 
 
 It must be recognized in the first place that every 
 account on the books represents property or claims 
 on the one hand, or profit or loss on the other. Every 
 item in a trial-balance column, then, must be ex- 
 tended into one of the other columns. The task is to 
 choose the column. If, indeed, any allowances are 
 needed because the books have not brought our rec- 
 ord quite down to the end of the period, some of these 
 amounts will need to be extended into two columns. 
 As a matter of fact, it is impossible for the books in 
 the ordinary course of affairs to represent the exact 
 situation of all accounts day by day. Many things 
 are occurring to change values every day and every 
 hour, and to keep the books written up to the latest 
 situation would require altogether too much labor. 
 Interest, for instance, is accruing every day, and to 
 keep our interest account always up to the moment 
 would mean figiu'ing upon all notes and bonds daily. 
 Wages, again, are constantly accruing, and whatever 
 figure we should have on our books at ten o'clock 
 in the morning, indicating the condition of the wages 
 element of cost, would need to be altered at eleven 
 o'clock. Taxes are accruing every day; the same 
 thing is true of insurance, of depreciation, of every- 
 thing else which is dependent upon the lapse of time. 
 Recognizing the absurdity of attempting to keep 
 books always up to the moment, we attempt to record 
 facts on the books only at times when the facts reach 
 some culmination, — such as actually becoming due 
 so that payment can be demanded, or adjusted to a 
 specific date because at that date it is desired to de- 
 
156 ACCOUNTING AND AUDITING 
 
 termine as closely as possible actual profit, loss, and 
 valuation. We must, then, at any time when we de- 
 sire to ascertain our profits, bring our books down 
 to the date chosen for this purpose. This will neces- 
 sitate many allowances. It is convenient to indicate 
 these allowances first on the six-column statement, 
 using red ink in the resource and liability col- 
 umns to show that the amounts are different from 
 those shown on the books. The use of red ink is not 
 essential, but it is of great assistance to the eye be- 
 cause it calls attention to the fact that the amount 
 so entered is taken by a calculation made outside the 
 books and is not quite in accord with the books them- 
 selves. When the six-column statement is complete 
 and has been proved, its conclusions may be entered 
 on the books. Let us work out the process in detail. 
 The first account, that of the proprietor, Laurence 
 Sterne, may be at once extended into the liability col- 
 umn, for the business is still responsible to him for 
 his investment. It is obvious that when we have fin- 
 ished our determination of profits any balance 
 will belong to him, and may then be carried 
 to his account; but for the present, since the purpose 
 of this sheet is to learn the profits, we are con- 
 cerned only with the present credit to his account be- 
 fore the profits of the year have been determined. 
 Cash will, of course, be an asset, and may be entered 
 directly in the resource column. Bills Receivable is 
 also an asset. Bills Payable is a liability, and should 
 be so extended. 
 
 Eeal Estate, representing on the books what was 
 supposed to be the value of the property at the be- 
 ginning of the period plus any additions made dur- 
 
DRAWING CONCLUSIONS FROM BOOKS 157 
 
 in^ the period, may or may not represent exactly the 
 value today. There has been, presumably, some de- 
 preciation, even though in the course of one month 
 it will be slight. On general principles, however, we 
 know that any real estate is constantly running down 
 hill unless a change in land values more than offsets 
 a change in buildings. In this case, to be on the safe 
 side, we consider the property to have depreciated 
 to the amount of $25, and, therefore, we insert in 
 the resource column in red ink the amount of $15,275. 
 The difference between $15,275, which we conceive 
 to be the present valuation, and the original $15,300, 
 is a loss of $25, and this is entered in the loss column. 
 Our next account. Interest, presents more compli- 
 cation. We have debited Interest for all sums which 
 we have lost because of the force which interest ac- 
 count represents, and we have credited Interest with 
 all sums accruing to us from that source, whether col- 
 lection has actually been made or not. When, for 
 instance, we took at the beginning of the year certain 
 notes belonging to the proprietor, we credited him 
 with less than the face of the notes because we must 
 wait for the money until some time in the future. 
 Some of these notes do not mature until later than 
 the end of the month, and yet our credit to Interest 
 was made as if the profit had been already realized; 
 the first note, for example, was dated January 1, and 
 does not mature until March 1. Yet on this note we 
 credited to Interest the whole difference between the 
 face value and the amount allowed Sterne. When we 
 are concerned to learn not only the total profits for 
 all time but for a particular period, such, for example, 
 as those for the month of January, we must be care- 
 
m ACCOUNTING AND AUDITING 
 
 ful that we are not giving credit in January to sums 
 which will not be really earned until later. To do so 
 may misrepresent very seriously the profitableness 
 of one period as compared with another. To do jus- 
 tice to the month of January, we must now see how 
 many of the interest items, debited and credited and 
 still to be debited and credited, have actually been 
 gained or lost during this month. This can be readily 
 learned by going over the record of the notes now 
 held in our safe and of those outstanding against us. 
 If we have a bill book, as we should in actual business, 
 we can at a glance by referring to that book see which 
 of the notes are now outstanding; for as soon as any 
 is paid, either to us or by us, it will be marked ^'Paid'' 
 in that book. Having no such book before us, how- 
 ever, we may now turn directly to the ledger accounts 
 for Bills Eeceivable and Bills Payable and see what 
 notes have not been canceled. We find that there re- 
 mains of Bills Eeceivable one note for a thousand dol- 
 lars, which, as just indicated, has one month to run; 
 the interest on this will be $5 at six per cent., and, 
 therefore, since we credited $10 to Interest at the 
 time we took the note, $5 of this should not be con- 
 sidered as yet earned, but should be carried over to 
 February. This $5 ought, in a sense, to be debited 
 back to January and credited to February. We also 
 hold a note dated January 16, due in thirty days, 
 which now has fifteen days to run. The business must 
 wait, therefore, fifteen days before it can realize 
 upon that note, and since the month of February does 
 not inherit from January quite so much as the books 
 indicate — that is, it inherits a note for $600, but must 
 wait fifteen days before that amount can be collected 
 
DBAwm0 coisrcLusioisrs from books 159 
 
 — ^this discount, of $1.50, should also be deducted from 
 January earnings under Interest. These two items 
 together give us $6.50, which should be considered as 
 a liability of January toward the month of February. 
 In addition, moreover, we issued on January 18 a 
 note for $4,000, bearing interest; the interest on this 
 has already accumulated to $9.33, which January has 
 thrust upon February or some future month to bear. 
 This interest, therefore, ought to be charged against 
 January, though it is not payable for some time to 
 come. The sum of these items, $6.50 and $9.33, gives 
 us $15.83, the total liability of January to the future. 
 We have, on the other hand, one item which serves 
 to offset this. Turning to Bills Payable, we find 
 that on January 10 a note for $5,000 was issued, not 
 bearing interest. We received for this note the face 
 value less interest, $4,975. Of this $25 charged to 
 Interest, a part, $7.50, was really chargeable to Feb- 
 ruary because the note does not become due until 
 February 10. We must, therefore, allow January 
 this $7.50, for of this loss February will reap the 
 benefit through the use of the money. This amount 
 deducted from our $15.83, previously found to be a 
 liability of January, leaves January a net liability 
 to the future of $8.33. This we now enter in red ink 
 in the liability column of our six-column statement. 
 Interest account is shown by our trial balance to have 
 caused a loss of $9.10 already charged against it, and 
 this additional net liability for $8.33, not yet on the 
 books, gives us a total loss on account of interest of 
 $17.43, which we enter in the loss column of our state- 
 ment. 
 
 With regard to Rent we have a somewhat similar 
 
160 ACCOUNTING AND AUDITING 
 
 situation. The trial balance shows a credit to Rent 
 of $100, which was for a payment three months in ad- 
 vance. Approximately one-tenth of that rent has 
 already been consumed or furnished by the month of 
 January, and, consequently, nine-tenths remains as 
 a liability of the business; that is, the business is still 
 responsible to supply office room, or, in default of do- 
 ing so, to return the money. That $90 is, accordingly, 
 a liability, and' the profit from this source belonging 
 to the month of January is only the difference be- 
 tween the $90 and the $100, or $10. So we enter $90 
 in the liability column in red ink (to show that the 
 $90 does not appear anywhere upon the books) and 
 carry $10 into the gain column. 
 
 We have already worked out a number of cases 
 with regard to Merchandise, and, therefore, need not 
 dwell upon the calculations here. We have only to 
 enter in our resource column the present inventory 
 of Merchandise, or $23,376.10, which we write in red 
 ink to indicate that the figure is not taken from the 
 books, and then to extend the difference between the 
 trial balance debit and the inventory into the gain 
 column as $951.10. If the balance of Merchandise 
 were in the credit column of the trial balance, we 
 should know that the sales had already brought in 
 more, by that amount, than the cost of merchandise, 
 and to find the profit we should add the inventory 
 to that credit excess. This sum would be carried to 
 the gain column. 
 
 Our expense, we find, was incurred for telephone 
 service, and the charge was for three months in ad- 
 vance. Approximately one-fourth of it has now ex- 
 pired, and we consequently enter in the resource col- 
 
DRAWING COiSTCLUSIONS FROM BOOKS 161 
 
 umn $18.75 in reel ink, for this amount is still an 
 asset, and we carry $6.25 into the loss column, as the 
 amount consumed. Our furniture and fixtures are 
 conceived to have shrunk in value $5, and conse- 
 quently we write $495 in the resource column and $5 
 in the loss column. We find that w^e have practically 
 no stamps on hand, and consequently we have no re- 
 sources from the $15 expense for postage, and so 
 we extend the full amount into the loss column. Most 
 of the other items are shown with sufficient clearness 
 on the six-column statement itself and require no 
 comment except the general statement that wherever 
 an item appears in red ink the amount is conceived 
 to be either the value of what remains of the prop- 
 erty originally charged to the account named, a claim 
 accrued but not yet due, or a liability to be met, and 
 the combination of that sum with the trial-balance 
 figure gives the loss or gain. 
 
 The accounts of Dickens, Swift, and Steele will 
 
 be extended in the six-column statement exactlv as 
 
 «/ 
 
 they appear upon the trial balance, for no allowance 
 need be made in connection with them. As the bus- 
 iness owes Dickens, the amount will be extended as 
 a liability; and as Swift and Steele owe the business, 
 the amounts will be extended as resources. 
 
 We are now ready to put our conclusions into 
 more summary form. It is evident that the net profit 
 of the business is the sum of the column of gains less 
 the sum of the column of losses. A little considera- 
 tion will remind us that there ought to be also another 
 method of getting the same profit and loss, — ^namely, 
 from the relation of resources and liabilities. Our 
 resource column shows what we now have on hand, 
 
 A & A-11 
 
162 ACCOUNTING AND AUDITING 
 
 and our liability column shows everything for which 
 the business is accountable, both to outsiders and to 
 the proprietor. The difference between the resources 
 and such liabilities, we saw long ago, is profits. If 
 our books have been properly kept, since whenever 
 we made a profit or suffered a loss we credited or 
 debited some profit and loss account as well as 
 debited or credited the property accoimt concerned, 
 the difference between resources and liabilities should 
 exactly equal the difference between losses and gains. 
 We find when we take totals of the columns of our 
 six-column statement that the resources equal 
 $45,458.25; that the liabilities equal $44,867.08 ; and 
 the difference is $591.17 — or net profit as shown by 
 the increase of assets. We find, on the other hand, 
 that the total gains, as shown by the gain column, are 
 $961.10 ; we find the total losses to be $369.93 ; and the 
 difference is $591.17. In other words, our explana- 
 tion or nominal accounts have shown from what 
 sources we have made a profit of $591.17, and our real 
 accounts have shown property distributed through 
 various asset accounts to have been increased during 
 the year by the same amount, or $591.17. Thus, our 
 six-column statement has proved, and our books may 
 be assumed to be correct unless we have made some 
 error in valuation of the property remaining. This 
 balance of $591.17 belongs, of course, to the pro- 
 prietor. 
 
 It is to be remembered that the figure of profit 
 which we have obtained does not now appear upon 
 the books. It has been derived to great extent from 
 figures not shown upon the books, such as the valua- 
 tion of merchandise, the calculation of expired in- 
 
DRAWING CONCLUSIONS FROM BOOKS 163 
 
 surance premiums, etc. If we wish our books to show 
 what is the profit at this time, and so distinguish this 
 profit from future profit, we must bring our books 
 into accord with the facts by entering upon them the 
 allowances which we made on the six-column state- 
 ment. This may be done by either of two methods. 
 The simple way is to enter on each ledger accoimt 
 any allowance that may be necessary and then to 
 transfer to Profit and Loss on the ledger the balances 
 of all accounts showing profit or loss. The second 
 method makes use of journal entries. 
 
 In illustration of the first method, we may well 
 take ledger accounts showing the balances found in 
 the trial-balance columns of our six-column state- 
 ment on page 154. Beginning with Real Estate, which 
 happens to come first on oiu* List, we should insert 
 in red ink on the ledger, just as we have done on the 
 six-column statement, the amount of $15,275 on the 
 credit side. A credit to Real Estate indicates that the 
 account is relieved of its responsibility by that 
 amount. As a matter of fact, if we close the books 
 for the end of January and are going to bring down 
 balances for the month of February, it is true that 
 the real estate account is, so far as January is con- 
 cerned, relieved of responsibility to that amount, and, 
 consequently, there is warrant for making this entry. 
 It is made in red ink to indicate that the item con- 
 sists of a mere transfer and does not come by posting 
 from books of original entry. When we have made 
 this entry of $15,275 on the credit side, the account 
 shows a balance of $25 for the debit excess. (See 
 page 167.) If this $25 is not now remaining in the 
 property, as is here the case, it indicates a loss; we 
 
164 ACCOUNTING AND AUDITING 
 
 accordingly enter on the credit side in red ink the 
 item ''Profit and Loss, $25"; that is, we have bal- 
 anced the account by measuring the shortage, by the 
 method indicated some time ago. Here, however, 
 our shortage is not to be carried down to the new 
 month, as usually it is, but to be carried to another 
 account, namely. Profit and Loss. We accordingly 
 turn at once to Profit and Loss and enter on the debit 
 side the item ''Real Estate, L. 16, $25." (See page 
 169.) This is entered on the debit side because it is a 
 transfer, to this account, of an excess debit in Real 
 Estate; for, as we previously indicated, the red ink 
 entry on the credit side of any account measures 
 simply the excess of the debit side. The symbol 
 "L. 16" indicates that this item is brought to Profit 
 and Loss not from a book of original entry but 
 through the ledger, page 16, by a mere transfer. 
 Turning back now to Real Estate, we see that the in- 
 ventory entry, $15,275, which represents the property 
 now on hand, will be inherited by February, and this 
 amount, accordingly, must be brought down as a new 
 debit balance for February first. To summarize this 
 treatment for Real Estate, we may say that we write 
 two items on the credit side of the account in red ink 
 to indicate the amount of debit excess of that account, 
 and of these two items one represents a sum carried 
 down to February, and, therefore, chargeable to Feb- 
 ruary, and the other represents a $25 loss of the ex- 
 cess of the January debits over the amount trans- 
 ferred to February; and this excess, a pure loss, is 
 transferred to Profit and Loss. 
 
 A similar method of transfer would be followed 
 for all the accounts concerned. In the case of Inter- 
 
DEAWING CONCLUSIONS FROM BOOKS 165 
 
 est, we have not a resource, but a liability to be met, 
 and, consequently, a red ink item should be written 
 on the debit side indicating that this account is re- 
 sponsible for an additional sum not yet recorded 
 through ordinary channels. (See page 167.) Then 
 the debit side is $17.43 in excess ; and that balance is 
 transferred by writing on the credit side *^ Profit and 
 Loss, $17.43" in red ink, and writing '' Interest, L. 18, 
 $17.43" on the Profit and Loss account as a debit. 
 What, in this case, must be brought down as a bal- 
 ance to February 1 Following the analogy of Real 
 Estate, we should bring down the $8.33. This red ink 
 entry as a liability of $8.33 represents interest for 
 which January is held responsible, though this 
 amount will not reach its regular entry on the books 
 until some time in February or later. Let us ex- 
 amine the situation. We issued in January a note 
 bearing interest for which payment will have to be 
 made in February. When that payment is made in 
 February, Interest will be debited, but as that interest 
 belongs properly to January, February should not 
 be held responsible for it. If, however, we bring 
 down from the month of January, to the credit side 
 of February, the $8.33 interest liability incurred in 
 January but not yet entered on the books, we shall 
 be relieving February by that amount from the re- 
 sponsibility with which it will later be debited. 
 Bringing down this $8.33 from the red ink entry on 
 the debit side of January to the credit side of Feb- 
 ruary will forestall, so to speak, the undue debit to 
 February, which is inevitable at the time the interest 
 is paid. This will leave February with a net debit on 
 
166 ACCOUNTING AND AUDITING 
 
 account of this payment for just its own share of the 
 interest charged. This, of course, is what is desired. 
 
 The same thing is true with regard to Rent, ex- 
 cept that here we have a gain, instead of a loss, to 
 transfer to Profit and Loss. Eent has been credited 
 in January with $100, but we have seen that only $10 
 of that really belongs to January; the rest was col- 
 lected for February and later months. We accord- 
 ingly write this liability of $90 in red ink on the debit 
 side, because January must be held responsible for 
 collecting $90 that did not belong to it. (See page 
 167.) The difference between. these two sides of the 
 account ($100 originally credited and $90 now deb- 
 ited) is to be transferred to Profit and Loss. We 
 measure that difference by writing '^Profit and Loss, 
 $10'' in red ink on the debit side of Rent, and then 
 we transfer it by writing **Rent, L. 22, $10," on the 
 credit side of Profit and Loss. The item of $90 on the 
 debit side of Rent must now be brought down to the 
 February account, because February is entitled to 
 credit for earning rent, even though the payment wa^ 
 made in January. February, in its turn, will pass on 
 a certain unearned portion to March by the same 
 process as that by which January passed on a por- 
 tion to February. 
 
 Practically all the complications which can arise 
 in this connection have now been illustrated in the 
 discussion of this six-column statement. The manner 
 of entry is indicated, for all the accounts concerned 
 in our six-column statement, on pages 167-169. Of 
 course the final balance of net profit or loss must be 
 carried to the proprietor's account. His account is 
 shown with the others. To save repetition of all the 
 
DEAWING CONCLUSIONS FROM BOOKS 167 
 
 LAURENCE STERNE [Page 1 
 
 BaUmce 
 
 
 36359 
 
 92 
 
 ■ 
 
 i 
 
 Jan. 
 Feb. 
 
 31 
 
 1 
 
 85359 
 
 
 Balance 
 Profit & Loss 
 
 Balance 
 
 L. 60 
 
 34768 
 
 35359 
 
 35359 
 
 CASH 
 
 [Page 5 
 
 Jan. 31 Balance 
 
 2894 65 
 
 BILLS RECEIVABLE 
 
 [Page 8 
 
 Jan. 31 Balance 
 
 1600 00 
 
 BILLS PAYABLE 
 
 [Page 12 
 
 Jan. 31 Balance 
 
 9000 00 
 
 REAL ESTATE 
 
 [Page 18 
 
 Jan. 31 Balance 
 
 Feb. 1 Balance 
 
 15300 
 15300 
 
 15275 
 
 Inventory 
 Profit & Less 
 
 L. 60 
 
 15275 
 25 
 
 15300 
 
 00 
 
 INTEREST 
 
 [Page 18 
 
 Jan. 
 
 Balance 
 Accrued 
 
 43 
 
 Profit <fc Lo82 
 
 Feb. 1 Balance 
 
 L. 60 
 
 17 43 
 
 RENT 
 
 [Page 22 
 
 Unexpired liability 
 Front d Lost 
 
 L. 60 
 
 100 
 
 Jan. 31 Balance 
 
 Feb. 
 
 Balance 
 
 100 00 
 
 100 
 
 90 
 
 
 
 
 
 MERCHANDISE 
 
 
 
 [Page 25 
 
 Jan. 
 
 31 
 
 1 
 
 Balance 
 Profit <fc Lo98 
 
 Balance 
 
 L. 60 
 
 22425 
 951 
 
 00 
 10 
 
 10 
 10 
 
 
 
 Inventory 
 
 
 23876 
 
 10 
 
 
 23876 
 
 28376 
 
 10 
 
 Feb. 
 
 23376 
 
 
 
 
 
 
 
 EXPENSE 
 
 
 
 
 [Page 30 
 
 Jan. 
 
 31 
 1 
 
 Balance 
 Balance 
 
 
 25 
 
 00 
 
 00 
 75 
 
 
 
 Uncomumed 
 Profit A Lm% 
 
 L. 60 
 
 18 
 6 
 
 S 
 
 
 25 
 
 25 
 
 00 
 
 Feb. 
 
 18 
 
 
 - 
 
168 
 
 ACCOUNTING AND AUDITING 
 
 FURNITURE A FIXTURES 
 
 POSTAGE 
 
 [Page 35 
 
 Jan, 
 
 31 
 
 1 
 
 Balance 
 Balance 
 
 
 500 
 
 00 
 
 00 
 0^ 
 
 
 
 Inventory 
 Profit & Loss 
 
 L. 60 
 
 495 
 5 
 
 00 
 00 
 
 
 500 
 
 500 
 
 00 
 
 Feb. 
 
 495 
 
 
 
 [Page 39 
 
 ^an. 31 Balance 
 
 Profit <k Loss 
 
 L.60 
 
 15 
 
 15 
 
 
 
 
 
 
 STATIONERY 
 
 
 
 [Page 41 
 
 Jan. 
 
 81 
 1 
 
 Balance 
 Balance 
 
 
 125 
 
 00 
 
 00 
 00 
 
 
 
 Inventory 
 Profit & Loss 
 
 L. 60 
 
 120 
 5 
 
 00 
 00 
 
 
 125 
 
 125 
 
 00 
 
 Feb. 
 
 120 
 
 
 
 FREIGHT 
 
 [Page 44 
 
 Jan. 31 Balance 
 
 Profit & Loss 
 
 L.60 
 
 65 
 
 
 
 
 DELIVERY EQUIPMENT 
 
 
 [Page 48 
 
 Jan. 
 
 31 
 
 1 
 
 Balance 
 Balance 
 
 
 500 
 
 00 
 
 00 
 00 
 
 
 
 Inventory 
 Profit & Loss 
 
 L.60 
 
 495 
 5 
 
 00 
 00 
 
 
 500 
 
 500 
 
 00 
 
 Feb. 
 
 495 
 
 
 
 ADVERTISING 
 
 Profit & Loss 
 
 [Page 50 
 
 Jan. 31 Balance 
 
 30 
 
 30\00 
 
 30 00 
 
 WAGES 
 
 [Page 52 
 
 Jan. 31 Balance 
 
 Profit & Loss 
 
 
 
 
 
 INSURANCE 
 
 
 
 
 [Page 56 
 
 Jan. 
 
 31 
 1 
 
 Balance 
 Balance 
 
 
 100 00 
 
 
 
 Unconswnert 
 Profit & Loss 
 
 L. 60 
 
 98 
 
 1 
 
 75 
 25 
 
 
 100 00 
 98 75 
 
 100 
 
 00 
 
 Feb. 
 
 
 
 
 
 
 
 
 FUEL 
 
 
 
 
 [Page 58 
 
 Jan. 
 
 31 
 1 
 
 Balance 
 Balance 
 
 
 100 
 
 00 
 
 
 
 Inventory 
 Profit & Loss 
 
 L. 60 
 
 ^■5 
 15 
 
 00 
 00 
 
 
 100 
 
 00 
 
 100 
 
 00 
 
 Feb. 
 
 85 
 
 00 
 
 
DHAWmG CONCLUSIONS FROM BOOKS 
 
 169 
 
 
 
 PROFIT & LOSS 
 
 Balance 
 
 
 100 
 
 00 
 
 
 
 I al Estate 
 
 L.16 
 
 25 
 
 UU 
 
 
 
 Interest 
 
 L.18 
 
 17 
 
 43 
 
 
 
 Expense 
 
 L.30 
 
 6 
 
 2d 
 
 
 
 F'rnit're AFixt'res 
 
 L.35 
 
 5 
 
 00 
 
 
 
 Postage 
 
 L.39 
 
 15 
 
 00 
 
 
 
 Stationery 
 
 L.41 
 
 5 
 
 00 
 
 
 
 Freight 
 
 L. 44 
 
 65 
 
 00 
 
 
 
 Delivery Eauipm't 
 
 L.48 
 
 5 
 
 00 
 
 
 
 Advertising 
 
 L.50 
 
 30 
 
 00 
 
 
 
 Wages 
 
 L.52 
 
 liO 
 
 00 
 
 
 
 Insurance 
 
 L.56 
 
 1 
 
 25 
 
 
 
 Fuel 
 
 L.58 
 
 15 
 
 00 
 
 
 
 Laurence Sterne 
 
 L. 1 
 
 591 
 
 17 
 
 10 
 
 
 
 
 961 
 
 
 
 
 — 
 
 
 
 [Page 60 
 
 Jan. 
 
 Rent 
 Merchandise 
 
 L. 22 
 L. 25 
 
 10 00 
 95110 
 
 961 
 
 CHARLES DICKEirS 
 
 [Page 80 
 
 Jan. 31 Balance 
 
 1000 00 
 
 JONATHAN SWIFT 
 
 [Page 84 
 
 Jan. 31 Balan(.:^ 
 
 SOOiOO 
 
 RICHARD STEELE 
 
 [Page 85 
 
 Jan. 31 Balance 
 
 500 00 
 
 items of the ledger shown on pages 126-128, those 
 items are consolidated for each account into one bal- 
 ance, and that balance is given below as if the ledger 
 had been ruled up and the balances brought down be- 
 fore the trial balance was taken. It is the first bal- 
 ance of each account below. Then follow the closing 
 entries. 
 
 One objection to the method of simple transfer 
 just illustrated lies in the fact that nothing in the 
 ledger indicates the processes by which the amounts 
 to be transferred to Profit and Loss have been de- 
 rived. Some careful calculation was necessary to 
 
170 ACCOUNTING AND AUDITING 
 
 learn, for instance, what part of the total interest 
 belongs to January and what part should be passed 
 on to February. This method of transfer leaves no 
 indication of the details of that computation. It is 
 thought by many bookkeepers preferable, therefore, 
 to make all transfers through the journal. In order 
 to accomplish this they make journal entries which 
 show exactly what account is to be debited and what 
 credited, and just why these transfers are made. 
 Below will be found the journal entries for the trans- 
 fers just made by the other method. When these are 
 posted the results are identical with those shown on 
 pages 167-169. The only difference will be in the 
 form of the items as they will appear upon the ledger. 
 Since, for example, all items come from the journal, 
 and are on the books of original entry, no red ink 
 items appear except as mere balances. 
 
 [Entries for closing the books] 
 
 
 31 
 
 
 Profit and Loss 35.00 
 
 
 To Sundries 
 
 
 Eeal Estate 
 
 25.00 
 
 Furniture and Fixtures 
 
 5.00 
 
 Delivery Equipment 
 
 5.00 
 
 Depreciation on these accounts for the month 
 
 
 (These accounts are credited not because what 
 they represent has done anything creditable, but be- 
 cause they are now relieved of their responsibility 
 by the transfer of that responsibility to another ac- 
 count.) 
 
DEAWING CONCLUSIONS FROM BOOKS 171 
 
 81 
 
 Profit & Loss 44.93 
 
 To Sundries 
 Interest 17.43 
 
 Expense - ^ 6.25 
 
 Stationery 5.00 
 
 Insurance ^ 1.25 
 
 Fuel * 15.00 
 
 Proportion of charges expired or consumed 
 during the month, as follows: Expense (tele- 
 phone) l^; Stationery, 1/25; Insurance, 1/80; 
 Fuel, 15% ; Interest, as follows : 
 Accrued on B. P. No. 3, 9.33 
 Unexpired on B. R. No. 1, 5.00 
 Unexpired on B. P. No. 5, 1.50 15.83 
 
 Less unexpired on B. P. 
 
 No. 
 
 2, 
 
 7.50 
 
 8.33 
 
 Dr. balance on ledger 
 
 
 
 
 9.10 
 
 Total 
 
 17.43 
 
 . 
 
 
 31 
 
 ^ 
 
 
 Profit & Loss 
 
 
 
 
 
 To Sundries 
 
 
 
 
 
 Postage * 
 
 
 
 
 
 Freight 
 
 
 
 ' 
 
 
 Advertising 
 
 
 
 
 ., 
 
 Wages 
 
 
 
 
 
 To close these accounts 
 
 
 
 
 190.00 
 
 15.00 
 65.00 
 30.00 
 80.00 
 
172 
 
 ACCOUNTING AND AUDITING 
 
 31 
 
 Sundries 
 
 
 * 
 
 To Profit & Loss 
 Merchandise 
 
 
 951.10 
 
 Kent 
 
 
 10.00 
 
 To transfer gains as follows : 
 
 
 
 Merchandise : 
 
 
 
 Inventory- 
 
 23376.10 
 
 
 Net debits, per ledger 
 
 22425.00 
 
 
 Gain 
 
 951.10 
 
 
 Eent: 
 
 
 
 Collection 
 
 100.00 
 
 
 Unexpired 
 
 90.00 
 
 
 Income 
 
 10.00 
 
 
 961.10 
 
 31 
 Profit & Loss . 
 
 To Laurence Sterne 
 To transfer the balance of profit to 
 his account 
 
 591.17 
 
 591.17 
 
 The process of figuring profit and closing the 
 books, as worked out in detail, requires a consider- 
 able amount of labor. This would be done in most 
 business houses only annually. Here we took a 
 month's interval only because we chanced to have a 
 month's material at hand. The only work done at 
 monthly intervals is in most houses the posting of the 
 purchase book, the sales book, and the cash book, and 
 the taking of the trial balance. 
 
 When the books have been closed for an earning 
 period, by closing out loss and gain accounts, a new 
 situation is shown by the books. If we were at this 
 point to take a new trial balance and make a new six- 
 column statement, what should we find'? In the first 
 
DRAWING CONCLUSIONS FROM BOOKS 173 
 
 place, there are no proiit and loss balances, for all 
 profit and loss have been carried to the proprietor's 
 account — and that represents a liability. So we 
 should have no use for the loss and gain columns in 
 the six-column statement. The resource and liability 
 columns, moreover, would be a mere duplication of 
 the trial-balance columns; for every debit represents 
 an asset, and every credit a liability. A six-column 
 statement, therefore, would contain no more informa- 
 tion than would a trial balance. Usually business 
 men report their business operations, so far as they 
 report them at all, only after the closing of the books; 
 and so six-column statements are not published. The 
 results of the six-column statement, however, are 
 usually given in two independent statements. One 
 of these gives the equivalent of the loss and gain col- 
 umns, and is called the * income account," or ^^ income 
 sheet." We shall have occasion to examine the form 
 later. The other is the ^^ balance sheet," and gives 
 a summary of the ledger as it stands after the closing 
 of the books. In form it usually consists of two 
 parallel lists, assets and liabilities, instead of one list 
 in parallel columns like the trigcl balance; but in sub- 
 stance it is simply the trial balance in new form. A 
 developed form of balance sheet will be discussed 
 later. Below is the balance sheet, in simple form, 
 for the ledger shown on pages 167-169. It will be 
 noted that (except for the proprietor's account) it 
 corresponds, item for item, with the resource and 
 liability columns of the six-column statement on page 
 154. The exception in the case of the proprietor's 
 account is due to the fact that the net profits, which 
 
174 
 
 ACCOUNTING AND AUDITING 
 
 in the other statement stood in the last two columns, 
 have now been transferred. 
 
 ASSETS 
 
 
 , 
 
 LIABILITIES 
 
 
 Cash 
 
 2894 65 
 
 Laurence 
 
 Sterne 
 
 35361 92 
 
 Bills Beceivable 
 
 1600 00 
 
 Bills Payable 
 
 9000 00 
 
 Keal Estate 
 
 15275 00 
 
 Interest 
 
 
 6 33 
 
 Merchandise 
 
 23376 10 
 
 Eent 
 
 
 90 00 
 
 Expense 
 
 18 75 
 
 Charles Dickens 
 
 1000 00 
 
 Furniture & Fixtures 
 
 495 00 
 
 
 
 
 stationery 
 
 120 00 
 
 
 / 
 
 
 Delivery Equipment 
 
 495 00 
 
 
 
 
 Insurance 
 
 98 75 
 
 
 
 
 Fuel 
 
 85 00 
 
 
 
 
 Jonathan Swift 
 
 500 00 
 
 
 
 
 Richard Steele 
 
 500 00 
 
 
 
 
 
 45458 25 
 
 45458 25 
 
CHAPTER Vn 
 
 SOME HIGHLY DEVELOPED TYPES OF 
 BOOKKEEPING 
 
 It is worth while now to examine some more 
 highly developed types of bookkeeping, for no one 
 is competent to interpret books — as an auditor, for 
 example, often has to do — unless he can read them 
 even in extremely complicated form. Let us carry 
 the principle of the special column further than 
 heretofore. 
 
 We have heretofore considered the trial balance 
 as an abstract of the ledger. When we realize that a 
 large business may have transactions with a great 
 many customers (some of the big department stores 
 have accounts with many thousand customers), we 
 see that a trial balance may be extremely volumi- 
 nous and may involve so much labor that the figures 
 are not available for several days after work is begun 
 upon it. It is desirable to have on the balance sheet 
 and on the trial balance one figure to represent aU 
 customers. This may be provided by a subordinate 
 ledger and an account in the general ledger to repre- 
 sent that subordinate ledger. If we put all cus- 
 tomers' accounts in a separate ledger, independent 
 of the general ledger, we shall by so much reduce the 
 bulk of our general ledger, and make it possible for 
 one man to devote all his attention to those accounts 
 
 175 
 
176 ACCOUNTING AND AUDITING 
 
 without interfering with other bookkeepers. Such a 
 book would be called the ^^ sales ledger," or ^^cus- 
 tomers ledger." We may now have in our general 
 ledger an account to represent the sales ledger as a 
 whole, and, so far as our general ledger is concerned, 
 consider all the customers as one customer. If, at 
 the end of the month, when we credit Merchandise 
 for the sales as shown by the sales book, we at th'e 
 same time debit this account, which we may call 
 ^'Customers," or *' Accounts Receivable," in the gen- 
 eral ledger, the debit to Customers in the general 
 ledger will exactly equal the total debit posted to all 
 individual customers in the subordinate sales ledger: 
 and it will have been attained with only one posting. 
 If, similarly, whenever in the cash book we credit a 
 customer we extend the amount in a special column, 
 and then not only post to his account in the subordi- 
 nate sales ledger but at the end of the month post the 
 total of that column into the general ledger as a 
 credit to Customers, the balance of Customers will 
 always represent the sums due us by customers, and 
 will agree with the total amount shown in the sub- 
 ordinate sales ledger as due by all customers. Cus- 
 tomers in the general ledger, in other words, shows 
 us, without our looking at the subordinate ledger, the 
 total balance of all customers' accounts: it is an 
 account with customers as a bunch. If, however, we 
 wish to know how much of that bunch total is owed: 
 by any individual, we must turn to the subordinate^ 
 sales ledger, for there only are shown the details of 
 the bunch. Such an account in the general ledger 
 serves as a check or control on its corresponding sub- 
 ordinate ledger, and is for that reason usually called 
 
SOME EIGSLY DEVELOPED TYPES IW 
 
 a ^^controlling account.'' The business may be, in- 
 deed, of such magnitude that it is worth while to have 
 a separate customers' ledger, or sales ledger, for 
 each initial letter of customers' names; and in that 
 case it might be worth while to keep in the general 
 ledger a corresponding controlling account for each 
 subordinate customers' ledger. Under that plan, 
 whenever a debit is made to a customer whose name 
 begins with A, a debit must also be provided for the 
 account called ^^ Customers A" in the general ledger; 
 and whenever a credit is made to such a customer, a 
 corresponding credit is provided for Customers A in 
 the general ledger. Accounts in customers' ledgers 
 do not appear on the trial balance, of course, for they 
 are represented there by the corresponding control- 
 ling accounts; but at convenient times the total bal- 
 ance of all customers' ledgers should be compared 
 with the controlling accounts, and any discrepancies 
 explained and rectified. 
 
 Controlling accounts are of use in many other con- 
 nections. Often a separate purchase ledger is desira- 
 ble. The account to represent it in the general ledger 
 is usually called ^* Accounts Payable," or '^ Cred- 
 itors." In some lines of business, for instance, it is 
 desirable to know daily the net balance of a large 
 group of accounts which it would be almost impossi- 
 ble to balance and add daily. By keeping a control- 
 ling account in the general ledger to represent the 
 total of all the detailed accounts, one can have that 
 balance always available. In a savings bank, for 
 illustration, it is desirable daily to know the sums 
 due to depositors. To add the balances of all the 
 depositors' accounts is a very heavy task. The de- 
 
 A & A-12 
 
178 ACCOUNTING AND AUDITING 
 
 posits account, representing in tlie general ledger the 
 total of all deposit ledger balances, shows the desired 
 figure at all times. 
 
 The extra work in keeping controlling accounts 
 is really insignificant. The only thing required is 
 usually that a separate column shall be kept in the 
 cash book and in the journal, and that extension shall 
 be made to this column whenever a change occurs in 
 any account included in the group which the control- 
 ling account represents. In the purchase book and 
 the sales book a separate column is hardly necessary, 
 for the total of all purchases and of all sales should 
 usually go directly to Creditors and to Customers. 
 
 Let us now apply this principle of the special col- 
 umn for a controlling account to a case which will 
 introduce another new element. We saw in Chap- 
 ter V. that discounts may be taken out of notes and 
 other face figures (such as bills to be paid) by entry 
 on the contrary side of the cash book — just as if the 
 full sum had been paid and then a rebate given. It 
 is obvious that when discounts are frequent, as they 
 are with firms offering and taking merchandise dis- 
 counts for all payments made to them or by them, 
 it is a good deal of labor to write the discount on the 
 opposite side for each discount taken, for each dis- 
 count must be fully explained. It would be a vast 
 convenience if the discount could be attached di- 
 rectly to the payment, for then no new explanation 
 would be necessary. This can be accomplished if 
 the cash book has a special column for discounts. 
 With such a column, one line and one writing of the 
 facts will do for both amounts, for one explanation 
 covers both the discount entered in one column and 
 
SOME HIGHLY DEVELOPED TYPES 179 
 
 the amount of the bill or the net amount entered in 
 another column on the same line. The compUcation 
 now lies in the fact that the discount, though written 
 on one side of the cash book, really belongs on the 
 other — for, as we have seen, since it is an amount 
 subtracted from the face of the bill, and the face of 
 the bill is entered as if received in full, we must offset 
 that exaggeration by an item on the other side. We 
 can do that easily at the balancing of the cash book 
 for that period — the week or the month — ^by trans- 
 ferring the total of the special discount column to the 
 other side of the cash book, just as we transferred the 
 single item when we were making entries one by one. 
 The custom when making these transfers is to place 
 in the explanation column the word ^^ contra," to in- 
 dicate that the amount is brought from the opposite 
 page. This is illustrated in the two forms below, 
 which have each a column also for the controlling 
 account. 
 
 In this form it will be noted that a balance has 
 been brought over from the preceding period and 
 stands in a column by itself. The purpose of this 
 column is to make it possible to get a total for all 
 receipts during the present period without complica- 
 tion with the balance brought over from the pre- 
 ceding period. If this sum were not set aside, it 
 might be included in the total to be debited to Cash; 
 and this would be erroneous, for since all cash re- 
 ceipts of the previous period were debited during 
 that period, any unexpended balance brought over 
 from that period must not now be debited again. 
 Several devices are possible to keep this balance out 
 without the necessity of a special column. One, for 
 
180 
 
 ACCOUNTING AND AtJDITlNd 
 
 
 o g 
 
 
 888 
 
 
 
 8 c^ 8« 
 
 
 
 r;3 
 
 t>. CO CD 
 
 r^ 
 
 
 Pi 
 
 <M 
 
 CO 
 
 
 ;3 
 
 
 
 
 OQ 
 
 
 
 
 •4^ 
 
 8 §8 81 
 
 
 
 S i^8 
 
 "1 
 
 
 Q 
 
 
 i-H 
 
 
 
 g 
 
 
 
 
 
 
 
 
 
 
 o 
 
 
 
 
 
 
 8 88 18 
 
 
 
 8 88 
 
 1 
 
 
 -2 
 
 tH 
 
 <M 
 
 
 
 
 
 
 o 
 
 
 
 
 1 
 
 8 SSI 
 
 8 
 
 O 1-1 
 
 
 S 
 
 »o t^ 
 
 <M 
 
 rH 
 
 § 
 
 t^ CO 
 
 T— 1 
 I— 1 
 
 !>• 
 
 
 ^ ^f 
 
 
 
 "1 P^'^.iO rt 
 
 
 
 
 
 
 
 ^-'^•^ 2 
 
 
 
 
 
 
 
 
 
 C3 3 3 § 
 
 
 
 o ® o o jd S 
 c 1f « <y oQ * 
 
 
 
 
 
 « O o o oS '"^ 
 
 
 
 <J^<j<J(;; ft 
 
 
 
 ^ 
 
 ^ 
 
 
 ■«j 
 
 +a 
 
 
 n 
 
 a 
 
 
 
 O 
 
 
 S 
 
 a 
 
 
 <M -t^ 
 
 ■^ 
 
 
 S.^ 1 1 
 
 J 
 
 
 a^"^ s. § 
 
 B 
 
 
 2 2.g^|J r 
 
 o 
 
 1 
 
 
 pqCfqfH^S 6 Q O 
 
 w 
 
 h4p^- 
 
 >^'^^^> > ^ S "^ > 
 
 
 rHlOOOO CD 00 tH 
 
 
 i-HrH(?qCs| 
 
 
 -S 53 
 
 
 s 
 
 
 
 
 
 !^ 
 
SOME HIGHLY DEVELOPED TYPES 
 
 181 
 
 02 
 
 .2 
 m 
 
 3 
 
 
 03 3i3§i3 
 
 O O fM CC lO lO 
 CO -t «^ 
 
 3 
 
 1 
 
 8 18 1 
 
 s 
 
 ^ 
 
 
 88 881811 1 
 
 ?s ^^ 
 
 X 
 
 
 
 
 
 o 
 
 1 
 
 88 88 18 \ 
 
 2000 
 300 
 
 700 
 400 
 
 1 
 
 
 
 
 less 
 less 
 
 mith 
 less 
 less 
 
 
 Invoice No. 57 
 '' No. 60 
 Office Supplies 
 Paid note H. S 
 Invoice No. 58 
 '' No. 59 
 Discount contra 
 
 
 Dombey & Son 
 Henry Esmond 
 Expense 
 Bills Payable 
 Adam Bede 
 Silas Lapham 
 
 Creditors 
 Expense 
 
 Discount — contra 
 Cash, Cr. 
 Balance 
 
 
 I>-t^^ G0O5'^rHi-(i-l y^ 
 
 
 rH rH T— 1 C^ 
 
 
 1 
 
 
 
 
 
 
182 ACCOUNTING AND AUDITING 
 
 instance, is adding it at the foot of the page after the 
 total cash receipts have been figured. This is unob- 
 jectionable except for the fact that until this balance 
 has been inserted the books do not show what is 
 the cash required to be on hand, and, therefore, they 
 are false at all times except when the cash book is 
 balanced. Sometimes the balance is brought over as 
 the first entry in the Sundries coliunn, but when the 
 cash book is closed and posting is to be made to the 
 Cash account, the amount posted is the total less the 
 balance. The amount to be posted is indicated by 
 what is called a '* short extension"; that is, the 
 amount is not written in the extension column. This, 
 again, is unobjectionable except for the fact that it 
 does not look right. To place in the money column 
 a figiu^e which is obviously a correct figure, because 
 it is the amount of an addition of the figures above it, 
 and then to post a smaller figure, looks decidedly 
 suspicious. 
 
 The amoimt extended in the Customers' and 
 Creditors' columns is the full face of each bill in 
 spite of the fact that less than the full face was paid; 
 for we must credit the customers and debit the cred- 
 itors with the full face of each bill because in each 
 case the full amount is entered on the ledger, and we 
 must show that the account has been squared. The 
 amount of discount is the subtraction from the full 
 face. In closing the cash book, the total discount 
 found by adding the Discount column is carried to 
 the other side of the cash book and entered there in 
 the Sundries column with an indication that it comes 
 from the other side of the book. In the place where 
 it originates, the word *^ Discount" is not written in 
 
SOME HIGHLY DEVELOPED TYPES 183 
 
 the journalization column, for no posting is made of 
 this item from this place. The journalization column 
 is left blank and only the explanation is used in con- 
 nection with the amount. It wUl be noted here that 
 $130.00, which is the total of the Discount column on 
 the receipts side of the cash book, is carried over to 
 the foot of the disbursements side in the journaliza- 
 tion and Sundries columns, and is not only posted 
 from that source but is included in the credit to Cash. 
 This is as it should be, for the amount of discount on 
 the receipts side is the same as an equivalent of cash 
 paid out, and, therefore, should be credited to Cash 
 and debited to Discount, as it now is, on the disburse- 
 ments side of the cash book. Similarly, the footing 
 of the Discount column on the disbursements side of 
 the book, which is $89.00, is carried to the receipts 
 side of the cash book and there entered in the sun- 
 dries column. This is as it should be, for those dis- 
 counts are equivalent to receipts because they were 
 subtracted from bills which were paid, and therefore 
 are to be debited to Cash and credited to Discount 
 when the cash book is posted. 
 
 It would be possible, of course, instead of carry- 
 ing the amount of discount appearing on each side 
 of the book to the other side and posting it thence, 
 to strike a balance between the two sides and post 
 only the excess. This would produce the right effect 
 on the cash account, but it would hardly give the full- 
 est information with regard to discount. One indi- 
 cation of the goodness of our accounts receivable is 
 the number of discounts which our customers take, 
 for a firm on the verge of insolvency is not likely to 
 be able to pay its bills promptly and receive the dis- 
 
184 ACCOUNTING AND AUDITING 
 
 counts for prompt payment. If we were to combine 
 our Discount debits with our Discount credits and 
 post only balances, we should be offsetting all dis- 
 counts which we ourselves received against discounts 
 taken by our customers, and we should have no indi- 
 cation of the actual magnitude of either side of the 
 account. This would mean that in comparing one 
 year with another we should not know whether we 
 ourselves had taken more or fewer discounts, and 
 whether our customers were improving or not. 
 
 The double ruling under the total of the two Dis- 
 count columns indicates, as double ruling always in- 
 dicates, that the amount goes no farther in this con- 
 nection. Here, for instance, the amount is not car- 
 ried into the Sundries column, but stops short. This 
 writing of it is to be neither added nor subtracted. 
 When it is transferred, the new writing is not so 
 double ruled, for it is to be employed in connection 
 with other figures. 
 
 The footing of the column for Customers is post- 
 ed to Customers in the general ledger, and will ex- 
 actly equal, of course, the postings made to the sub- 
 ordinate, or customers' ledger, from the individual 
 items. This amount is also extended into the Sun- 
 dries column because it must be included in the Cash 
 debits — for the excess over the amount actually 
 received is offset by the discount transferred to the 
 other side of the cash book. 
 
 This matter of the treatment of discounts is in- 
 teresting because it shows how great a variety of 
 forms and processes is open to any bookkeeper in 
 the treatment of his items. It should be remem- 
 bered, as has already been suggested, that but two 
 
SOME HIGHLY DEVELOPED TYPES 186 
 
 principles govern the arrangement of books. The 
 first is the need that everything shall be very clearly 
 stated and so arranged that it can be easily under- 
 stood by any ordinary reader familiar with book- 
 keeping. The second is that items shall be so ar- 
 ranged that posting can be conveniently made to the 
 ledger, which is the ultimate destination of all fig- 
 ures of debit and credit. If it is found in any case 
 that one arrangement is better adapted to the needs 
 of this business or to the temperament of the book- 
 keeper than another, that arrangement is to be pre- 
 ferred. In the form just illustrated it is seen that 
 the full amount of the bill is written in the column 
 for the controlling account, and that the discount is 
 written in a column by itself; so that the actual 
 amount of Cash is the difference between the two; 
 but by extending the total amount of discount to the 
 other page at the end of the week or the month the 
 proper balance of Cash is preserved. If, however, 
 we wish to see what cash was actually collected on 
 any bill, we must perform a subtraction of the 
 amount in the Discount column from the amount in 
 the other column. It is obvious, however, that it 
 would be possible so to arrange the books that the 
 discount would not need to be carried to the other 
 page. If, for instance, instead of entering opposite 
 the name of the customer the full amount of the bill, 
 we should enter the net amount paid by him after 
 the discount was deducted, the total of the column 
 would be the total cash received and would be the 
 proper debit to Cash without regard to discount. It 
 is equally obvious, however, that in posting to the 
 customer's credit we should need to use not merely 
 
186 ACCOUNTING AND AUDITING 
 
 the net amount of the bill — that is, the face less the 
 discount, — but the full amount, or the sum of the two 
 items written in the cash book — that is, the amoimt 
 which he pays plus the discount allowed; for on the 
 ledger he is debited with the full amount of the bill 
 and our credit to him must be of sufficient amount 
 to show that his bill has been paid. This introduces 
 a slight complexity from the fact that in posting it 
 is usually awkward to add two sums together in the 
 head and accurately transfer that amount to the 
 ledger. Some bookkeepers, however, like this 
 method. It is shown, for the receipts side of the cash 
 book, with the items used in the previous form. 
 
 This form has one new peculiarity. The amount 
 of discount on the receipts side of the cash book must 
 be posted as a debit, for it represents a deduction 
 from our collections : that is. Discount is responsible 
 for our failure to collect the face of the bills. Yet 
 normally items on the debit side of the cash book are 
 credits, — for since the debit side of the cash book 
 shows items to be debited to Cash, it shows items to 
 be credited to other accounts. This discount, however, 
 has no real relation to Cash, and is on the cash book 
 only for convenience. The credit to the customer is 
 from two items — one of cash and one of discount. To 
 put them together, with one explanation, saves writ- 
 ing. This discount column, then, is really only a jour- 
 nal entry inserted in the cash book for economy of 
 labor. Care must be taken that it is plainly labeled 
 to be debited, for otherwise its position here might 
 lead to erroneous crediting of it. 
 
 Our treatment of totals here is necessarily differ- 
 ent from that in the last form. Since discoimt is 
 
SOME HIGHLY DEVELOPED TYPES 
 
 187 
 
 1 
 
 'a 
 
 8 8 
 
 8 
 
 
 
 $ 
 
 
 
 8 ^ 
 
 g 
 
 
 
 ^ 
 
 a 
 
 t^ CO 
 
 ^ 
 
 
 
 ^ 
 
 3 
 
 
 <N 
 
 
 
 CO 
 
 QQ 
 
 
 
 
 
 
 
 8 SB 
 
 88 
 
 g 
 
 
 lO 'O o 
 
 
 o 
 
 O 
 
 
 
 ^ OOtH 
 
 r^ 
 
 CO 
 
 o 
 
 
 -IJ 
 
 Tt< 
 
 1—1 
 
 (^ 
 
 
 © 
 
 rH 
 
 'N 
 
 
 Ol 
 
 
 ^ 
 
 
 
 
 
 
 1 
 
 8 BB 
 
 3 
 
 
 ^ ^S 
 
 
 g 
 
 
 
 9) 
 
 
 
 rH 
 
 
 
 
 
 
 
 
 
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 3 
 
 
 
 < 
 
 BSls 
 
 g 
 
 
 
 
 
 r? 
 
 ^ 
 
 
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 Oi 
 
 rH 
 
 i5 
 
 t^ 
 
 
 
 
 -o 
 
 (^ 
 
 h* 
 
 W 
 
 
 
 
 
 
 rH 
 
 
 
 ^ ^f 
 
 
 
 
 
 
 ^ '^o, 
 
 
 
 
 
 
 S'S sg s 
 
 
 
 
 
 
 
 
 
 
 
 
 iH ^ 05 rH 
 
 «a 
 
 
 
 
 
 . ^ . . 
 
 a 
 
 
 
 
 
 ^ O o o 
 
 o 
 
 
 
 
 
 nt Fe 
 A. Sc 
 nt Fe 
 nt Fe 
 sales 
 
 ■4J 
 
 1 
 
 
 
 
 
 3 3 P 
 
 o 
 
 
 
 
 
 O <D O O j3 
 
 
 
 
 
 
 
 -M 
 
 
 
 
 
 
 
 
 
 
 
 <j ;z; <1 <5 o iz; 
 
 
 
 
 
 :S 
 
 
 
 
 a 
 
 
 A 
 
 
 
 
 ij 
 
 
 o 
 
 a 
 
 
 
 
 1 
 
 
 >3 J^ 
 
 
 
 
 1 
 
 
 s^-S s. 
 
 
 
 
 g 
 
 
 ££.!:« = S 
 
 
 O 
 
 
 2 
 
 
 :«P^1 
 
 
 
 i. 
 
 S g 
 
 
 Balan 
 
 Danie 
 
 Bills 
 
 Felix 
 
 Marti 
 
 Merch 
 
 
 Disco 
 Custo 
 Cash, 
 
 Balan 
 
 Jfe 
 
 >c^'^^^> 
 
 
 CO 
 r-» 
 
 (N 
 
 CN > 
 
 
 rH^OCO^OO 
 
 
 
 
 rH 
 
 
 1 
 
 
 
 
 
 
 1 
 
188 ACCOUNTING AND AUDITING 
 
 directly subtracted, and not, as before, added to the 
 other side of the cash book, our posting to Customers 
 at the end of the period must be the sum of the net 
 cash column and the Discount column — for the credit 
 to each customer as the bills were paid was necessa- 
 rily the sum of those two items for each bill; our 
 total net cash must be included in the sundries col- 
 umn, to be debited to Cash; and our total discount 
 may be debited directly from this place. We may 
 provide for all this by a simple precaution in the 
 order of taking totals. If we first take the total of 
 net cash, we may extend the item into the Sundries 
 column and thus provide for our Cash debit. Since 
 we must include the Discount in the credit to cus- 
 tomers, we next take the footing of the Discount col- 
 umn, which must be independently posted, and then 
 extend it into the net cash column after the total of 
 net cash has been determined. By adding the Dis- 
 count to the net cash we get the full amount to be 
 posted as a credit to Customers. 
 
 Another device to serve the same end is to enter 
 the full amount of the bill in the Customers column, 
 to enter the discount in the Discount column, and to 
 carry the net amount to the Sundries column. Then 
 all figures are provided : we post to the credit of 
 the customer the amount in the total column, we 
 credit to Customers the total of the total column, we 
 include the net amount in the Cash receipts, and we 
 post to Discount, as a debit, the total of the Discount 
 column — which, as in the last form, has really noth- 
 ing to do with Cash. This is complete and simple. 
 It is shown below: 
 
SOME HIGHLY DIVBLOPED TYPES 
 
 189 
 
 
 1 
 
 S88S8 
 
 
 
 8 
 
 
 
 
 ■^ t^CO rH CO 
 
 
 S 
 
 
 rt 
 
 
 Tj< 
 
 
 rH 
 
 tH 
 
 
 CO 
 
 
 OQ 
 
 
 
 
 
 -^ 
 
 8 BB 
 
 o| 
 
 
 
 
 ^ 
 
 
 
 OQ 
 
 
 rH 
 
 
 
 Q 
 
 
 
 
 
 £ 
 
 
 
 
 
 
 S3 
 
 8 88 
 
 3 
 
 
 
 
 8 88 
 
 ^ 
 
 
 
 
 lO ^ 0-1 
 
 ^ 
 
 
 
 
 s 
 
 r-l 
 
 <>4 
 
 
 
 
 O 
 
 
 
 
 
 
 8 
 
 o 
 
 
 3 
 
 8 
 
 8 
 
 
 o 
 
 
 U~) 
 
 *o 
 
 cSs 
 
 
 ^ 
 
 
 Oi 
 
 05 
 
 lO 
 
 
 >§ 
 
 l> 
 
 
 ^ 
 
 i-H 
 
 rH 
 
 CQ 
 
 
 
 
 
 EH 
 
 
 T3 
 
 
 
 & 
 
 
 •3 
 
 
 
 o 
 
 
 iH rH 
 
 
 
 H 
 
 
 ■•^ 
 
 
 
 « 
 
 
 last month 
 
 a Account Feb. 
 le Note A. Scot 
 
 On account 
 ewit Account Feb. 
 
 Cash sales 
 
 
 i 
 1 
 
 
 
 a'^'S 1 
 
 ^ 
 
 g 
 
 
 
 o o > So 
 
 P 
 
 >-• 
 
 
 
 ^ 5 5j S jO . iH OQ 
 
 
 
 
 
 
 1' 
 
 
 
 
 alan 
 
 anie 
 
 ills 
 
 elix 
 
 arti 
 
 erch 
 
 usto 
 
 O 
 
 S 1 
 
 
 
 pqQpqpM^^ o 
 
 « { 
 
 U « 
 
 
 yiii 
 
 ^rH ICt^ »0 -^ <M 
 
 QO 
 rH 
 
 ^ > 
 
 
 
 ri »0 O 00 CD dS 
 
 
 f-H 
 
 
 
 1-1 ^ r-l G*^ 
 
 
 . 
 
 
 
 -S 
 
 
 ^ 
 
 
 
 S 
 
 
 
 
 
 1^ 
 
190 ACCOUNTING AND AUDITING 
 
 In this form both the column for Customers and 
 that for Discount are really for journal entries alone, 
 and have no effect upon the amount of Cash. We 
 have extended into the Sundries column the net 
 cash in every case, and, therefore, that amount is 
 automatically included in the receipts. The Cus- 
 tomers column, containing the total of all bills, must 
 be posted as a credit to Customers, and the total of 
 Discount must be posted as a debit to Discount, for 
 it is this discount and the cash which together make 
 up the equivalent credit to Customers. The only 
 peculiarity of the arrangement here is a provision 
 that neither the amount of total for Customers nor 
 that of Discount shall get into the Cash columns. 
 This form has for its advantage over the others that 
 it shows at all times the actual totals of all accounts 
 concerned. It is impossible under the first form to 
 find the cash receipts without first finding the Dis- 
 count total, subtracting it from the Customers, and 
 adding the remainder to the sundry cash receipts. It 
 is impossible under the second form to learn the 
 credit to Customers without adding the Discount to 
 the net cash, and it is impossible to learn the total 
 cash receipts without adding the net cash to the 
 sundry cash. Here, however, the total of the Sun- 
 dries column is always the total cash receipts, and 
 the total of Customers is the total credit to Cus- 
 tomers. 
 
 All this sounds very complicated, but in practice 
 as soon as one has learned the lay of the land it works 
 very simply. 
 
 We have just seen forms in which certain items 
 that really belong on the journal are introduced into 
 
SOME HIGHLY DEVELOPED TYPES Idl 
 
 the cash book because they may be inserted there in 
 special columns with perfect clearness and without 
 explanation. This suggests the fact that the cash 
 book may be used commonly as a journal for any 
 items if only the items are written on both sides. It 
 is common in banking, for instance, to enter many 
 things not cash at all on both sides, and to designate 
 on the debit side of the cash book the name of the 
 account to be credited and on the credit side of the 
 book the name of the account to be debited. When 
 these items are posted in the ordinary course, the cor- 
 rect results are attained; for the cash balance is not 
 affected, and items on the debit side of the cash book 
 are of course credited and those on the other side 
 are debited. Let us now, in order to see this prin- 
 ciple in its fullness, apply it to an extremely compli- 
 cated form. One who thoroughly understands this, 
 and can reproduce it and make desired changes in it 
 without throwing it out of order, may be said to have 
 mastered the principle of the special column. 
 
 Let us assume a commission business in which we 
 receive commissions on sales which we make and 
 pay commissions on sales made for us. We also buy 
 certain merchandise directly for our own account 
 and sell it both directly and on commission. Our 
 profits are both commission and gain on merchandise, 
 and our losses are both commission and losses on 
 merchandise. We have then a variety of purchasing 
 and selling relations. It is desired in such a business 
 to keep constant run of the course of profits, and, 
 therefore, to figure profit and loss on each shipment 
 for sale on commission. In the illustration given 
 below it will be seen that we save entries by treating 
 
in \CCOltNTtNG AND ATTBITIKG 
 
 as cash things that are not cash, for by entering such 
 items in connection with other items repetition of 
 explanation is saved, and, though the amount of cash 
 is overstated, the balance is correct. This form also, 
 it will be noted, provides special columns for several 
 controlling accounts. We have, then, a combination 
 of practically all the complexities of bookkeeping 
 form. 
 
 In this business, four separate subordinate ledg- 
 ers are kept: a consignment ledger, with a separate 
 account for each lot of goods received to be sold on 
 consignment — that is to say, to be sold for others on 
 a commission basis; a shipment ledger with an ac- 
 count for each lot of goods shipped to others from 
 our own stock to be sold by them for us on commis- 
 sion; a customers ledger for customers; and a cred- 
 itors ledger for creditors. It is necessary to keep in 
 the general ledger an account to represent each of 
 these subordinate ledgers. We must debit each con- 
 signment with expenses and commission and remit- 
 tances to the shippers, and we must credit each with 
 what we get for the goods. We must debit each ship- 
 ment with what the goods cost us and expenses and 
 commission allowed to our agents, and credit each 
 with the net receipts from our agents. To close ship- 
 ments accounts, moreover, we must debit them for 
 gains — to make the debits equal the receipts, — and 
 credit them for losses — to make the credits equal the 
 debits. It is convenient, moreover, to close such 
 shipment accounts as soon as possible, for the man- 
 agers must govern their future shipments by the 
 results of present and past shipments. If cer- 
 tain goods shipped to a certain town always result 
 
SOME HIGHLY DEVELOPED TYPES 193 
 
 in a loss, a manager ought to know it as soon as pos- 
 sible. It will save labor, moreover, if we can close 
 each such shipment account at the time of receiving 
 the final ^^ account sales" — that is, the final report, 
 from the agent, concerning that shipment; for then 
 the loss or gain may be placed in a special column, 
 without explanation, in connection v/ith the entry of 
 the amount received from the shipment. 
 
 In om* cash book, therefore, we must provide a 
 large number of special columns, for we have not 
 only expenses and discounts and profit and loss, but 
 several controlling accounts. On the receipts side, 
 our controlling accounts will be Shipments — for 
 amounts received from shipments sent away, — Con- 
 signments — for amounts received for goods sold for 
 others, — and Customers. On the disbursements side 
 our controlling accounts will be Shipments — for ex- 
 penses, commission, etc., — Consignments — for ex- 
 penses and remittances sent to shippers, — and Cred- 
 itors. For most of these controlling accounts, more- 
 over, there will be more than one column, for in many 
 cases the payments are likely to be less than the full 
 amount of the bill. When payment is received for 
 goods which have been shipped away to be sold on 
 commission, the amount may be more or less than 
 the sum debited to that shipment account, for com- 
 mission is always to come out, loss may have been 
 suffered, or profit may need to be added. Similarly, 
 when payment is made to those for whom the busi- 
 ness has sold goods on consignment, less is paid 
 than the full price received on the goods, for commis- 
 sion is to be deducted. When, again, payment is 
 made for merchandise purchased, discount is likely 
 
 A. & A-13 
 
194 ACCOUNTING AND AUDITING 
 
 to be deducted. Obviously, the commission, the dis- 
 count, the loss, and the gain, are not properly cash 
 items and do not belong ux3bn the cash book; but if 
 we can save labor by inserting in that book items 
 that do not theoretically belong there it is worth 
 while to do so. Many forms will serve this purpose. 
 We will take, for practice, not the simplest but the 
 most complicated. The reader wishing to improve 
 his understanding of the principle of the special col- 
 umn is recommended to* see clearly the full meaning 
 of this and then to devise ways of simplifying it, as 
 suggested later. 
 
 The first column on the debit side of the cash 
 book indicates the total amount received on settle- 
 ment with those who sell shipments for us. Obvi- 
 ously, it this amount is more for any shipment than 
 that shipment cost us as shown by the shipment 
 ledger, the difference is gain. It may be entered at 
 once in the gain column. If the return is less than 
 the cost, the loss nmy be entered. Our shipments 
 account, not only in the general ledger but as a total 
 of the items in the shipments ledger, must balance so 
 far as each particular shipment is concerned; and to 
 make it balance the gain or loss must be entered. 
 Shipments, in other words,^must be credited for more 
 or less than the actual receipts by the amount of loss 
 or gain; but gains may as well be added to the debits 
 as subtracted from the credits ; so losses are credited 
 to Shipments and gains are debited. 
 
 These items of gain and loss are really not cash 
 items at all, for their only connection with cash is 
 registered in the amount entered in the Shipments 
 column — which shows the amount of cash actually 
 
SOME HIGHLY DEVELOPED TYPES 
 
 195 
 
 
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 cct. sales 257 
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 cct. sales 247 
 ash sales. S. B. 
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 ipment 
 
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 pense 
 
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 editors 
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 sCount 
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 SSS^iS S"*5§§^SS 2"= "^ 
 
 
 
 
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 V 
 
 
 
 
 
 
 
 
 
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196 ACCOUNTIKG AND AUDITING 
 
 received. Entries for them need simply to close each 
 shipment account and transfer the gain or loss to a 
 nominal account — ^just as in the last chapter we made 
 journal entries to close various accounts. These en- 
 tries could perfectly well go upon the journal, as has 
 already been indicated; but for every entry of this 
 sort an explanation would need to be 'made, and that 
 would involve rewriting the history of the trans- 
 action. If the entries are made here, however, no 
 additional explanation is necessary. Our present 
 bookkeeping problem is then to provide means of 
 debiting Shipments and crediting Gain, and of debit- 
 ing Loss and crediting Shipments, for the amounts 
 shown in the Gain and Loss columns. We have seen 
 that any item may be placed on the cash book, even 
 though no cash is involved, if only it is put on both 
 sides. If, then, we carry the total of the Gain col- 
 umn, $6.25, into our Sundries column, as if it were a 
 cash receipt, and write the word '^Gain" in the jour- 
 nalization column, this amount will be posted as a 
 credit to Gain at the closing period. If, at the same 
 time, we carry this $6.25 also to the other side of the 
 cash book and there call it ^^ Shipments," it will be 
 posted in due course as a debit to Shipments (be- 
 cause items appearing on the credit side of the cash 
 book are debited to the accounts named) and we shall 
 have produced just the desired effect. The debit and 
 the credit to Cash, though both excessive, offset each 
 other. Similarly, if we extend the $5.10, which is the 
 total of the Loss column, into the Sundries column as 
 a cash receipt, and call it '^Shipments," to Shipments 
 it will be credited when the book is posted, as we have 
 already seen that it ought to be. If, finally, we carry 
 
SOME HIGHLY DEVELOPED TYPES 197 
 
 this $5.10 also to the disbursements side of the cash 
 book and there call it ^^Loss," it will be posted as a 
 debit to Loss, as we have already seen it ought to be. 
 We have, then, by carrying both of these totals to 
 both sides of the cash book, but in one case calling 
 them ^^ Shipments" and in the other calling them by 
 their natural names, produced the same effect as if 
 we had made a journal entry, or, rather, two journal 
 entries, to express the situation. Since, in the form 
 as shown, the $6.25 gain on the credit side of the 
 cash book should be posted as a debit to Shipments, 
 it may be extended into the Shipments column and 
 so be posted in total with the other Shipments items. 
 Otherwise it must needs have a separate posting. 
 Similarly, the loss appearing on the debit side is to 
 be credited to Shipments, and so we save a posting 
 by inserting it in the Shipments column so that it 
 shall be included with the other credits to Shipments 
 and be posted in a lump sum. The other half of each 
 of these entries, however, is posted individually, and 
 is individually extended into the Sundries column; 
 for there are no other Gain items on the debit side of 
 the cash book and no other Loss items on the credit 
 side. 
 
 The next column, *^ Consignments," includes cash 
 receipts from the sale (not charged to any customer) 
 of goods sent to us on consignment, and, therefore, 
 shows the amount which should be credited not only 
 to Consignments but to the individual consignment 
 accounts in the consignment ledger — for since these 
 goods belong to shippers, we must be sure that in 
 each case we credit the shipper with the receipts on 
 bis own goods. Since it shows an actual receipt of 
 
198 ACCOUNTING AND AUDITING 
 
 cash, the amount is finally, of course, extended into 
 the Sundries column. The next column, that for Cus- 
 tomers, again represents a receipt; but since the 
 amount to be credited to Customers is the full face 
 of all bills paid, regardless of discount, any over- 
 statement of Cash when the amount is extended into 
 the Sundries column must be offset by the items in the 
 next column which are carried to the opposite side of 
 the cash book whenever the book is balanced. The 
 Merchandise column contains cash receipts from the 
 sales (not charged to any customer) of merchandise 
 directly from our own stock without the intervention 
 of any commission merchant, and is finally, of coiu'se, 
 extended into the Sundries column. 
 
 When we come to close the cash book we must 
 note that on the receipts side the total Discount col- 
 umn is not to be extended into the Sundries column 
 nor to be posted from this source, but is to be carried 
 to the other side of the book; that the amount of 
 Loss is not to be extended into the Sundries column, 
 for it is included among the Shipments; and that 
 before ruling up the page we must bring over from 
 the opposite side the amount of Discount found there 
 as a deduction from the bills which we have paid. 
 
 On the disbursements side of the cash book we 
 find a similar condition. Shipments is here debited 
 for expenses incurred in sending goods away for sale 
 on commission, and, as we have already seen, for the 
 amount of gain as shown by the other side of the cash 
 book. Consignments, on the other hand, represents 
 the remittances or expenses incurred for goods which 
 we have sold for others; and the amount indicated 
 is here the full sum before commission has been 
 
SOME HIGHLY DEVELOPED TYPES 199 
 
 deducted, for this is the amount which must be deb- 
 ited to the individual consignments even though a 
 smaller sum was sent in cash. The next column is 
 simply for the commission deducted on these remit- 
 tances. The next is for sums paid on bills which we 
 owe for merchandise purchased on our own account; 
 and the amount is the full face of such bills; but in 
 case we pay less than the face, the difference is 
 shown in the next column. The expense column is 
 self-explanatory to one who understands the ele- 
 ments of special-column usage. 
 
 In closing the credit side of the cash book, we 
 must realize that some items are under this plan to 
 be extended into the Sundries column and some are 
 not. For instance, we have in the case of Consign- 
 ments debited Consignments with the full face of the 
 bill, credited Commission with the deduction, and 
 extended the net amount of Cash into the Sundries 
 column because it represents the net outgo. It is 
 obvious, then, that we must not again extend into 
 the Sundries column the footing of the Consignments 
 column, for to do so would duplicate the expendi- 
 tures on this score. The Commission item, on the 
 other hand, does not even indirectly represent cash. 
 It might have been treated as a deduction from the 
 remittance on Consignments, just as the discounts 
 are treated as a deduction from the amount to be 
 paid to creditors, but as a matter of fact we have not 
 so treated it here, and, therefore, must not enter it 
 in any cash column either on this side of the book or 
 on the other. This Commission total is nothing but 
 a journal item which must be posted as a credit to 
 that account. The other half of this item — that is. 
 
200 ACCOUNTING AND AUDITING 
 
 the debit to offset this credit — is included in the Con- 
 signments, which again, it will be noted, is not a cash 
 item at all, but merely a journal item to be posted 
 directly without reference to the cash, for the amount 
 of net cash in connection with it is entered in the 
 Sundries column. 
 
 The total of the Creditors column, however, is to 
 be extended into the Sundries column, because we 
 shall later offset the excess, here debited over the 
 amount actually paid, by the transfer of the tot^l of 
 the Discount column to the other side of the cash 
 book. The Shipments total, including the gain 
 brought from the other side, is, of course, extended 
 into the Sundries column, for it represents actual cash 
 paid out except for the item of $6.25, which is offset 
 by a similar extension on the other side. 
 
 The net result of all this apparent complexity is 
 that Cash is debited more than it is credited by just 
 the amount of net receipts, and that each other ac- 
 count is debited or credited exactly as it should be. 
 Any sceptic may easily prove the correctness of the 
 cash : for he will find the actual receipts to be 
 $973.00; the actual disbursements to be $795.60; and 
 therefore the balance to be, as shown above, $177.40. 
 
 The reader who is interested to get additional 
 practice in the handling of these accoimts is recom- 
 mended to make several changes so as to make a uni- 
 form system out of the unsystematic form here 
 shown. Here, for instance, discounts, both those 
 subtracted from bills paid by customers and those 
 subtracted from bills paid to creditors, are trans- 
 ferred to the other side of the cash book in order to 
 correct the overstatement of cash: but commissions, 
 
SOME HIGHLY DEVELOPED TYPES 201 
 
 which bear the same relation to Consignments that 
 Discount does to Creditors and Customers, are not 
 here entered upon the other side of the cash book; 
 they are deducted directly from the Consignments 
 and the result is extended into the Sundries column. 
 It is good practice to alter the form shown above so 
 as to provide uniformity — to treat Commission, for 
 instance, as a contra item to go upon the other side 
 of the cash book and be posted thence — as is done 
 with Discount. When this has been done, it would 
 be well to reverse the process ^nd treat Discount as 
 Commission is here treated, so that discounts shall 
 be deducted from the amount of the bills and only net 
 cash shall reach the Sundries column. Another 
 change that may be made here to advantage is to 
 treat the Gain and Loss items independently of Cash,, 
 as if they were journal items, and credit the Gain 
 and debit the Loss directly, as Commission is cred- 
 ited on the credit side of the cash book shown above. 
 Care must be taken in that case not to neglect the 
 Shipments portion of the entries. It is desirable al- 
 ways to provide that whatever plan is followed in 
 one part of a book shall be followed in other parts, 
 and therefore if net amounts are to be extended into 
 the Sundries column in one connection, they should 
 be in all connections; or if contra items are to be 
 used in one connection, they should be in all; or if 
 any items not strictly Cash are posted as if they were 
 journal items independent of Cash, all such items 
 shall be so treated. Much opportunity for practice 
 in this line is afforded by the forms given above. 
 Those forms are not recommended as they stand, but 
 they are serviceable when unified and simplified. 
 
202 ACCOUNTING AND AUDITING 
 
 It is worth while now to note certain bookkeeping 
 devices which involve less a new principle than a 
 modern development of an old principle. These are, 
 primarily, to provide for small items or infrequent 
 items which are not quite worth placing in a ledger 
 account by themselves. 
 
 The most obvious of these is the account com- 
 monly called ^' Petty Cash." To insert in the ordi- 
 nary cash book small items for telegrams, cleaning, 
 extra newspapers, car fares, and things of that sort, 
 would make considerable bother — especially if these 
 items needed to be posted one by one to separate 
 accounts. In highly developed lines of business, 
 moreover, it is felt that for the purposes of auditing 
 and making sure that all items are properly ac- 
 counted for, it is well to make general payments 
 wholly through the medium of checks drawn on 
 banks. These small items, however, could hardly be 
 provided for in this way. It is well, therefore, to 
 keep in a ^^ petty cash book," so called, all items not 
 paid by check, and to limit such expenditure to 
 things of slight consequence. The method of han- 
 dling the petty cash may vary with circumstances, 
 but the most satisfactory seems to be what is called 
 the ^ impressed system." Operations are begun by 
 drawing a check for a lump sum which is supposed 
 to supply the cashier with all the ready money he 
 will need for petty payments during a considerable 
 period of time. This is debited on the general cash 
 book to Petty Cash. As the cashier makes payments 
 from this sum he keeps a record on a subordinate 
 book, or petty cash book, which, with a number of 
 special columns, may classify the items according 
 
SOME HIGHLY DEVELOPED TYPES 203 
 
 to the accounts to which they are ultimately to be 
 charged. When the cashier finds his supply of ready 
 cash low, he requests from his superior a check for 
 another sum. The amount of such check is the total 
 expenses shown by the petty cash book at that time; 
 so that the check drawn exactly re-establishes the 
 original petty cash balance. On the general cash 
 book this second sum is debited not to Petty Cash, 
 but to the accounts for which the original petty cash 
 was spent. The result of this method is that small 
 sums are kept in the petty cash book until such time ' 
 as it is worth while to enter them in lump sums 
 on the general cash book and to meet them out of 
 the bank balance; and the amount standing on the 
 general ledger charged to Petty Cash represents at 
 all times the amount for which the petty cashier is 
 responsible — either the actual cash in the petty cash 
 drawer or that sum plus expenditures which have not 
 yet been entered on the general cash book. 
 
 Another method of accomplishing the same result 
 is to debit Petty Cash on the general cash book not 
 only for the original check drawn for the petty cash 
 drawer, but for all subsequent payments, and then at 
 suitable intervals, by a journal entry, to debit the va- 
 rious accounts for which petty cash has been spent 
 and to credit Petty Cash. Whenever, then, all the 
 petty cash book items have been entered in the 
 ledger, through the journal, the petty cash account 
 will show as a balance the actual amount that should 
 be on hand. The advantage of the former method is 
 that the check drawn for the replenishment of petty 
 cash always agrees in amount with the expenditure 
 entered on the general cash book for such petty cash 
 
204 ACCOUNTING AND AUDITING 
 
 payments. This, from the auditing point of view, is 
 an advantage, for the amounts can be checked item 
 
 bv item. 
 
 >/ 
 
 Another device for handling petty items is con- 
 cerned with the ledger. In certain lines of business 
 having but few relations with customers, such as gas 
 companies, electric light companies, telephone com- 
 panies, etc., which have usually debits to their. cus- 
 tomers at regular intervals for certain common but 
 not numerous items, the ledger may be arranged in 
 horizontal form so that names appear at the left of 
 the page and a series of separate columns across the 
 page shows detailed charges for a month or a year or 
 whatever period is convenient. By the provision of 
 special columns for credits and for balances, the sum- 
 mary of every account can be seen at a glance, and 
 the addition of any column will show for the page the 
 total of each kind of charge — such as telephone rent- 
 als, telephone toUSj messenger service, etc. These 
 totals may then be compared with the controlling 
 account, which should represent all such customers, 
 and with the nominal accounts which were credited 
 when charges were made to custom^ers. Such a book 
 is usually called a * tabular ledger." 
 
 Sometimes an account is kept in the general 
 ledger with so-called ^^ petty accounts." Here, in- 
 stead of separate accounts with each individual who 
 has few and slight dealings with the business, the 
 items for all these individuals may be carried to one 
 general account representing the lump sum — just as 
 Customers is kept for the total of all details shown 
 in a customers ledger, — and yet no individual ac- 
 counts need be kept anywhere, even in a subordinate 
 
SOME HIGHLY DEVELOPED TYPES 205 
 
 ledger, with these separate individuals. The plan of 
 such Petty Accounts is usually that whenever a debit 
 or a credit is made to it (with a designation of the 
 individual concerned instead of the account w^hich is 
 the other half of the entry) the line on the opposite 
 side is left vacant until that item is squared; so that 
 although ordinarily on a ledger account the credit 
 items would be placed one directly under another, 
 regardless of any attempt to arrange them line by 
 line opposite the debit items with which they corre- 
 spond, on this Petty Accounts, if debits were usually 
 made before credits, each credit would be placed 
 opposite the corresponding debit, however many 
 lines needed to be left blank on the credit side. This 
 is illustrated by the form given below. 
 
 Jan. 15 
 Jan. 27 
 Jan. 30 
 Feb. 3 
 
 PETTY ACCOUNTS 
 
 40 
 51 
 57 
 63 
 
 15 00 
 20 00 
 17 15 
 11154 
 
 Jan. 31 
 Feb. 10 
 
 John Nicholson 
 
 Peter Ibbetson 51 20|00 Jan. 31 Peter Ibbetson 
 
 John Halifax 
 
 George Tressady 63 11)54 Feb. 10 George Tressady 
 
 102 
 
 20 
 
 We may now turn to something which is a sort of 
 combination of Petty Accounts, as just indicated, a 
 tabular ledger, and a controlling account. This is 
 common in what is commonly called the ^^ voucher 
 system'' of bookkeeping. Under this system, in its 
 full form, a voucher is made out for every debt owed 
 by the business, and when payment is made the pre- 
 pared form is sent out with a request that it be 
 signed and returned. The voucher itself is very little 
 concerned with the books, however, and we may dis- 
 regard its details. Indeed, the term 'Voucher" is 
 used unfortunately in this system, for a voucher is 
 really a proof that money has been paid; and the 
 term is here used for bills to be paid as well as for 
 
206 ACCOUNTINCt AND AUDITING 
 
 bills paid. We are concerned onl}^ with the method 
 of handling a large number of liabilitirs witliout 
 opening separate accounts in the ledger for each firm 
 owed. The foundation of the bookkeeping under 
 this system is a voucher register. This is, in nature, 
 very much like the accounts payable book described 
 in Chapter V. That book, however, is often only an 
 auxiliary book, and so is not used either to origi- 
 nate postings or to receive postings. The voucher 
 register contains usually in the first column the 
 names of the firms or the corporations to whom pay- 
 ments must be made for debts incurred. The second 
 column contains the address of each. The third 
 gives the number of the voucher to be used at the 
 time of payment. Next will be shown the date of the 
 bill for which payment is to be made, the terms of 
 such payment, and the time when the bill is due. 
 Next are columns for the date of payment and the 
 method. The next column shows the amount to be 
 paid, and may w^ell be headed ^^ Vouchers Payable, 
 Cr." Then may follow a number of columns for ac- 
 counts which are to be ultimately debited for the debt 
 incurred. If, for instance, the business is that of a 
 department store, a column will be provided for each 
 department, and when an advertising bill amounting 
 to $25 comes in, it will be entered at once and per- 
 haps $5 of that will be entered in a special column 
 to be debited to the hosiery department, $10 in an- 
 other column for the shoe department, and $10 in 
 a third column for the lace department. Entries are 
 made in this register as soon as bills are received and 
 irrespective of the time when payment is to be made. 
 No other credit than this is given on the books for 
 
SOME HIGHLY DEVELOPED TYPES 201' 
 
 the firms to whom x)a7ment is to be made. The post- 
 ing is made to one general account representing the 
 whole mass of such debts. This is usually called 
 ^* Vouchers Payable." Under this plan, then, the 
 amount of all debts which have not separate accounts 
 in the ledger is shown as the total of this Vouchers 
 Payable column in the voucher register, and the 
 amount due to any particular firm is shown by the 
 details opposite the items bearing its name. At the 
 end of each day, w^eek, or month, the items may be 
 got upon the general ledger by simply debiting the 
 departmental accounts for the amount indicated for 
 each in the separate columns in the register and cred- 
 iting Vouchers Payable for the total. Whenever 
 payments are made in settlement of any of these 
 debts, of course, Vouchers Payable is debited, and 
 Cash is credited, on the cash book. At the same 
 time, in the vouchers payable register the columns 
 for the date of payment and the method of payment 
 are filled in. The balance of Vouchers Payable in 
 the general ledger should always agree, of course,^ 
 with the amount show^n in the register and not indi- 
 cated as paid; for as Vouchers Payable has been 
 credited for all debts (by the voucher register) and 
 has been debited for all payments (by the cash 
 book), the balance is the amount still unpaid. 
 
 This handling of vouchers payable is serviceable, 
 of course, m.ainly for dealings with firms who have 
 rather infrequent relations with the business; for 
 since all the items are handled individually assump- 
 tion is always made that each bill will be paid by 
 itself and will not be combined with others in a set- 
 tlement of the lump. If there is outstanding more 
 
308 ACCOUNTING AND AUDITING 
 
 than one debt with any firm at the same time, there 
 is under this system no way of finding the total obli- 
 gation to that firm except by going through the reg- 
 ister and discovering that there are several items due 
 to it. In other words, under this vouchers payable 
 system there is no indexing, and the possibility of 
 indexing, as we saw long ago, is one of the chief ad- 
 vantages of a ledger. 
 
 Often the managers of a business wish to withhold 
 from their bookkeepers information about its inner 
 relations. This can be accomplished by providing a 
 separate private set of books — but without duplica- 
 ting labor. Indeed, comparatively few kinds of trans- 
 actions need to be known to the general bookkeepers. 
 The numerous transactions, which require much labor 
 for entry, are purchases, or manufacturing, sales, 
 payments for purchases, collections from sales, and 
 payments for expense. These, of course, the general 
 bookkeepers will enter on the books. Investment of 
 capital, borrowings, salaries of managers, division of 
 profits among partners, payments of interest, taxes, 
 and numerous other items, however, are usually so 
 infrequent that entries for them may be made by a 
 proprietor or confidential bookkeeper in the private 
 cash book, private journal, and private ledger. Such 
 an arrangement, moreover, does not preclude the pos- 
 sibility of a trial balance for the general ledger or 
 for the private ledger. The device of a controlling 
 account makes possible the complete separation of 
 these two sets of books without robbing either set of 
 any desirable figures. 
 
 The method may be summarized briefly. On the 
 general books any items of assets received from 
 
SOME HIGHLY DEVELOPED TYPES S09 
 
 sources not shown on the general ledger are credited 
 to an account called ^* Private Ledger." The details 
 show on the private ledger — as details of Accounts 
 Receivable show on the sales ledger. When cash is 
 received, the general bookkeepers need not know 
 whether it comes from investment of partners, from 
 loans, or from conversion of other assets not known 
 to them. Similarly, any outgo to destinations not 
 indicated on the general ledger is debited to Private 
 Ledger ; and no one, unless he has access to the pri- 
 vate ledger or to checks drawn, can know whether 
 such outgo is for interest on loans, for partners' sal- 
 aries, for payment on debts, for partners' withdrawal 
 of capital, for payment of expenses, or for partners' 
 withdrawal of profits. The private books, however, 
 show all details. If a separate bank account is kept 
 for the private transactions, moreover, private re- 
 ceipts and pajonents need not appear on the general 
 books even for the controlling account — except when 
 transfers are made from the private bank account to 
 the general, or vice versa. The general books need 
 not be complete. They must balance, of course, but 
 all matters not of concern to the general bookkeepers 
 are lumped in the private ledger account. A big real 
 estate purchase, for example, would involve a debit 
 to Real Estate and a credit to Cash in the private 
 books ; but since it does not affect anything that con- 
 cerns the general books, it does not affect even the pri- 
 vate ledger account in the general ledger. 
 
 The private books, on the other hand, may show 
 the summary of the whole business, and therefore 
 may include all transactions of the general books, or 
 they may show only net results. In the latter case, 
 
 A & A-14 
 
m ACCOtTNTING AND AUDITING 
 
 the private ledger may have an account entitled '* Gen- 
 eral Ledger" to serve as an explanation when items 
 are taken over from the general books into the private 
 books. A trial balance is then possible for the private 
 books without the details of the general books. If in 
 making up the private trial balance, moreover, the 
 bookkeeper substitutes the individual items on the 
 general trial balance for his own General Ledger ac- 
 count, the trial balance of the private ledger will be 
 complete for the business as a whole. If, on the other 
 hand, it is desired to show on the private ledger itself 
 a summary of the accounts on the general ledger (in- 
 stead of an adjustment account as just described), the 
 totals of general books may be posted directly to the 
 private ledger as well as to the general ledger ; so that 
 the total of the purchase book, for illustration, will be 
 posted as a debit to Purchases and a credit to Ac- 
 counts Payable in both books. It is likely to be sim- 
 pler, however, to carry to the private books only items 
 which affect private accounts, making adjustment 
 through the account called *^ General Ledger," as pre- 
 viously described, and to use the general-ledger trial 
 balance for ascertaining details. 
 
 This device for the separation of private and gen- 
 eral matters is capable of many variations; but it 
 makes possible the employment of an army of book- 
 keepers without opening one's affairs to common 
 knowledge. If inventories are kept private, even a 
 knowledge of both purchases and sales fails to disclose 
 gross profits, and net profits are still further removed 
 from disclosure. 
 
 Another interesting use of a controlling account is 
 in connection with business transacted in foreign cur- 
 
SOME HIGHLY, DEVELOPED TYPES M 
 
 rencies. If a pound sterling were always equivalent 
 to the same sum in dollars and cents, it would matter 
 little if all such foreign items were converted imme- 
 diately into American figures ; but rates of exchange 
 are constantly changing, and the price actually paid 
 for goods bought or sold abroad may not agree with 
 the nominal equivalent of the bill. It is desirable, 
 moreover, that the books of buyer and seller shall 
 agree. It is customary when bills are expressed in 
 foreign currency, therefore, to keep separate pur- 
 chase or sales books and purchase or sales ledgers 
 for foreign trade and keep them in the original cur- 
 rency. Since the amounts must be included in the 
 general books, however, and in American currency, a 
 controlling account is kept in the general ledger, and 
 the amount is shown in both currencies — that is, the 
 ruling provides two sets of money columns. When 
 goods are bought, therefore, they are credited in the 
 foreign purchase book and the foreign purchase 
 ledger at the foreign price ; when the total is carried 
 to the controlling account the amount is converted 
 into American currency at the nominal exchange 
 rate (say $4,86 2/3 for a pound sterling), and both 
 amounts are posted to the general ledger. When 
 payments are made, on the other hand, the control- 
 ling account is debited in American currency for the 
 amount actually paid for the bill of exchange, the 
 posting to the general ledger is not only for the 
 amount actually paid in American currency, but for 
 the aniount of foreign currency which the bill ac- 
 tually covers, and the posting in the foreign pur- 
 chase ledger is for the amount of foreign currency 
 vemitted. This device allows the books to show at 
 
^1^ ACCOUNTING AND AUDITING 
 
 all times the balance due in foreign currency — not 
 only on the subordinate ledger, but also on the gen- 
 eral ledger, — the actual cost of remittances as com- 
 pared with the nominal equivalent, and hence, of 
 course, the profit or loss on exchange. As often as 
 desired, the controlling account. may be closed; then 
 the difference between the nominal exchange figure, 
 for paid bills and the amount actually paid on them 
 will be transferred to Profit and Loss. 
 
CHAPTER Vm 
 
 THE PECULIAEITIES OF COEPORATION ACCOUNTS 
 
 In the accounting of corporations certain features 
 are unlike anything that is possible under a single 
 proprietorship or a partnership. It is well at this 
 point to study these with some care, for most busi- 
 ness operations are nowadays carried on under cor- 
 porate ownership. 
 
 Among accounts peculiar to corporations is Divi- 
 dends. This is of use, of course, only where there is 
 an issue of capital stock. The method of distributing 
 profits in a corporation is to carry to Dividends the 
 amount of profits which the directors have voted to 
 distribute, and to enter it, of course, as a credit; for 
 since the profits must stand on the credit side of the 
 profit and loss account, and this amoimt is simply 
 transferred to Dividends, it must appear on the same 
 side. A simple journal entry debits Profit and Loss 
 and credits Dividends — explaining, of course, why 
 the entry is made. Dividends are, of course, a lia- 
 bility of the corporation until they are paid. When 
 they are paid. Dividends is debited. Cash is credited, 
 and so the dividend account is balanced. 
 
 The most important distinction between the ac- 
 counts of single proprietorships and partnerships, on 
 one hand, and corporations, on the other, lies in the 
 capital stock account. This is always merely a con- 
 trolling account and represents the lump sum of the 
 
 213 
 
214 ACCOUNTING AND AUDITING 
 
 holdings of all stockholders. It is obviously unneces- 
 sary to enter on the general ledger the names and 
 shares of individual stockholders, for each share of 
 stock is represented by a certificate held by the 
 owner and sufficiently indicating his title. One cer- 
 tificate may cover all the holdings of one person, and, 
 therefore, may cover many shares; but it is possible 
 for one person to have many certificates, each for a 
 small lot of shares, so that he may sell a part of his 
 holding without affecting the rest. In order to keep 
 run of the holdings of stock, so that the corporation 
 may know not only who is entitled to vote and to 
 whom dividends should be paid, but also on whom 
 calls may be issued for assessments in case any are 
 necessary, a stock ledger or stockholders' ledger is 
 kept to indicate exactly wh^t is the holding of each 
 person. This is purely a subordinate ledger. The 
 total credit balance of the individual stockholders' 
 accounts in the stock ledger must agree, of course, 
 with the total credit of the capital stock account in 
 the general ledger. 
 
 The process by which the credits to individual 
 stockholders are established is in many cases inter- 
 esting. If the total capital stock of a corporation 
 were issued at once and the full amount of cash were 
 received immediately in return, the bookkeeping 
 would be simply a debit to Cash, and a credit to Capi- 
 tal Stock, for that amount. This, however, is not 
 the common operation. Usually new stock may be 
 paid for by installments; often the amount to be 
 paid is either more or less than the par value; stock is 
 often issued, moreover, in return for property, or in 
 payment for a business bought outright by the corpo- 
 
COEPORATIOK ACCOUNTS 215 
 
 ration. We have sometimes to provide, then, for in- 
 stallment subscriptions, sometimes for premium or 
 discount, and sometimes for the transfer of property 
 and good will. All three of these complications, in- 
 deed, may arise in connection with one issue. They 
 must, therefore, be examined in some detail. 
 
 Let us take first the issue of stock on installments 
 in cases where the full face value is ultimately to be 
 paid. In order to keep run of the amount paid on 
 each installment, it is desirable in this sort of case to 
 open in the general ledger an account with each of 
 the installments. Let us suppose that 1,000 shares 
 of stock are to be issued at $100 a share, and that 
 payment is to be made in four equal installments. 
 The stock itself cannot be issued until all install- 
 ments have been paid, and it is undesirable to enter 
 on the books a credit to Capital Stock until the stock 
 is actually issued; and yet we must make some credit 
 to o:ffset the debits for the installment subscriptions 
 which, as promises to pay sums to the business, are 
 assets similar in nature to bills receivable. Since 
 the promise of the business to deliver stock, when all 
 installments are paid, has created the possibility of 
 these subscriptions, an account for stock subscribed 
 is credited. The common entry when these subscrip- 
 tions are received, then, is as follows : 
 
 Installment Subscription No. 1 25,000 
 
 Installment Subscription No. 2 25,000 
 
 Installment Subscription No. 3 25,000 
 
 Installment Subscription No. 4 25,000 
 
 To Stock Subscribed 100,000 
 
 An additional advantage in this Stock Subscribed 
 is that since Qs^ve must be taken that not more capital 
 
216 ACCOUNTING AND AUDITING 
 
 stock is promised to be issued than is authorized by 
 law, it is desirable to know what amount is already 
 pledged. The difference between this and the sum 
 authorized is available for further subscription or for 
 issue by some other method. Only by establishing 
 this account is it possible, without much hunting 
 through the books, to show properly just what is the 
 margin of unpledged stock. Some bookkeepers in 
 such a case credit Capital Stock directly for the 
 amount subscribed and then by a new entry debit 
 Treasury Stock and credit Unsubscribed Stock for 
 the balance unpledged. This is misleading, for, as 
 will be shown later, the term * treasury stock" 
 should be reserved for another sort of thing. 
 
 When one of these installments is paid the entry 
 is simple: 
 
 Cash 25,000 
 
 To Installment Subscription No. 1 25,000 
 
 When all these have been paid, so that Cash is deb- 
 ited for the full value of the stock and the install- 
 ment accounts are closed, the stock itself must be 
 issued. The entry for the issue will be as follows : 
 
 Stock Subscribed 100,000 
 
 To Capital Stock 100,000 
 
 This entry balances Stock Subscribed, and the net 
 result of all the entries is a debit to Cash and a credit 
 to Capital Stock^ — which is, as we have seen, .just 
 what the entry would have been if all the capital 
 stock had been issued in a lump sum for cash. 
 
 A complication arises in the handling of these 
 installment subscriptions in case transfers are made 
 before stock is fully paid. It may happen that a 
 
CORPORATION ACCOUNTS 217 
 
 subscriber desires to surrender his subscription to 
 another, or to purchase another's right to stock. In 
 that case he is not only selling a right, but is trans- 
 ferring to another an obligation; for he is not only 
 selling the right to receive stock, but is transferring 
 an obligation to pay the unpaid portion of the sub- 
 scription. On the books of the corporation it is nec- 
 essary to show, then, for each installment, just what 
 portion has been paid, and, when any transfer is 
 made, just how much obligation is taken by the pur- 
 chaser of the right. This is done on an installment 
 ledger. On the next page will be found a convenient 
 form 
 
218 
 
 ACCOUNTING AND AUDITING 
 
 I? 
 
 (N CO rHco 
 
 2 o _^ _^ 
 
 1^^ 
 
 ® C<1COOOI>. 
 r-( rHCO 
 
 •T3 
 
 „ g 
 
 
 TSaQ 
 
 PhoqQPh 
 
 
 gg 
 
 1 
 
 1= = 1 
 
 10,000 
 3,750 
 1,875 
 1,875 
 
 6^ 
 
 cocoes 
 
 
 QIC ir lo 
 
 1—1 
 
 
 S3 OiC(MC0 
 
 S - 
 
 rt, iC »o o p 
 
COKPORATION ACCOUNTS 219 
 
 It is necessary to note, before one can under- 
 stand this installment ledger, that whenever a right 
 is transferred a new certificate must be issued, and 
 in this case the certificate is not for ownership of 
 capital stock, but is simply a receipt for the payment 
 of a certain proportion of the full subscription. If 
 a man sells all his holdings, he will simply surrender 
 the old certificate and request that a new one be 
 issued to the new holder. If, however, he transfers 
 only a portion of his holdings, the old certificate must 
 be surrendered and tw^o new ones issued in its place, 
 one of which will then be transferred to the pur- 
 chaser. The explanation on the installment ledger in 
 connection with all such transfers should indicate, 
 therefore, the surrender of the old certificate on the 
 credit side and the issue of the two new ones on the 
 debit side; then on the credit side will be indicated 
 the surrender of one of the new certificates to the 
 purchaser. On the credit side of this ledger, there- 
 fore, two sets of columns will be necessary; one of 
 these will show the actual payment of installments, 
 which, of course, will be each for a certain percent- 
 age — say twenty-five per cent. — of the total amount 
 subscribed; and the other will show the surrender of 
 shares partially paid. In the account shown above, 
 the subscription is recorded as of February 15; on 
 March 1 the first installment of 25% is paid; on 
 March 15 a subscription of 50 shares, made by John 
 Brown, on which the first installment has already 
 been paid, is transferred to this account; on March 
 20, 25 shares are sold to David Grieve, by exchanging 
 certificate No. 13 for two certificates and transfer- 
 ring one of them; on April 1, the second installment 
 
220 ACCOUNTING AND AUDITING 
 
 is paid on all subscriptions now belonging to this 
 account. At all times a balance of the total debits 
 and credits, in dollars and cents, shown on any in- 
 stallment account will indicate the balance still un- 
 paid, and a balance of the debit and credit shares will 
 show the number of shares on which the person is 
 still responsible to make payment. In the case above, 
 for instance, a balance struck on April 2 will show 
 liability for 200 shares and $17,500, and credit for 75 
 shares and $11,250, or a balance of 125 shares and 
 $6,250, — which is as it should be, for it is 50% on 125 
 shares. 
 
 The stock ledger is of similar form except that it 
 needs no provision for the payment of installments. 
 The balance of the stock ledger, however, will always 
 be upon the credit side, for the stockholder has en- 
 trusted property to the business; whereas the bal- 
 ance of the installment ledger will always be on the 
 debit side, for until the subscriber has made full 
 payment, he is still responsible to the corporation on 
 account of his promise. 
 
 If the stock is issued in payment for a business 
 taken over by the corporation, the entries will not 
 necessarily be very different, but they may require 
 an allowance of the difference between the present 
 worth of the old business, as shown by the books, and 
 the amount of stock to be issued in payment for it. 
 If, for instance, the corporation is to succeed to an 
 old business, and will continue with the same books 
 -^as it naturally will do if it takes over all the prop- 
 erty and assumes all the debts, — ^it may give in capi- 
 tal stock considerably more than the present worth 
 of the old business as shown by the balance sheet ; for 
 
CORPORATIOiSr ACCOUNTS tn 
 
 the old business may have such high earnings that it 
 is worth a premium. It is not customary in the books 
 of a proprietorship to write up the value of the assets 
 merely because they happen to produce large earn- 
 ings. If the net assets of such a business are $100,000 
 and the net profits are $15,000 a year, this business is 
 regularly earning fifteen per cent., and, if taken over 
 by a corporation, its proprietors would probably re- 
 ceive more than $100,000 in capital stock; for a cor- 
 poration would hardly desire, usually, to pay an an- 
 nual dividend of fifteen per cent. Capital stock would 
 be issued of such an amount as to produce a dividend 
 of possibly seven and a half per cent. In that case, 
 if it were assumed that under the corporation the 
 business would earn as much as previously, the cap- 
 italization of the old business would be put at $200,- 
 000, for seven and a half per cent, on $200,000 w^ould 
 equal the $15,000 expected as an earning. If this 
 business were to be taken over by a corporation al- 
 ready engaged in operations, and it had been the 
 previous experience of this corporation that it could 
 pay seven and a half per cent, dividends, the owners 
 of the business now taken over would hardly be will- 
 ing to make a sale unless they could be guaranteed 
 practically as high profits as they had been receiving 
 in the past, and, therefore, on the assumption that 
 the corporation would not pay more than seven and 
 a half per cent, dividends, they could exact, from 
 those who wished to buy them out, capital stock to 
 the amount of $200,000. It is actually true in this 
 case that w^hat is called the ^^good will" of the busi- 
 ness is $100,000; for since the present value of its 
 tangible assets is only $100,000, and yet its earnings 
 
m ACCOUNT^IKG AISTD AtTDITINO 
 
 are equivalent to seven and a half per cent, on $200,- 
 000, the extra $100,000 — due to the excess of profits 
 over the normal rate on its investment — represents 
 the value of its superior organization or its reputa- 
 tion, and any corporation taking over this enterprise 
 can afford to pay $100,000 for the right to use its 
 name and privileges with customers who have been 
 accustomed to buy of it, with dealers who have sold 
 it goods and granted it credit, with the labor which it 
 has employed, and with others who may help to util- 
 ize what it has built up in the past. We must, then, 
 if we are going to transfer to the corporation the 
 books of the firm, bring up the assets to $200,000 in 
 order that when the stock is issued the assets sur- 
 rendered may exactly offset it. The method would 
 be simply to debit Good Will $100,000 and credit the 
 proprietors; for this amount, though real, has not 
 been previously entered to their credit; the valua- 
 tions have not been based upon earning capacity, as 
 it is now desired that they shall be, but upon cost. 
 When we have made this entry, the proprietors stand 
 credited with $200,000, for their previous net credit 
 was $100,000. When stock is issued to them, on the 
 transfer of their title to the business, another entry 
 will debit the proprietors and credit Capital Stock 
 for $200,000. This will balance the proprietors' ac- 
 counts and show that they have no further interest, 
 as individuals, in the business. Their portion of the 
 business is simply that of stockholders holding two 
 thousand shares. Then entries may be made in the 
 books exactly as if no transfer had been made to the 
 corporation; for the assets including the good will 
 
CORtOBATION ACCOUNTS M 
 
 are now the assets of the corporation-, and its liabili- 
 ties are the liabilities of the corporation. 
 
 We come now to the situation when stock is sold 
 for more or less than par. It is obvious that if shares 
 of stock with a par value of $100 are sold for $125 in 
 cash, this amount of cash realized is capital just as 
 much as if the $125 had been invested by a proprie- 
 tor. In no sense can this extra $25 be considered 
 profit to the corporation, for the $25 is just as much 
 invested property, which the corporation may use in 
 operations to get profits, as is the $100 which is rep- 
 resented in the par value of the stock. A stockholder 
 who has bought stock at par and sells it for $25 pre- 
 mium is, of course, making that $25 as profit, but 
 with that the corporation has nothing to do; and we 
 are concerned only with the premium which the cor- 
 poration itself receives on stock issued by itself at 
 more than par. In a single proprietorship or a part- 
 nership this premium, or its equivalent, would be car- 
 ried to the credit of the partners' accounts, but since 
 in a corporation we have no partners' accounts and 
 can represent proprietors' shares only in the capital 
 stock account at par, we must indicate the premium 
 in this case as an additional sum belonging to stock- 
 holders but not represented on the face of the shares 
 of capital stock issued. Surplus, as we have already 
 seen, is nothing but an undivided portion of capital, 
 and it is quite as much so when it consists of original 
 investment paid in by stockholders as when it con- 
 sists of accumulated profits from the operations of 
 the business. National banks are by law required to 
 establish a surplus of twenty per cent, of their capi- 
 tal stock, and the law prescribes that out of each 
 
%U ACCOUNTING AND AUDITING 
 
 year's earnings a certain percentage shall be laid 
 aside and placed in the surplus until this required 
 twenty per cent, has been accumulated; but many 
 banks begin business with a surplus already on hand 
 through the medium of stock issued originally at a 
 premium. When, therefore, stock is issued at a pre- 
 mium, we have not only to carry it to Surplus, but to 
 do so under a name that will show that it must not be 
 distributed as profits. A simple entry covers the sit- 
 uation, as follows: 
 
 Cask 125,000 
 
 To Capital Stock 100,000 
 
 Capital Surplus 25,000 
 
 The situation would not be materially altered if 
 the cash were collected in installments, and not in 
 one lump sum as here indicated. If, for instance, the 
 stock were to be paid for by five installments, the 
 entry would read: 
 
 Installment Subscription No. 
 Installment Subscription No. 
 Installment Subscription No. 
 Installment Subscription No. 
 Installment Subscription No. 
 To Stock Subscribed 
 Capital Surplus 
 
 When all such installments are paid, the entry will 
 be, as before, 
 
 Stock Subscribed 100,000 
 
 To Capital Stock 100,000 
 
 This closes out Stock Subscribed. 
 
 When stock is sold at a discount a somewhat dif- 
 ferent situation is to be faced. Under the law if 
 stockholders have not paid the full value of their 
 
 1 
 
 25,000 
 
 2 
 
 25,000 
 
 3 
 
 25,000 
 
 4 
 
 25,000 
 
 5 
 
 25,000 
 
 
 100,000 
 
 
 25,000 
 
CORPORATION ACCOUNTS 225 
 
 stock they may be legally held liable for the debts 
 of the corporation up to the amount of the unpaid 
 portion of their subscriptions. If, therefore, capital 
 stock is issued by the corporation at less than par, a 
 liability still stands against each stockholder for the 
 deficiency in his subscription, and if the corporation 
 goes into insolvency he must pay. Usually stock- 
 holders do not desire such a liability to stand against 
 them, and, consequently, they endeavor to make the 
 stock fully paid. Unfortunately, many organizers of 
 corporations attempt to do this by falsification upon 
 the books, but sometimes the process is legitimate, as 
 we shall see. The desire is to provide that the stock 
 issued shall be represented upon the books either 
 truly or fictitiously as fully paid, and yet to make it 
 possible to sell stock at a discount. The method of 
 doing this is commonly for the organizers of the com- 
 pany to issue stock to' themselves at par in return for 
 assets which they surrender to it, and then to donate 
 some of that stock back to the corporation. On the 
 books, therefore, the capital stock appears to have 
 been once fully paid, because it was given in ex- 
 change for assets; and since it was donated to the 
 corporation and has cost the corporation nothing, it 
 may now, once fully paid up, be even given away by 
 the corporation if the directors find good reason for 
 so disposing of it, or — and this is the desired thing — 
 it may be sold at a discount. In such a case it is ob- 
 vious that if the corporation goes into insolvency and 
 the creditors can show that the stock was originally 
 issued on a fictitious valuation of property, the stock- 
 holders are still liable for the deficiency. The ad- 
 vantage of this method, from the point of view of the 
 ▲ ik A-ii 
 
226 ACCOUNTING AND AUDITING 
 
 dishonest organizer, is that the burden of proof is 
 placed upon the creditor; for unless he can prove the 
 overvaluation of assets, the books, showing that full 
 value was given, defend the stockholder against as- 
 sessment. 
 
 Under some circumstances there may be a dona- 
 tion of stock to the corporation when absolutely no 
 taint of fraud attaches to it. If, for instance, the 
 organizers are satisfied that the property which they 
 hold is absolutely good and is sure to bring in large 
 earnings, but know that they can hardly convince 
 others of the value of this property, they realize that 
 others will buy the stock in the corporation only at 
 a discount. They may then issue stock at the equiva- 
 lent of what they know to be the actual value of the 
 property and donate some of it back to the corpora- 
 tion to enable the corporation to sell it at a discount; 
 for, as we have already seen, if the stock has once 
 been fully paid, it may be sold at any reasonable price 
 without liability for assessment. (The national bank 
 law, however, makes stockholders liable for an as- 
 sessment equal to the par value of their stock, in case 
 of insolvency, even when the full par value has once 
 been paid.) It may at first seem as if it would be as 
 well for the original subscribers in such a case to take 
 their stock at a premium, say at 125 — so that they 
 would get eight shares for a thousand dollars — as to 
 take it at par and then donate some of it — say two 
 shares — ^back to the company; for then the company 
 would have unsubscribed shares available for it to 
 sell without increasing its capitalization. That would 
 be true if stock could be sold at par; but the purpose 
 of this public sale of stock is to raise working capital, 
 
CORPORATION ACCOUNTS 227 
 
 and the stock must be sold for what it will bring. 
 Those who have faith in the business must induce 
 others to subscribe, and it is a fact of human nature 
 that men look for low prices — even when the value is 
 exactly proportionate to the price. Even though it 
 were true that the profits would be just in propor- 
 tion to the capital, so that a man could as well af- 
 ford to pay par (and get eight per cent, dividend on 
 his stock) as to pay 75 (and get six per cent.), he 
 would be more likely to buy at 75 than at par. For 
 practical reasons, therefore, this method of making 
 stock not only legally but actually fully paid is some- 
 times worth while. This is the only honest method 
 of providing for the original sale of stock at a dis- 
 count. Stock is sometimes sold by outsiders at a 
 discount when it has not ever been actually sold at 
 par; but in such cases it was originally issued in re- 
 turn for what were ostensibly adequate services ren- 
 dered — such as fees for promotion, for underwriting 
 or guaranteeing the sale of bonds or stock. Some of 
 these transactions in the past have been open to grave 
 suspicion as devices to evade the law, but unfortu- 
 nately the burden of proof is laid on the objector. 
 The tendency nowadays is to hold corporations more 
 strictly responsible for their acts; for the community 
 is coming to realize that as stockholders are relieved 
 from some responsibilities which attach to partners, 
 they must, in compensation, be held strictly respon- 
 sible for fulfilling other duties falling on them. 
 
 The entries for stock sold at a discount are inter- 
 esting. The proper bookkeeping term to indicate 
 stock which has once been fully paid and, therefore, 
 belongs to the corporation to treat as it pleases, is 
 
228 ACCOUNTING AND AUDITING 
 
 'treasury stock." This term, however, may include 
 stock which the corporation has itself purchased in 
 the market from its own issue, as well as stock do- 
 nated to it. It seems preferable, therefore, in the 
 case of a donation of stock, to use the title '* Donated 
 Stock, ' ' for then there can be no question as to origin. 
 Let us suppose that a corporation, with stock issued 
 at $100,000, in exchange for a business actually or 
 fictitiously valued at $100,000, receives back from its 
 stockholders $20,000 of that stock, to be sold for the 
 benefit of the treasury — that is, as a means of raising 
 so-called working capital, read}^ money to supply it 
 with the means of hiring labor, buying materials, etc. 
 The original entry would have read, possibly, 
 
 Real Estate 25,000 
 
 Machinery 25,000 
 
 Supplies 25,000 
 
 Accounts Eeceivable 25,000 
 
 To Capital Stock 100,000 
 
 It is obvious that, at the time of the donation, 
 Donated Stock must be debited and something must 
 be credited. As the donation is out of a clear sky, 
 so to speak, an account on the other side must be 
 established to indicate the fact that this surplus has 
 arisen neither from the ordinary course of business 
 nor from investment. Some bookkeepers would un- 
 questioningly credit Surplus in the ordinary way; 
 but it is desirable, if we are going to have our books 
 represent the truth, as they always should do, to indi- 
 cate that this surplus is of unusual origin. This can 
 be done by the following entry : 
 
 Donated Stock 20,000 
 
 T^ Donated Surplus 20,000 
 
GORPOEATIOIS^ AC€OUNTS 339 
 
 This donated stock may now be sold, as we have seen, 
 at any figure which can be got for it. We will assume 
 it in this case to sell at $75 a share. Our entry will 
 then be as follows: 
 
 Cash 15,000 
 
 Donated Surplus 5,000 
 
 To Donated Stock 20,000 
 
 It is obvious that, since we originally credited Do- 
 nated Surplus for the full amount of stock donated, 
 and then we failed to realize the par value when it 
 was sold, we must debit that account for the differ- 
 ence. It is better to enter the donated stock and the 
 donated surplus originally at the par value, even 
 though we know that par value will not be received, 
 than to enter it at the estimated selling price; for it is 
 desirable that so long as we have any donated or 
 treasury stock on hand it shall appear on the books 
 at par value as an indication of the nominal amount 
 in the possession of the corporation. It may be worth 
 while in such a case to open an account with Stock 
 Discount and debit that account instead of Donated 
 Surplus for the amount of discount, for if we wish a 
 record on our books of the actual amount of discounts 
 suffered, we should keep such discounts in an account 
 by themselves. When all the stock is issued. Stock 
 Discount may be closed out into Donated Surplus, re- 
 ducing it to the amount actually realized on the dona- 
 tions. Donated Surplus may then be transferred in 
 turn to Capital Surplus. By this method all the steps 
 in the stock issue are shown clearly, and the net re- 
 sult is summarized in one account. 
 One other complication of the situation arises when 
 
230 ACCOUNTING AND AUDITING 
 
 stock has been subscribed for on the installment plan 
 and some subscription is later defaulted. It is com- 
 mon to provide when installment subscriptions are 
 received that if any sum subscribed for is unpaid 
 after a certain date the subscriber shall forfeit not 
 only his right to the stock but even to the return of 
 the amount already paid on installments. In such a 
 case, if any sums have been paid — and corporations 
 usually require that a certain sum shall be paid at 
 the time of subscription — this amount paid is a clear 
 gain to the corporation. It is not a gain, however, 
 in the sense of profits, for profits ought to be con- 
 sidered as only sums realized from the operation of 
 the business. This gain is in a sense investment, 
 but it represents investment for which the business 
 is not responsible to the particular person who made 
 the investment. Properly, such gain should be con- 
 sidered as surplus, similar to surplus created by a 
 subscription to stock at more than par. It is obvious, 
 too, that when any sums have been forfeited to the 
 corporation on failure to meet subscriptions, these 
 sums have actually been paid on account of capital 
 stock to be issued, and, therefore, by so much make 
 it possible for the corporation to sell stock at less 
 than par. Although the law requires that all stock 
 shall have been fully paid, it does not require that 
 stock shall have been fully paid by the purchaser; 
 since the only concern of the stockholder is that the 
 corporation shall have received full payment from 
 someone, any sums paid and forfeited by one person 
 may be utilized to complete the payment for stock 
 delivered to another. Forfeited payments, then, are 
 equivalent to a payment for that many dollars' 
 
CORPORATION ACCOUNTS 231 
 
 worth of treasury stock which the corporation may 
 dispose of at its own terms. A proper method of 
 entry when it is found that any installments have 
 been forfeited is to carry the amount of forfeiture to 
 Treasury Stock and indicate that a certain number 
 of shares are by that amount fully paid. Suppose, 
 for instance, the corporation calls for installments 
 at twenty-five per cent., and after two installments 
 have been paid on a one-hundred share subscription 
 finds the rest defaulted. The corporation has then 
 collected on these shares $5,000, and $5,000 remains 
 to be paid. The entry for the forfeiture would be as 
 follows : 
 
 Treasury Stock 5,000 
 
 Stock Subscribed 5,000 
 
 To Installment Subscription No. 3 2,500 
 
 Installment Subscription No. 4 2,500 
 
 Capital Surplus 5,000 
 
 The Treasury Stock is debited $5,000 because this 
 amount is available for the corporation to put to its 
 own uses as once fully paid, and the gain is credited 
 as a surplus. Stock Subscribed is debited $5,000 be- 
 cause, of the original subscription of $10,000 once 
 credited to Stock Subscribed, one half is now can- 
 celled. The other half, now pledged to the treasury, 
 must be left in Stock Subscribed to prevent an over- 
 issue. The credits to the installments, of course, 
 simply wipe out the installment accounts previously 
 debited and now cancelled. It would be possible to 
 debit Treasury Stock for the full $10,000 if we could 
 properly indicate that only one half of that stock 
 had been paid, and that it must be sold for not less 
 than $50 a share. The difficulty would be in making 
 
2«2 ACCOUNTING AND AUDITING v 
 
 such an indication without too much complication, 
 and in avoiding over-issue or under-issue. The 
 simplest method is to treat the $5,000 paid and for- 
 feited as if it were full payment on one half the num- 
 ber of shares ; then the corporation may do as it likes 
 with that half and may call for subscriptions from 
 outside for the other half. If, indeed, the corpora- 
 tion concludes to sell the one hundred forfeited 
 shares for $50 a share, it may still do so, for it may 
 on its books enter — what is practically the fact — a 
 subscription for fifty shares at par, with a bonus of 
 the other fifty shares of treasury stock thrown in. 
 This is equivalent to having a new subscriber take 
 up the subscription of the old and pay the two re- 
 maining installments. In that case the entry will be 
 as follows: 
 
 Capital Surplus 5,000 
 
 Subscription Installment No. 3 2,500 
 
 Subscription Installment No. 4 2,500 
 
 To Stock Subscribed 5,000 
 
 Treasury Stock Subscribed 5,000 
 
 This entry, of course, reverses the last entry and 
 puts everything back where it was before the for- 
 feiture except for the fat^t that the Treasury Stock 
 is now pledged (though it is still in the possession of 
 the company) ; and, as a matter of fact, everything 
 is as it was before the forfeiture except for the fact 
 that the person who is to pay the installments is 
 different. On the actual final total issue of stock. 
 Stock Subscribed will be debited and Capital Stock 
 will be credited. Treasury Stock Subscribed will be 
 debited and Treasury Stock will be credited; the re- 
 
CORPORATION ACCOUNTS 333 
 
 suit will be a cancellation of all items but Cash and 
 Capital Stock. 
 
 The only complication remaining is that arising 
 when shares subscribed for by installments at a pre- 
 mium or at a discount are forfeited. Here the entry 
 for forfeiture must take into account the fact that 
 surplus or discount is affected at the time of the for- 
 feiture, for surplus or discount was concerned in the 
 original subscription. 
 
 Suppose the original subscription was for 100 
 shares at 120, to be payable in six installments. The 
 original entry would have debited six installment 
 accounts each for $2,000, would have credited Stock 
 Subscribed for $10,000, and Capital Surplus, or 
 Premium Surplus, for $2,000. On the payment of 
 two installments. Cash would have been debited for 
 $4,000, and two installment accounts would have been 
 closed. On the present forfeiture of the remainder of 
 the right, it will be necessary in the first place to 
 debit Stock Subscribed $6,000, because three $2,000 
 installments of par value are no longer pledged, and 
 to debit Capital Surplus $2,000, because the amount 
 of premium surplus previously promised is now 
 known not to be collectible. The calculation of these 
 amounts is a little complicated because our debit to 
 Stock Subscribed, which must cancel the unpaid por- 
 tion of the par value, is based not on the payment of 
 two installments of the original six (leaving four to 
 cancel), but on the payment of two out of five of the 
 original six (leaving three to cancel) ; for one of the 
 original six was not for par value, but for premiiun. 
 If, on the other hand, we had made our original 
 entry in such form that the premium as well ajs the 
 
234 ACCOUNTING AND AUDITING 
 
 par value was divided into installments, we should 
 have had a larger number of items on the books but 
 an easier method of determining the exact nature of 
 the various installments. In such a case, our original 
 entry would have debited six subscription install- 
 ment accounts each for $1,666.66§, and six pre- 
 mium installment accounts each for $333.33J. The 
 credits would have been the same as before. Then 
 when any installment of $2,000 was paid we should 
 have debited Cash and credited not only a subscrip- 
 tion installment account but also a premium in- 
 stallment account. Whenever a forfeiture occurred, 
 therefore, the books w^ould have shown at once just 
 how much had been collected on subscription install- 
 ments, and the uncollected balance would need to 
 be debited to Stock Subscribed and credited to the 
 subscription installment accounts as no longer a 
 pledge of stock to be issued. A similar debit to 
 Capital Surplus and credit to premium installment 
 accounts would have properly removed from the 
 books the asset consisting of the promise to pay 
 premium. In ultimate result, therefore, we should 
 have got the same results as here by more entries; 
 but the advantage would have been an easier de- 
 termination of just how much debit to make to Stock 
 Subscribed at the time of the forfeiture. Under 
 either method the debit to Stock Subscribed wiU 
 show how much stock previously pledged for a sub- 
 scription is now free. Next a debit to Treasury 
 Stock must show the amount of paid-up stock for- 
 feited to the treasury, and the credit to Capital Sur- 
 plus wiU show the gain to the corporation from the 
 forfeiture. The full entry for the forfeiture, when 
 

 6,000 
 2,000 
 
 4,000 
 
 3 
 4 
 
 
 2,000 
 2,000 
 
 5 
 
 6 
 
 
 2,000 
 2,000 
 
 COKPOEATION ACCOUNTS 235 
 
 the installments were not originally divided between 
 par and premium, will be as follows: 
 
 Treasury Stock 4,000 
 
 Stock Subscribed 
 Capital Surplus 
 
 To Capital Surplus 
 
 Installment Subscription No. 
 
 Installment Subscription No. 
 
 Installment Subscription No. 
 
 Installment Subscription No. 
 
 This entry gives us both a debit and a credit to 
 Capital Surplus. It would be possible to combine 
 these and show a net credit of $2,000; but in order 
 here to show the origin of each they are given sep- 
 arately. The debit of $2,000 is to offset and cancel 
 expected gain from the promise of the stockholder to 
 pay $2,000 premium, for that promise is no longer 
 binding; but the credit is due to the fact that he has 
 already paid into the corporation $4,000 in install- 
 ments, which is now forfeited and is, consequently, 
 to be carried to Capital Surplus. The net result is 
 greater fortune to the corporation than if the stock 
 had never been subscribed for — provided it can still 
 find a customer for the stock at higher than 80 ; for 
 though it has lost this subscriber's promise to pay 
 $20 premium, it has collected from him $40 in cash 
 without expense to itself. 
 
 If, on the other hand, this subscription, now de- 
 faulted after two payments, had been originally for 
 treasury stock to be taken at 80 and paid for by four 
 installments, we should have had a somewhat differ- 
 ent appearance on the books. The original entry 
 would have been a debit to four accounts of Treasury 
 Stock Subscription Installments at $2,000 each and 
 
336 ACCOUNTING AND AUDITING 
 
 one debit to Discount on Stock (or to Capital Sur- 
 plus), and a credit to Treasury Stock Subscribed of 
 $10,000. On the payment of two installments, two of 
 these treasury stock subscriptions would have been 
 credited and Cash would have been debited. On the 
 forfeiture, it would be necessary to debit Treasury 
 Stock Subscribed the full $10,000, for none of such 
 stock is now pledged, and the amount of original 
 stock pledged was properly indicated originally 
 when this stock just forfeited was first put into the 
 treasury. At the same time, a credit must be given 
 to the third and fourth treasury stock subscription 
 installments, for they have been cancelled; a credit 
 must be given to Discount on Stock (or Capital Sur- 
 plus) to offset the debit made at the time this treas- 
 ury stock was subscribed for at 80 — for the item 
 is at present cancelled and no one knows at what 
 price this stock will ultimately be sold; finally, since 
 from this transaction — that is, collecting two sub- 
 scription installments — the company has gained 
 $4,000, Capital Surplus must be credited by this 
 amount. These credits exactly offset the debit to 
 Treasury Stock Subscribed. In this case no debit 
 needs to be made to Treasury Stock, for since the 
 treasury stock was never actually issued — ^because 
 the installments were not paid — this account was 
 never credited, but shows that the stock still remains 
 in the possession of the treasury. The full entry fol- 
 lows: 
 
 Treasury Stock Subscribed 10,000 
 
 To Treasury Stock Subscription No. 3 2,000 
 
 Treasury Stock Subscription No. 4 2,000 
 
 Discount on Stock 2,000 
 
 Capital Surplus 4,000 
 
COEPORATION ACCOUNTS 237 
 
 If no separate account has been opened for Dis- 
 count on Stock, Capital Surplus will have a credit 
 of $6,000. This replaces the $2,000 taken out of this 
 account at the time the stock was thought to have 
 been sold at a discount, and adds the $4,000 gained 
 on this forfeiture. 
 
 The attention given here to these last transac- 
 tions is out of proportion to the importance of the 
 subject in itself, but is justified by the opportunity 
 offered for the illustration not only of bookkeeping 
 principles, but of the accounting principle which 
 wisely distinguishes between things which though 
 a good deal alike in appearance and in name are far 
 different in real meaning. 
 
* CHAPTER IX 
 
 PROPERTY OR EXPENSE? 
 
 We have been discussing the principles of book- 
 keeping and have found that if only debit and credit 
 are properly distinguished, if items are carried to 
 the proper accounts, and if, in spite of a multiplicity 
 of special columns and special forms, the complica- 
 tions do not lead to the omission or duplication of 
 items, our books are bound to be correct. We have 
 been handling certain accounting problems on our 
 way, but these have arisen only incidentally, as ma- 
 terial for bookkeeping solutions. We may now turn 
 to accounting pure and simple and assume that the 
 bookkeeping will take care of itself; for, as has been 
 indicated before, the task of the accountant is to 
 learn what is the real nature of a transaction — either 
 before an entry, so that the bookkeeper may know 
 what facts to enter, or after all entries have been 
 made, so that the manager may know the meaning 
 of the facts that the books disclose. If, for instance, 
 we make certain expenditure on our real estate, it 
 may be a difficult task to determine whether the 
 charge should be made to Real Estate or to Repairs. 
 If the real value of our property has been increased, 
 we ought to indicate on the books that there is a 
 greater value remaining in the property and should 
 therefore debit Real Estate. If the expenditure 
 
 239 
 
240 ACCOUNTING AND AUDITING 
 
 does not increase the real value, it should be charged 
 to Repairs — that is, to an account which is merely 
 nominal and explains the loss of funds. This dis- 
 tinction between real and nominal accounts is funda- 
 mental and lies at the basis of most problems of ac- 
 counting. It applies not only in making original 
 charges for expenditure, but quite as much in de- 
 termining, at the end of any earning period when 
 we close our books, how much property originally 
 charged shall be still considered a good asset. To 
 make a careful study of the problems connected with 
 it is therefore desirable before we consider complica- 
 tions of any other sort. 
 
 In the last paragraph emphasis was laid on the 
 reality of the value. It may seem at first as if a 
 value is a value, and that there can be no such thing 
 as an unreal value. On general principles this is 
 true, but it is necessary to realize that a thing which 
 has value from one point of view has none from 
 another, and that in accounting we must recognize 
 the point of view before we determine w^hat figures 
 shall be used in connection with any property. If we 
 are considering the value of property which we are 
 on the point of bu}dng, we are concerned only with 
 what it would cost us to get that property some- 
 where else — ^that is, with the cost of duplication. So 
 if we are to use cost of duplication as the basis for 
 valuation on a balance sheet, in closing the books at 
 the end of a year our sole concern is to learn what it 
 would cost us to buy similar property on the market. 
 If, on the other hand, we are not thinking of buying 
 property, but only of the investment value to us of 
 property which we already hold, we are concerned 
 
PROPERTY OR EXPANSE «41 
 
 solely with the income which it yields. A house 
 which brings an income of $1,000 a year over the 
 taxes, insurance, and repairs, is worth, when interest 
 is considered to be five per cent., $20,000; for $20,000 
 invested elsewhere will produce $1,000 a year at that 
 rate of interest. Whether it would cost $20,000 to 
 duplicate that house or not, the house is worth 
 $20,000 to the owner as long as it will yield him an 
 income of $1,000 a year. So on the basis of earning 
 capacity we may have a very different valuation 
 from that based on the cost of duplication. If, 
 fina"'\Y, I have built a house for my own dwelling at 
 an original cost of $20,000, and the house has been 
 kept in excellent repair, it may still be worth, for my 
 purposes, $20,000 and only $20,000; and this may be 
 true even though I can now build another similar to 
 it for less than $20,000 and even though I should have 
 to pay more than $1,000 rent for another house which 
 I might hire. In this case, it is not merely a dwelling 
 that I am looking for, but this particular dwelling, 
 with its associations connected with the past; the 
 cost to me and the value to me are the same. If I 
 abandon my original purpose, however, and decide 
 that another house will do, I shall value it on a dif- 
 ferent basis. Let us examine this. 
 
 The situation may be expressed as follows: the 
 house can now be duplicated for $15,000, it can be 
 rented for $1,250, but I have paid $20,000. If another 
 house will serve me just as well, and can be built for 
 $15,000, my house is worth to me only $15,000 and 
 should appear on the balance sheet at that cost of 
 duplication; if, again, I need only a house of that 
 type and do not require that particular house, and it 
 
 A & A-16 
 
^42 ACCOUNTING AND AUDITINa 
 
 would cost me $1,250 to hire any other, this house is 
 worth $25,000, because possession of it saves $1,250 
 — that is, its earning capacity is five per cent, on 
 $25,000; but if only this house will serve, my purpose, 
 its value is the cost or sacrifice which enabled it to 
 serve that purpose, namely, $20,000. Every valua- 
 tion must have regard to the intent for which the 
 valuation is made. Each of these valuations, $15,000, 
 $25,000, $20,000, is correct on the basis used; but it is 
 obvious that they are not equally satisfactory for 
 general purposes. Yet in actual business one is 
 likely to find all these methods defended by different 
 persons as proper for use in valuations on balance 
 sheets. One man argues for valuation at cost of 
 duplication, another at capitalization of earning 
 capacity, another at original cost or sacrifice. 
 
 It has been common in railroad accounts to base 
 valuations on expected earning capacity of the prop- 
 erty purchased. If, for example, new locomotives 
 are bought at an expense of $100,000, that $100,000 
 will be charged to Equipment if the locomotives are 
 additions to equipment and are expected to enable 
 the road to earn more; if the new locomotives take 
 the place of old ones worn out but are expected to 
 yield to the road greater earnings than the old — 
 or, what is the same thing, reduce operating ex- 
 penses — a portion of their cost representing ex- 
 pected increased earnings may be charged to Equip- 
 ment as measuring the increased earning capacity 
 of the road as a whole, and the rest will be charged 
 to Maintenance (the practical equivalent of Re- 
 pairs); but if these new locomotives are expected 
 simply to earn the same revenue as the old loco- 
 
I>ROPERTY OR EXPENSE M3 
 
 motives — however much better service they may 
 render — the whole cost will be charged to Mainte- 
 nance. For many roads this last statement is true 
 even if the cost be much greater than the original 
 cost of the locomotives that are replaced. This is the 
 extreme form of basing valuation on earning 
 capacity. 
 
 Many persons who complain of the high rates 
 charged by railroads insist that as a general prin- 
 ciple railroads should earn profits equivalent only 
 to what is considered a fair rate upon the cost of 
 duplicating the property. If a railroad cost, say, 
 $50,000,000 to build, but can be today duplicated for 
 $40,000,000, this principle would require that since 
 a fair rate of interest upon that $40,000,000 is all that 
 the company ought to expect to receive, rates should 
 be adjusted so as to yield that income. The advo- 
 cates of this principle would on the balance sheet of 
 the railroad show property equivalent only to the 
 cost of duplication. Whether what they demand in 
 the way of rates is fair or not is hardly an accounting 
 question; but it is undoubted that if their principle 
 is to be accepted — namely, that the real value of a 
 property is the cost of duplication — all balance 
 sheets should be adjusted to that basis, and the 
 shrinkage due to a falling value of property should 
 be deducted either from capital or from profits. 
 
 The real question for the accountant to determine 
 is which one of these three methods gives the facts 
 most desirable to show on the books. A little thought 
 suggests that there is limited virtue for ac- 
 counting purposes in representing on the balance 
 sheet a valuation based on earning capacity. Every- 
 
U4: ACCOUNTING AND AUDITING 
 
 body knows that when interest is five per cent., for 
 example, a property yielding five dollars a year is 
 worth one hundred dollars. If we know the earning 
 capacity of property, we do not need any bookkeep- 
 ing, either simple or complex, to show us the value of 
 that property. To cause a balance sheet to show a 
 capitalization based on earning capacity, therefore, 
 is simply to base the balance sheet on the income 
 sheet — that is, to fix the total value of the property 
 at one hundred times as much as the income divided 
 by the number of per cent, indicating the current 
 rate of interest (income $l,000,000-r-5 [the current 
 rate of interest] =$200,000; which multiplied by 
 100 [to find 100%] =$20,000,000). There is no great 
 value in a balance sheet which tells little more (ex- 
 cept some details) than the income sheet has already 
 suggested. To cause the balance sheet to indicate 
 the cost of duplication, on the other hand, is hardly 
 more fruitful. The cost of duplicating any prop- 
 erty is fluctuating continually, and whatever valua- 
 tion might be put on the books on the first of Janu- 
 ary, 1911, would be to great extent out of date by the 
 first of January, 1912; and though a possible profit 
 indicated by a change in valuation might be very 
 high for that year, in the subsequent year a change 
 in valuations as indicated by the cost of duplication 
 might entirely wipe out very large actual earnings. 
 It is not true that any propert}^ which has shrunk in 
 market value has necessarily involved a loss, for 
 unless the property must be sold that nominal de- 
 preciation may not really touch it. If the property 
 is just as good for serving the end which it was pur- 
 chased to serve, it is every whit as good for account- 
 
PEOPEETT OR EXPENSE. M5 
 
 ing purposes. In other words, the cost of duplica- 
 tion has nothing whatever to do with the value of 
 property for a going business, and, therefore, may 
 perfectly well be disregarded in valuations on the 
 books of any such business. 
 
 It follows, therefore, that the only logical basis 
 for any valuation as shown by books of account is 
 the cost of the property for the service which it is to 
 perform. If property bought for $50,000 can be 
 duplicated for $40,000, from one point of view it is 
 true that the business has lost $10,000; but that is 
 true only if there have been no intermediate opera- 
 tions and we are sure that the proprietors in spite of 
 waiting until the price had fallen could have earned 
 as great profits as they have earned during the 
 period between the original purchase and the time 
 when the price has fallen to $40,000. In other words, 
 this notion of a loss of $10,000 is based on a supposi- 
 tion which is usually far from the actual fact; and of 
 course the profits of business should be indicated on 
 the books not at all on the price of what might have 
 been, but of what is known to be. Since, moreover, 
 the figure of cost could never be recovered if once 
 lost, it should not be confused by artificial valua- 
 tions ; but since valuations based on earning capac- 
 ity and on cost of duplication can be found at any 
 time, the books do not need to register them. 
 
 Hereafter, in deciding whether an expenditure 
 shall be considered as for property or for expense, 
 we shall in this book use for our basis neither earn- 
 ing capacity nor cost of duplication, but the actual 
 legitimate cost or sacrifice in securing the property 
 adequate for the desired service; for, as we have 
 
246 ACCOUNTING AND AUDITING 
 
 seen, that is the only scientific method. We consider 
 property to be whatever will render future economic 
 service — even though that service be not productive 
 of new revenue, — such as new locomotives that will 
 merely run more reliably. One should realize, how- 
 ever, that by cost, or sacrifice, is meant only the cost 
 or sacrifice not yet compensated for. If, for instance, 
 machinery has been in part worn out by use, con- 
 verting itself, so to speak, into manufactured goods, 
 the original cost of the machinery has been in 
 part compensated for in its product, and only the 
 cost of the portion yet unconsumed should now be 
 considered as an asset. Depreciation must always be 
 considered before the figure of cost or sacrifice to 
 stand on the books as an asset is determined. 
 
 An interesting problem arises if at a time of re- 
 placement of worn-out property the new property is 
 acquired at a different price from the old. If the 
 extra cost is accompanied by an extra efficiency, 
 coupled with k corresponding increased earning 
 capacity, unquestionably the new additional cost 
 may be charged as a real asset, for from every point 
 of view — ^that of valuation based on earning capac- 
 ity, on cost of duplication, on original cost — the value 
 of the property is greater. If, again, though the 
 earning capacity is not greater, efficiency is in- 
 creased, from the point of view of valuation based 
 on cost, the increased expenditure should be con- 
 sidered an asset — for though it will not earn more, it 
 will actually perform additional service to the com- 
 munity. 
 
 When, on the contrary, such property is replaced 
 at a lower cost than the original, a rather nice new 
 
PROPERTY OR EXPENSE 247 
 
 problem in accounting is raised. This difference be- 
 tween the two costs is a gain to the company, for the 
 same efficiency and the same earning power are re- 
 placed at a lower cost. It would not be wise account- 
 ing, on the other hand, to consider this as profit for 
 the year in which the replacement took place. What 
 has really happened is that the operating facilities 
 of the company have been kept intact by this re- 
 placement purchase, and that still a certain surplus 
 of product (for the replacement should be provided 
 for out of product, of course) proves to remain after 
 the expenditure of the amount necessary to keep the 
 capital in good working order. This surplus has had 
 its origin in all the years in which the old capital 
 was in use, even though it may chance that the exact 
 replacement and therefore the gain on replacement 
 occur in only one of the years. In result, then, this 
 gain is nothing but capital now set free by the 
 changes in conditions in the commimity. It has not 
 been earned by the company through its operations; 
 it has not been contributed by stockholders; it is 
 benefit derived, probably, from the progress of the 
 arts. The assets account should show what the 
 equipment now on hand has cost — the sacrifice that 
 the company has made for this property; and as the 
 cost of the original property has been returned, 
 through product, and is more than enough to replace 
 the worn-out property (assuming, of course, that the 
 business is successful), the original cost is no longer 
 in the equipment and therefore the valuation should 
 be reduced on the books. 
 
 Let us glance at the entries. As the old equip- 
 ment (costing, we will say, $10,000) wore out, it pro- 
 
248 ACCOUNTING AND AUDITING 
 
 duced revenue, and cash (or its equivalent) became 
 debited to the amount of $10,000 above other ex- 
 penses and normal profits. Since, when this equip- 
 ment needed to be replaced, only $8,000 was needed, 
 $2,000 remains in cash. Since the original $10,000 
 valuation must be reduced to $8,000, for only that 
 value now remains in the form of equipment, this 
 $2,000 remaining in cash takes the place of the $2,000 
 displaced from equipment. The entry at the time of 
 replacement, then, is as follows: 
 
 Maintenance 8,000 
 
 Profit and Loss 2,000 
 
 To Cash 8,000 
 
 Equipment 2,000 
 
 This entry accomplishes three purposes. It reduces 
 equipment to the cost of what is now on hand. It 
 shows the actual expenditure for maintenance. It 
 shows that the product of the business is responsible 
 to do more than merely replace the efficiency of the 
 equipment; for by debiting Profit and Loss $2,000 it 
 declares that no profit can be counted imtil $2,000 
 in addition to maintenance has been deducted from 
 product as an offset to property consumed and not 
 replaced in value. The actual consumption of value 
 has been $10,000. Though the worn-out equipment 
 has been replaced in efficiency, if the books fail to 
 record that it has not been replaced also in value the 
 gain from the lower price will be taken up as profits 
 in the year of replacement, and, as we have seen, it 
 is not a gain of that year. The gain from the lower 
 price of the new equipment comes from the setting 
 free of assets — which were previously $10,000 in 
 
PROPERTY OR EXPENSE 249 
 
 equipment, but are now only $8,000 in equipment 
 with cash set free (from earnings) of $2,000; and 
 this $2,000 can be either returned to stockholders or 
 invested to earn more profits. 
 
 Before we attempt to work out new problems, let 
 us summarize the situation. Let us assume that our 
 ledger accounts are so named as to indicate sufficiently 
 which of them are intended to represent property 
 and which mere forces involving profit or loss. Our 
 property accounts we will assume to be Real Es- 
 tate, Plant and Machinery, Bills Receivable, etc., 
 and our nominal accounts to be Expense, Rent, 
 Taxes, Insurance, etc. We are likely at any time to 
 have certain expenditures for repairs of machinery 
 and plant. If an expenditure of this nature in- 
 creases the value of the property over that appear- 
 ing on the books, it should be debited to the real ac- 
 count. Plant and Machinery; if it merely replaces a 
 value worn out, such as substituting a new part for 
 one broken, the charge should be made not to Plant 
 and Machinery, but to some nominal account which 
 will indicate on the books at the end of the period a 
 loss or cost of conducting the business. In every 
 case of this sort, then, it is desirable to determine be- 
 fore the entry is made just what is the ultimate 
 result of the expenditure. A charge to a real ac- 
 count implies that the property is expected to re- 
 main at the end of the earning period and to be 
 counted as a good asset; a charge to a nominal ac- 
 count implies that nothing of this expenditure is to 
 be counted as an asset at the end of the period. Yet 
 in spite of the fact that it is not always easy to know 
 whether an expenditure is of one sort or the other, 
 
250 ACCOUNTIN'G AND AUDITING 
 
 the line must be drawn as exactly as the nature of 
 the case allows. If carelessness occurs, one may find 
 that assets have disappeared without any record on 
 the books. We shall find many cases in which the 
 real decision will depend upon a consideration not at 
 first obvious; but always the principle underlying 
 can be found if one analyzes the case deeply enough. 
 As we saw in Chapter VI., however, property ac- 
 counts usually have some profit and loss relations — 
 depreciation, for example, — and nominal accounts 
 are likely to include accrued or prepaid items. Al- 
 lowances are therefore inevitable. The necessary 
 thing, then, is not so much that the line between prop- 
 erty and expense be drawn exactly at the time an 
 entry is made, as that it shall be drawn correctly at 
 the time the books are closed ; but a correct drawing 
 of the line during the year makes easier a correct 
 drawing of it at the close. 
 
 The distinction between property and expense, 
 moreover, is not more important than the distinction 
 between property and revenue; for to consider as 
 clear profit a sum received from the sale of property 
 is as great an error as to conceive to be property what 
 was really only expense. One must distinguish as 
 carefully between real and nominal accounts in mak*^ 
 ing credits as in making debits. 
 
 Let us take an extreme case. Everyone knows 
 that certain bonds sell at more than par value — that, 
 for instance, a four per cent, bond of a good railroad 
 which promises to pay $1,000 twenty years from now 
 is likely to sell at considerably more than $1,000 — 
 perhaps for $1,046.25. The reason for this premium 
 is that investors believe so thoroughly in the security 
 
PEOPEETY OE EXPENSE 251 
 
 of the investment that they consider that they are 
 taking practically no risk and can afford to lend 
 their money at a low rate of interest — so low, indeed, 
 that the four per cent, paid by the bond is more than 
 they insist upon getting. They bid against each 
 other and^ffer for the bond, then, more than $1,000, 
 because the extra interest w^hich they will be re- 
 ceiving as long as the bond runs is worth a premium. 
 Though they pay $1,046.25, however, they will re- 
 ceive when the bond matures only $1,000, and out of 
 the interest pajTuent received every half year they 
 must set aside a certain sum to make good that 
 shrinkage of $46.25 which they will suffer at the ma- 
 turity of the bond; that is to say, they must realize 
 that the reason they are paying cash premium out- 
 right when they buy the bond at $1,046.25 is because 
 they expect a semi-annual payment of more than the 
 required rate of interest while the bond lasts, and 
 this extra sum of semi-annual payment is not in- 
 terest upon their investment but is simply part re- 
 payment of the $46.25 premium which they paid. 
 Suppose an estate is entirely invested in such bonds, 
 and the trustee, who is charged by a will to ad- 
 minister the property so that the widow of the tes- 
 tator shall receive the income of the estate and the 
 sons shall inherit the body or ^^ corpus" of the estate 
 at the death of the widow, does not realize that a 
 part of the semi-annual interest payment includes a 
 partial return of the $46.25 premium on each bond. 
 In this case he will turn over semi-annually to the 
 widow $20 for every installment of interest on each 
 bond. When the bonds mature, if the widow is still 
 living, but $1,000 will remain for each bond — though 
 
U2 ACCOLTNTING AISTD AUDITINa 
 
 the estate originally included $1,046.25 for each. 
 Suppose, now, the trustee invests this $1,000 return- 
 ed principal in other bonds for which possibly he 
 pays $1,250 because the rate of interest offered is 
 high. At the maturity of these last bonds, again, he 
 collects only $1,000 for each, and in the meantime 
 has paid the widow the full amount of interest re- 
 ceived on the bonds purchased at $1,250. Once more 
 he invests the principal in other bonds, perhaps at 
 133^. It is obvious that if this process continues 
 very long, though on the face of it the trustee has 
 apparently been paying to the widow only the in- 
 come on the bonds — namely, the interest which the 
 bonds pay-— he has in reality been paying her a part 
 of the principal, and on her death the amount of 
 principal remaining in the fund will have shrunk 
 considerably; for each time the par value of a bond 
 is paid and he purchases new bonds at a premium he 
 gets a smaller face value of bonds than he had be- 
 fore, so that whereas the original investment maj 
 have been $104,625, it will now be only $60,000' 
 He fails to live up to the terms of the will because he 
 does not recognize the difference between capital 
 and revenue, between real accounts and nominal ac- 
 counts. He should have known that though a part of 
 every semi-annual interest payment was income or 
 interest on the capital of the estate, another part was 
 simply the repayment of principal, which ought to 
 be kept intact and reinvested in order that the re- 
 mainder-men or inheritors of the permanent estate 
 shall not suffer loss through his neglect of account- 
 ing principles. 
 
 This sort of case is of frequent occurrence. 
 
PROPERTY OR EXPENSfe 253 
 
 though the names by which the property is called 
 may differ widely. If we have an impression, for in- 
 stance, that we are keeping up our machinery by re- 
 pairs and replacements and each year charge to 
 Maintenance what seems to us a reasonable figure 
 for such repairs and replacements, we may find sud- 
 denly that machinery standing on our books at a 
 valuation of $50,000 is worth only $10,000. This 
 error in judgment may have arisen not at all from a 
 failure to spend enough in repairs and replacements, 
 but from a neglect to realize that machinery may 
 sometimes become worthless though it is quite as 
 efficient in production as it was the day it was new. 
 Many times in the last hundred years machinery as 
 good as could be made has been kept equally good so 
 far as its own production is concerned, and yet has 
 become worthless because other machinery has been 
 invented and put upon the market to do either the 
 same work at a cost so low that the old machinery 
 could not compete with it in price, or to do work so 
 far superior that the old machinery could not com- 
 pete with it in quality at the old price. Here, then, 
 was no failure of calculation in keeping up the prop- 
 erty; there was only failure to recognize the force of 
 change in business operations. Allowance should 
 always be made, in any business using machinery, 
 for possible supplanting of property before it has 
 lost its original efficiency — for what is commonly 
 called '* obsolescence," or growing old. In some lines 
 of business the average period of obsolescence is per- 
 haps five years, even though the machinery itself 
 might last for twenty years. Accounting is good 
 only when it represents on the books all the facts: 
 
254 ACCOtJNTiNG AND AUDITING^ 
 
 and, therefore, the books should show that a part of 
 each year's product should be devoted to establish- 
 ing and keeping up a fund big enough to replace 
 obsolete machinery as often as on the average it is 
 likely to require such replacement. If this is not 
 done, the books are representing profits as far 
 greater than they really are. 
 
 Another illustration of the same thing applies in 
 the use of what are commonly called ^^ wasting as- 
 sets." It may be known, for instance, that a certain 
 quarry has in it marble enough to produce 50,000 
 tons a year for twenty j^ears. We may pay $20,00p 
 for the right to get out marble from that quarry. If 
 we figure profits by simply subtracting from sales 
 the cost of getting out, dressing, and selling the 
 marble, we are misrepresenting our profits; for at 
 the expiration of the twenty years we shall have no 
 asset left in the form of quarry right, and the $20,000 
 will have disappeared. Proper accounting would in- 
 dicate how much of each year's product should be 
 set aside to keep intact the original investment. This 
 need not necessarily be set aside in cash or invested, 
 but may be used possibly in the development of the 
 business in some other line, as, for instance, in the 
 gradual purchase of other quarry rights to take the 
 place of that exhausted. It is inevitable, however, 
 that if the books are kept so as to neglect the gradual 
 exhaustion of this quarry right and to maintain it 
 continually at a valuation of $20,000, on the ex- 
 haustion of the rock that $20,000 asset will seem to 
 have shrunk in a moment to nothing, and there will 
 be a deficit instead of a profit as a result of the last 
 
PEOPERTY OR EXPENSE 255 
 
 period of operation — unless, indeed, the profits are 
 extraordinary and could easily swallow up such a 
 shrinkage. 
 
 These cases are fairly simple when we once 
 recognize the fact of shrinking assets. The only 
 complication is in the figuring to determine just 
 what allowance shall be made each year, and that 
 computation is in most cases a mere matter of arith- 
 metic applied to a judgment concerning the probable 
 duration of the property. In the case of a bond the 
 valuation is capable of exact computation as soon as 
 the basis of interest is determined. A case involving 
 the same principle where there may be some differ- 
 ence of opinion as to the method of calculation may 
 be illustrated by agreements involving a maximum 
 and a minimum sale. Suppose we are in the publish- 
 ing business and have made plates for a book under 
 an agreement with certain booksellers that we will 
 supply them with a thousand copies a year for five 
 years, and that they will take the five thousand 
 copies at any time in five years provided not over 
 three thousand copies shall be delivered in any one 
 year. Under this agreement we have the option of 
 supplying from one to three thousand copies in any 
 one year, but we are not obliged to furnish more than 
 one thousand, and we know that the maximum sale 
 at least under this contract will be five thousand 
 copies. Let it be assumed, also, that we have no 
 faith to believe that more than five thousand copies 
 will ever be sold. This is not, of course, a common 
 agreement, but it illustrates a principle which is 
 common in many relations. Let us suppose that we 
 
m^ ACCOUNTING AND AUDITING 
 
 supply the publishers two thousand copies in the 
 first year, and that the plates for the book — which, 
 of course, are useless for any other purpose than 
 printing this particular book — ^have cost us $500. 
 What shall we consider a proper allowance to make 
 for depreciation of those plates during this year"? Is 
 it one-fifth because one-fifth of the five years of the 
 contract has expired, or is it two-fifths because two- 
 fifths of the total expected sales have already been 
 made? On one basis, of course, the plates have 
 served one-fifth of their usefulness — if we assume 
 that they will last for the printing of as many as five 
 thousand copies, which is, of course, presumable. On 
 the other basis, since the total amount of the con- 
 tract is five thousand copies, and two thousand have 
 been produced and sold, the plates have served two- 
 fifths of their usefulness. Yet a decision of this mat- 
 ter involves a difference of $100 profit for the year — 
 that is, the difference between one-fifth, or $100, and 
 two-fifths, or $200. In a case of this sort something 
 else than a consideration of mere lapse of time is 
 necessary to enable us to determine what proportion 
 of the value should be written off in any period. In 
 this case, it is true that the plates have not appre- 
 ciably lost in productiveness, and can produce many 
 more than the five thousand copies; but since their 
 actual effectiveness is to be only five thousand 
 copies, and two thousand have been produced, we are 
 concerned not with how much potential value is left 
 in them but with how much actual value has been 
 exhausted. Here the exhaustion of value is two 
 thousand, and we must reduce the original value of 
 
PEOPERTY OH EXPENSE 25'J 
 
 the plates by two-fifths, or by $200 — though theo- 
 retically only one-fifth of the time of the contract 
 has elapsed and though the plates might potentially 
 serve for printing twenty thousand copies. 
 
 Still one sort of case remains — different from the 
 others, however, only in the magnitude of the 
 shrinkage. Let us suppose that it is learned that a 
 railroad contemplates changing its traffic arrange- 
 ments in such fashion that a certain town heretofore 
 of slight consequence is to be made a great railroad 
 center. We seek to make a profit out of the change 
 and build a large hotel at heavy expense in order to 
 cater to the traveling public which must use this 
 junction. At about the time the hotel is completed 
 it is found that on account of legal complications and 
 competition with water transportation the railroad 
 is obliged to abandon its plans of increasing traffic 
 at this point, and our hotel is a white elephant. What 
 shall we do with the value of the property as stand- 
 ing on our books'? Though the hotel actually cost 
 what we have charged to Real Estate, it is not from 
 any point of view worth anything like that sum. In- 
 deed, it is conceivable that it will be practically 
 worthless if there is no demand for such a building 
 in that locality. Even our principle of basing valua- 
 tion on cost, as expounded in the first part of this 
 chapter, would put this valuation down; for the cost 
 there used was the cost of getting the desired 
 efficiency, and here the desired efficiency is not pro- 
 duced and the expenditure was therefore wasted. It 
 would not be necessary in such a case to make anv 
 entries on the books until it became time to close the 
 
258 ACCOUNTING AND AUDITING 
 
 accounts at the end of the year; for the debit to this 
 account, originally made with the thought that the 
 account represented an asset, would simply turn out 
 to be a debit to an explanation account — merely ex- 
 plaining the loss of this value. In closing our books 
 at the end of the year, therefore, we should carry 
 this debit not into the resource column of a six- 
 column statement (as described in Chapter VI.), 
 which is equivalent to considering it a good asset, 
 but into the loss column of such a statement, which 
 is equivalent to considering it merely an explanation 
 for the disappearance of property. It is noteworthy 
 that the bookkeeping will be absolutely the same in 
 both cases — ^that is, whether the property be con- 
 ceived to remain or to be exhausted: only in the 
 treatment of the account at the end of the year, in 
 drawing conclusions from the books, shall we need 
 to know whether the property really exists or has 
 disappeared. Many accounts are of this sort. The 
 commonest, of course, is that for bad debts. If we 
 have sold goods to one of our regular customers, as 
 long as the account remains on the books we are in 
 the habit of counting it as an asset; but if the cus- 
 tomer suddenly goes into bankruptcy, with the 
 ability to pay nothing whatever, the account may 
 still remain on our books, but we must recognize that 
 it is nominal, explaining a loss instead of represent- 
 ing an asset. 
 
 In any case, when we are handling accounts it is 
 desirable that we shall use the most conservative 
 judgment as to valuations, for only so can we be sure 
 that we are not considering as still on hand property 
 which was long ago consumed. The basis of sueH a 
 
PROPERTY OR EXPENSE 259 
 
 valuation will be determined by the particular case 
 in hand, and no general principle can be laid down 
 except that the valuation should always be made as 
 accurate as possible and in cases of genuine doubt 
 the lowest probable. With regard to merchandise, 
 for instance, the valuation should be put at cost price 
 if we are judging the business with the expectation 
 of selling the goods in the ordinary run of trade and 
 no marked fall in value has occurred since they were 
 purchased. If, on the other hand, we are considering 
 a winding-up of affairs, so that the merchandise 
 must be sold for a lump sum, either at private sale or 
 by auction, we are sure that it will not bring any- 
 thing like its proper price, and the valuation should 
 be, therefore, a great deal less than cost. 
 
 Whenever an item is presumed to be an asset 
 and, therefore, remaining on hand at the end of the 
 earning period (usually a year), so that it is debited 
 to a real account, it is commonly said to be ^^ charged 
 to capital"; when, on the other hand, it is presumed 
 to be consumed during the year and is debited to a 
 nominal account, it is commonly said to be ** charged 
 to revenue." In the terms of the six-column state- 
 ment discussed in Chapter VI., charging to capital is 
 debiting an item to an account so that the amount 
 will appear among the resources in the six-column 
 statement; and charging to revenue is debiting an 
 amount so that it will appear among the losses on 
 that statement. To '^charge to revenue" is really an 
 unfortunate expression, for revenues are always 
 credits; the expression means that the item will be 
 subtracted from earnings at the end of the year. A 
 better expression is '^charging against revenue." 
 
260 ACCOUNTING AND AUDITING 
 
 As was stated in Chapter VI., most business 
 houses, in drawing up their conclusions at the end 
 of the year or in making reports to commercial 
 agencies and to stockholders, give the facts as shown 
 in a six-column statement, but in a somewhat dif- 
 ferent form. The six-column statement is usually 
 supplanted by two statements, one of which, the bal- 
 ance sheet, contains on one side a list of all assets 
 and on the other a list of all liabilities, and the other, 
 the income sheet, contains a condensed list of the 
 items in the last pair of columns on the six-column 
 statement, viz., those for loss and gain. It will be 
 seen that the balance sheet shows the condition of 
 the business at the end of the year, after all allow- 
 ances for depreciation and accrued items have been 
 made. The income sheet, on the other hand, repre- 
 sents not at all the condition at the end of the year, 
 but simply the summary of all transactions affecting 
 profit and loss during the year. The balance sheet, 
 in other words, represents the facts at a definite 
 moment of time and can bear a definite date ; but the 
 income sheet represents the nominal accounts over 
 a period of time, usually one year. As a good illustra- 
 tion of these two sheets extracts from the annual re- 
 ports of the United States Steel Corporation are ap- 
 pended. 
 
PEOPERTY OR EXPENSE 361 
 
 BALANCE SHEET 
 
 ASSETS 
 
 Property (real estate, plant, etc.) $1,500,092,134.63 
 
 Mining royalties, etc., paid in advance 6,763,191.22 
 
 Investments (outside real estate, etc.) 2,353,109.56 
 
 Special funds 21,738,953.06 
 
 Current assets (inventories, cash claims, etc.) 291,018,166.95 
 
 $1,821,965,555.42 
 
 LIABILITIES 
 
 Capital stock $ 869,202,602.50 
 
 Funded and mortgage debt 609,147,904.87 
 
 Current liabilities 61,144,725.55 
 
 Special funds 131,115,794.75 
 
 Surplus* 151,354,527.75 
 
 $1,821,965,555.42 
 
 INCOME SHEET 
 
 Gross receipts from production $646,382,251.29 
 
 Producing costs, including maintenance... $483,417,842,21 
 
 Administrative and selling costs 19,082,226.90 502,500,069.11 
 
 Net receipts from operation $143,882,182.18 
 
 Other income 6,817,998.87 
 
 Gross income $150,700,181.05 
 
 Taxes $ 8,704,193.39 
 
 Interest 31,504,471.58 40,208,664.97 
 
 Net income from operations $110,491,516.08 
 
 Less profits between departments, not yet realized by the 
 
 combined business 2,617,395.54 
 
 $107,874,120.54 
 Appropriations for sinking funds, extraordinary deprecia- 
 tion allowance, etc 29,348,870.58 
 
 Available for dividends $ 78,525,249.96 
 
 Dividends 45,551,777.00 
 
 Surplus for year $ 32,973,472.96 
 
 * This includes the surplus for the year, brought from the income 
 sheet below. 
 
CHAPTER X 
 
 DEPKECIATION 
 
 We saw in the last chapter that it is necessary 
 whenever one is drawing conclusions from books of 
 account to make allowances for changes in value of 
 many kinds of property. Indeed, there is practically 
 nothing in busiaess which remains for long quite the 
 same in value. Let us examine several kinds of prop- 
 erty subject to different laws of change. 
 
 The most common property on which deprecia- 
 tion must be figured is merchandise. If a stock of 
 goods is turned over rapidly and is of a standard 
 variety, very little allowance need be made. A coal 
 dealer, for instance, is likely very seldom to make al- 
 lowance for depreciation unless a fire gets into his 
 bins. Even he, however, must see to it that no short- 
 age results from careless weighing and from theft. 
 Since coal is usually bought by the gross ton of 2,240 
 lbs., and is sold by net tons of 2,000 lbs., a shortage is 
 little likely to occur. A wine dealer, on the other 
 hand, is likely to suffer considerable loss from break- 
 age, and therefore, though in general it is true that 
 his stock increases in value with age, it may never- 
 theless be true that an amount of money invested in 
 wine may suffer shrinkage in the course of time if 
 there is careless handling. For ordinary stocks of 
 goods, however, many elements of depreciation, but 
 
 263 
 
264 ACCOUNTING AND AUDITING 
 
 few of appreciation, are likely to be at work. One is 
 the common change of fashion, or custom, which ren- 
 ders goods once of high value practically worthless. 
 The effect of this varies in force not only from busi- 
 ness to business, but even from line to line in the 
 same business. In a dry goods store, for instance, 
 cotton sheeting is likely to be fairly steady from year 
 to year not only in price, but also in demand. Its 
 value decreases only slowly, moreover, with de- 
 terioration. Expensive figured silks, on the other 
 hand, are likely to vary in value not only because of 
 changing prices and of varying demand, but because 
 of deterioration with age. In valuing stocks of 
 goods, therefore, it is essential that one shall con- 
 sider many factors. In other words, a stock cannot 
 necessarily be valued at all on the basis of purchase 
 price, nor can any normal percentage of depreciation 
 be applied generally for any business selling many 
 varieties. The only effectual valuation is to examine 
 the goods in detail and see what is the probable de- 
 preciation on each sort. In the book business, again, 
 there is still another element of depreciation in the 
 privilege which most customers or intending cus- 
 tomers or pretending customers have of examining 
 books offered for sale. The loss from the difference 
 in price between fresh and shop-worn goods is likely 
 to be considerable. This applies in many other lines 
 of business. 
 
 Real estate is subject to changes in value both 
 upward and downward; but the upward movement 
 is sure to be confined to the value of the land itself 
 or to leases, whereas the buildings are sure of a 
 downward tendency even when repairs are made with 
 
DEPEECIATION 265 
 
 frequency. Certain parts of buildings are so inac- 
 cessible that extensive structural repairs would re- 
 quire an expense even practically prohibitive. The 
 changes in factory, store, and office conditions, more- 
 over, require different construction as the years go 
 on and make it often cheaper to demolish and re- 
 build than to repair or alter. The rates of deprecia- 
 tion on buildings are various, for the use -to which 
 a building is put has a great influence upon its dur- 
 ability. A stone warehouse or boiler house is likely 
 to be little affected by lapse of time. Wooden 
 buildings subject to heavy jars or the action of 
 steam, smoke, acid, vapors, etc., are likely to need 
 replacement often. It is impossible, therefore, to 
 give any hard and fast figures, but in the main it may 
 be said that building accounts should be treated as 
 shrinking in value by a certain percentage each year 
 — that percentage varying from perhaps two to 
 twenty. 
 
 Machinery, as already suggested, is subject to 
 shrinkage in value not merely because of actual 
 wear, but because it is likely to be displaced at any 
 time by inventions rendering it out of date, or by 
 changes in fashion destroying the demand for its 
 product. Machinery differs from buildings, how- 
 ever, in that to a certain extent it may be kept to the 
 original value through the medium of repairs and re- 
 placements. It can usually be taken apart and set 
 up with a new gear, a new shaft, a new belt, a new 
 feed, and what not. Indeed, it may be said that very 
 few machines are really ever worn out, for unless 
 they are of extremely simple type, constant repairs 
 and replacement of parts will continue their ef- 
 
266 ACCOUNTING AND AUDITING 
 
 ficiency. It is mainly because better machines have 
 come upon the market that old machines are dis- 
 carded. In allowing for depreciation, therefore, the 
 task is to consider the number of years which the 
 machine will remain useful, and to figure its cost 
 for those years as not only the full initial cost, but, 
 in addition, all expense for repairs and replace- 
 ments. This expense must be distributed evenly 
 over those years, for clearly to charge against the 
 profits of any one year more than its fair share of the 
 total cost of the machine is to misrepresent the real 
 profits of that period. The main question arising in 
 the treatment of depreciation of machinery is the 
 method of calculation of the total cost to be dis- 
 tributed. This is worthy of careful examination. 
 
 Repairs and replacements, of course, which not 
 only should be distributed over a series of years but 
 will actually be made and paid for in those years, 
 should be charged to an account by themselves. This 
 is usually called ** Maintenance." One method of 
 treating depreciation is particularly well illustrated 
 by the former common practice of railroads. Among 
 the total operating expenses of railroads Mainte- 
 nance of Equipment — that is, repairs, renewals and 
 replacements of locomotives, cars, snow-plows, etc. — 
 constitutes about fifteen per cent. Since the total 
 expense of this sort is so heavy it is probable on a 
 railroad that if one engine requires more repairs this 
 year than usual, some other engine will require 
 fewer; the number of engines is so large, and the 
 nimaber of types of engines is so great, that a fair 
 average is likely to be maintained one year as com- 
 pared with another. It ha^ not been customary, 
 
DEPEECIATION" 267 
 
 therefore, for railroads to make any theoretical al- 
 lowance for depreciation — or, at least, it was not 
 customary until, a few years ago, the Interstate 
 Commerce Commission pressed such an allowance 
 upon the American roads. The same sort of thing is 
 true of maintenance of way and structures; for 
 though the cost may be slightly heavier in one year 
 than in another, it is likely to run along fairly close 
 to the average. This method of treating deprecia- 
 tion, it should be noted, is sometimes the only 
 method necessary. If the property is comprised of 
 many parts, having different lifetimes, and therefore 
 depreciating at different rates, it may chance that 
 each year a good many parts will need to be replaced 
 — so many, in fact, that the general efficiency will 
 never decline and the cost of maintenance may never 
 vary much from the average ; the depreciation on old 
 machines not replaced will be offset each year by the 
 excess value of new machines over those which they 
 replace, and the total value will be unimpaired. To 
 maintain property does not mean, of course, that 
 each hit of property is maintained, but only that the 
 property as a whole is maintained. To improve 
 twenty locomotives as much as twenty other loco- 
 motives decline in value is to maintain the equip- 
 ment. When this sort of thing is carried out, no 
 further provision for depreciation is necessary, and 
 maintenance is automatic. It is necessary to realize, 
 however, that in very few enterprises is it practi- 
 cable each year to keep the property exactly at its 
 original value by repairs and replacements and at 
 a steady cost. The Interstate Commerce Commis- 
 sion refuses to assume that the railroads can or will 
 
WS ACCOUNTING AND AUDITING 
 
 do so. We have, then, to provide for the actual de- 
 preciation which repairs and replacements cannot 
 or do not prevent. 
 
 Let us turn now to the provision for the esti- 
 mated unavoidable depreciation. Each of several 
 methods of making the necessary calculations has 
 its defendants. The most obvious of these is a sim- 
 ple division of the total original cost of the machine 
 by the number of years which it is expected to re- 
 main in use. Two objections to this are clear. In 
 the first place, if we write off each year, beginning 
 with the first year, a sum which is one year's pro- 
 portion of the total cost, we are neglecting the fact 
 that money is always capable of earning interest, 
 and that, therefore, a sum laid aside each year in a 
 special fimd for ultimate replacement will at the 
 snd of the time have increased in value through in- 
 terest to a larger sum than is needed. In other 
 words, each year's share except the last may as well 
 be less than the exact arithmetical proportion, for 
 the accumulation of interest will make up the de- 
 ficiency. The second objection to this method is that 
 the machine does not depreciate at anything like a 
 steady arithmetical rate. This method, then, is pure- 
 ly artificial, and although it produces the desired 
 sum, it may yet result in a considerable unfairness 
 as between different years of the life of the machine, 
 — especially since, as we shall see later in connec- 
 tion with other plans, it neglects several important 
 elements of what is going on. 
 
 A second method is to use what is called a sink- 
 ing-fund device, — that is, to find by calculation a 
 sum of money which, actually set aside and put at 
 
DEPRECIATIOI^ 269 
 
 interest, will produce the desired sum at the end of 
 the time. This may be illustrated as follows: one 
 dollar set aside now will, at 4 per cent, interest, 
 amount to $1.04 at the end of the year ; a dollar then 
 set aside and added to the first will, at the end of 
 the next year, amount to another $1.04, and the first 
 dollar will in the meantime have become in value 
 something more than $1.08; a third dollar set aside 
 at that time will amount to $1.04 in the next year, 
 the second dollar will at the same time have amount- 
 ed to something more than $1.08, the first to some- 
 thing more than $1.12; and so on. Adding each year 
 a dollar and the accumulated interest of preceding 
 dollars, we get a considerably larger sum at the end 
 of the period than the amount of money invested. 
 If we now divide the amount of money which we 
 wish to raise at the end of the period by the total ac- 
 cumulation of single dollars just found, we shall 
 know what number of dollars set aside each year will 
 accumulate in the given number of years to the de- 
 sired sum. This annual sum set aside is called a sink- 
 ing fund, and, as we have seen, will be steady. The 
 annual payment throughout the period will be less 
 than the total amount to be raised divided by the 
 number of years, as found by the first method, for 
 the accumulations of interest will make up the de- 
 ficiency. 
 
 A third method is to recognize the fact that the 
 machine depreciates much less in the early years 
 than in the later, and, therefore, to distribute the 
 total amount of depreciation among the various 
 years in an increasing proportion, such, for instance, 
 as 5 per cent, in the first year, 10 in the second, 15 in 
 
270 ACCOUNTING AND AUDITING 
 
 the third, 20 in the fourth, and so on by such an ar- 
 rangement that the total 100 per cent, will have been 
 written off in the expected lifetime of the machine. 
 To this method much objection can be found. It is 
 true, as the theory assumes, that the machine will de- 
 preciate but little in the first years, and rapidly in 
 the last. As we have^ seen in another connection, 
 however, the real accounting test is not so much 
 the change in the value remaining as it is in the 
 ability of each year to endure a share of the total ex- 
 pense; that is to say, we are not so much concerned 
 with the actual depreciation for that year, which is 
 at best but a matter of guess and purely arbitrary, 
 as with the amount of depreciation which that year 
 can endiire to have charged against its products 
 without throwing it out of proper relation to other 
 years. It is obvious, in the first place, that a new 
 machine requires fewer repairs and replacements 
 than an old one, and that, therefore, the direct 
 charges to Maintenance will be less in those years. 
 In the second place, such a machine, since it is of the 
 newest type, is competing probably only with its 
 equals or v^th machines of an older type, and, there- 
 fore, places its owners either on an equality or at an 
 advantage as compared with other shops using older 
 types of machines. On a double ground, there- 
 fore, the business can afford to set aside a con- 
 siderable sum out of the product of the early 
 years as a fund for ultimate retirement and re- 
 placen^t of the machine,— because repairs are 
 less, ana because it is competing at an advantage 
 with other machines. Yet this third method actually 
 charges less against the product in the early years 
 
DEPRECIATION 271 
 
 than in the later, and in the later years, when the 
 machine requires many repairs and at the same time 
 must compete against new machines of a superior 
 type, it charges as arbitrary depreciation a heavier 
 sum than in the early years. The business is far less 
 able to take out of product in the old age of a ma- 
 chine a large sum for repairs and for a replacement 
 fund than in the early years, and so this third 
 method is really unscientific and violates in its as- 
 sumptions a most obvious fact. 
 
 The fourth method is based almost entirely on 
 the considerations suggested in the last paragraph, 
 that is, it attempts to use the facts which the third 
 method disregards. Under this plan the amount of 
 depreciation written off in the early years is very 
 much heavier than in the later because the business 
 can stand such heavy depreciation in the early years 
 and cannot in the later. One mathematical mettiod 
 of making the calculation of annual depreciation is 
 to find a fixed percentage which shall be applied 
 each year; but this percentage is to be applied not 
 to the original cost of the machine, but to that orig- 
 inal cost less the previous depreciation. Suppose, 
 for instance, a machine expected to last five years 
 cost $200 and will be worth $20 for junk when sold. 
 By the application of a mathematical formula it can 
 be learned that the percentage to be applied is about 
 37. This will give us, applied to the $200 in the first 
 year, a depreciation of about $74 and a remaining 
 valuation of $126.19; in the next year, a deprecia- 
 tion of about $47 (that is, 37% on the $126.19), and 
 a valuation of $79.62; in the next year, 37% upon 
 that last valuation will give about $29 additional 
 
372 ACCOUNTING AND AUDITING 
 
 depreciation, and leave a balance of $50.24; 31% ap- 
 plied to that gives us a depreciation of about $19, 
 and a valuation of $31.70; and a final 37% reduction 
 gives a final remaining scrap value of $20. This is 
 distributing the charge for depreciation over the 
 various years on the basis of what each is best able 
 to stand, and the amount subtracted from the prod- 
 uct should leave a fair sum of profit. The method 
 of calculation for this percentage is rather compli- 
 cated, and in many cases is hardly worth while, but 
 a rough substitute for it is found readily by simple 
 arithmetic. If we add the numbers representing all 
 the years which the machine is expected to last, in 
 this case 5, 4, 3, 2 and 1, the sum represents the de- 
 nominator of a convenient fraction; if we each year 
 write off from the original value of the machine a 
 share (of the total depreciation) represented by a 
 fraction having for its numerator the number of 
 years remaining and for its denominator this total 
 number of years just indicated, we shall attain prac- 
 tically the desired result. To illustrate, in this case, 
 as we have just seen, the sum of all the years, 5, 4, 3, 
 2 and 1, gives us a denominator of 15, and if we in the 
 first year write off 5/15, in the second 4/15, in the 
 third 3/15, in the fourth 2/15, and in the last 1/15, 
 we shall have written off in the end the total 15/15; 
 and we shall have made each year bear a proportion 
 considerably smaller than that of the year before. 
 The figures of depreciation will be $60, $48, $36, $24 
 and $12. For the purpose of making this method 
 clear let us take another illustration. Suppose the 
 machine will be obsolete in ten years. We add to- 
 gether 10, 9, 8, 7, 6, 5, 4, 3, 2 and 1. This gives us 55 
 
DEPRECIATION ^I'S 
 
 for a denominator, and if we assume that the ma- 
 chine cost $600 and will be worth at the end of the 
 ten years $50 as scrap, we get $10 for each 55th of 
 the total. In the first year, since we are to write off 
 10/55, we reduce the valuation by $100. The next 
 year we are to write off 9/55, and reduce the valua- 
 tion further by $90, and so on in a decreasing figure 
 each year until in the next to the last year we write 
 off $20, and in the last year $10. Then the whole 
 $550 has been subtracted from the original $600 and 
 we have our scrap value of $50 remaining. 
 
 It is obvious that at best, under any conceivable 
 conditions, our writing off of depreciation is to a cer- 
 tain extent arbitrary, for it must always be based 
 on a mere judgment as to how long the machine will 
 be useful. The machine may actually, so far as its 
 physical substance is concerned, last far longer than 
 we expect, or it may wear out much sooner; and new 
 machines may not come upon the market for fifteen 
 years, though we base our calculations on ten, — or 
 they may appear in three years. Since, then, our 
 calculation is so largely guess work, it is absurd to 
 carry the figuring of depreciation to a very great re- 
 finement. Theoretically, if we decide that we should 
 write off each year 37% of the preceding valuation, 
 we ought to allow for the fact that the 37% if set 
 aside will accumulate interest, and that, therefore, 
 a smaller sum than 37% will suffice for the purpose. 
 Such a provision, however, would be finical, for since 
 the whole calculation is a mere estimate, an allow- 
 ance of anything annually for interest is quite as 
 likely to increase the discrepancy between the fund 
 
^H ACCOUNTING AND AtJDITING 
 
 accumulated and the amount actually needed as it is 
 to decrease it. 
 
 The substance of the whole matter lies, then, in 
 this: depreciation inevitably goes on in such things 
 as machinery; it goes on with increasing rapidity; 
 but that increasing rapidity is in part offset by the 
 fact that we necessarily in the monthly conduct of 
 the business are making charges to Maintenance 
 which tend to keep good the value of the machine, 
 and in part by the fact that only in the early years 
 can the machine compete successfully with other 
 machines; so in practice it is desirable that the 
 amount of depreciation charged against the product 
 shall in each year be a decreasing rather than an in- 
 creasing sum. The practical task is to determine the 
 probable life of the machine and to calculate a rea- 
 sonable rate of decrease for the valuation. 
 
 As was indicated in an earlier chapter, even 
 bonds and other investments are likely to be chang- 
 ing in value, — though in this case the value may be 
 increasing as well as decreasing with the lapse of 
 time. Whenever any contract promises to yield 
 more than the normal value of the property con- 
 cerned, that contract is, of course, worth something 
 to the holder. Let us examine this, more thoroughly 
 than before, under the conditions of a bond. If, for 
 instance, the market rate of interest for security 
 of a certain class is 4 per cent, and a bond promises 
 to pay 5 per cent, interest, that bond will bear in the 
 market more than the par value, — that is, it will 
 sell for something more than its face value because 
 it is promising to give each year a larger sum than 
 the market interest on its face. It commonly hap- 
 
iDEPRECiATIOIT m 
 
 pens that when such bonds of a railroad are first 
 issued, though the face of the bonds calls for but 
 $1,000, people will pay a considerably larger sum 
 than that into the coffers of the railroad company in 
 exchange for those bonds. In fact, the railroad by 
 issuing a bond has promised to pay the purchaser 
 not only his $1,000 at the maturity of the bond, and 
 the normal rate of interest, say 4 per cent., in the 
 interim, but still a larger sum by the amount of the 
 higher rate of interest; and for this the purchaser 
 of the bond is willing to pay. The premium on the 
 bond, that is, the sum paid in addition to $1,000, is 
 recognized, or should be recognized, by both the 
 purchaser and the railroad as compensation for an 
 annual payment which we may call an annuity. This 
 annual payment, however, will cease at the maturity 
 of the bond because only the par value, or $1,000, 
 will then be paid (with interest accumulated during 
 the last period). The value of the bond, then, is 
 made up of three elements; first, the value of the 
 railroad's promise to pay $1,000 at the maturity of 
 the bond; second, the value of the promise to pay 
 normal interest; and, third, the value of the promise 
 to pay extra interest — that is, a sum in excess of the 
 normal rate. If the bond called for only the normal 
 rate of interest on the par value of $1,000, it is ob- 
 vious that it would bear no premium at all, for the 
 purchaser would be getting just the normal rate of 
 interest on his money during the life of the bond and 
 the repajmient of his principal at maturity. 
 
 At the end of one year after the bond is issued, 
 the railroad's promise to pay more than the market 
 rate of interest is less valuable than before, simply 
 
^76 ACCOUNTING AND AUDITINO 
 
 because the promise is now of shorter duration and 
 not so many payments of this excess interest remain; 
 at the end of the second year the promise to pay ex- 
 cess interest has shrunk by two years' value; and 
 so on until the end of the time, when all these excess 
 interest promises will have expired, and the bond 
 will be worth just par. It is obvious, therefore, that 
 if we wish our books to represent the value of our 
 property we must each year reduce the valuation of 
 all bonds which have been purchased at a premium; 
 for by just the degree of their approach to maturity 
 there has been a shrinkage of value. The amount 
 of such shrinkage can always be learned readily 
 from published tables which show what is the value 
 of bonds paying practically any common rate of in- 
 terest on the basis of what is assumed to be the mar- 
 ket rate. A bond table, for instance, will show what 
 is the value of a 5 per cent, bond for any number of 
 years or half years on the assumption of a market 
 rate of interest of, say, 2%, 2%%, 21/2%, 23/4%, and 
 so on up to 5% and 6%. Some tables, indeed, show 
 the values of bonds worked to bases as close to one 
 another as one hundredth of one per cent. 
 
 If, on the other hand, a bond pays a lower rate 
 of interest than the purchaser believes to be right 
 for the kind of security which it offers, he will pay 
 less than the par value of the bond for just the same 
 reason that in the other case he pays more. If, for 
 Instance, he considers that in view of the risk in- 
 volved the bond ought to pay 5%, but it actually 
 pays 4%%, he will pay less than par by the amount 
 of difference of interest for the number of years that 
 it has to run. As such a bond approaches maturity, 
 
DEPRECIATIOJiT 277 
 
 therefore, it will be gradually increasing in value; 
 for since the bond promises to pay $1,000 on ma- 
 turity, with each year's lapse of time that valuation 
 of $1,000 is getting nearer, and the length of time for 
 which the owner will be receiving less than the mar- 
 ket rate of interest will be shorter. If the bond is 
 good, the owner is sure of $1,000 at the end of the 
 time, and, therefore, he will at every new closing 
 of his books increase on his books the valuation of 
 the bond toward the thousand-dollar point. The 
 amount of such valuation can be found, as for bonds 
 at a premium, in bond tables. 
 
 Similar to bonds are all other documents promis- 
 ing to pay a fixed sum of money at definite intervals, 
 such, for instance, as leases and contracts for the 
 payment of royalties. If a change has taken place 
 in the value of real estate so that property which we 
 can hire, because we have long held a lease, for $1,000 
 a year, is really worth $1,500 a year to us, that lease 
 is a source to us of an annual saving of $500. It may 
 be worth while, indeed, to purchase such a lease of 
 someone else and pay him a price which is equivalent 
 to this annual $500 profit. Obviously, however, as 
 the expiration of the lease approaches, the lease is 
 less valuable; for if it was taken originally when the 
 lease had five years to run, it was then a promise of 
 five $500 savings, the next year it is good for only 
 four $500 savings, the next year for three $500 
 savings, etc., and at the end of the period, since 
 there will be no savings remaining, it will be value- 
 less, — ^unless, indeed, there is a provision in the lease 
 for its continuance at the option of the holder. We 
 must each year, therefore, reduce the valuation of 
 
278 ACCOUNTING AND AUDITING 
 
 the lease on our books in proportion to the reduction 
 in the number of $500 savings. This reduction, 
 however, would not be exactly $500 because, on the 
 principle of discount previously discussed, $500 pay- 
 able some years in the future is not worth $500 to- 
 day. We should simply find the present worth of 
 each of these $500 savings and each year reduce 
 the value of the lease by the present worth of thie 
 most remote saving — ^which would be the same as 
 the present amount of one installment less the in- 
 crease in the value of the other installments (due, 
 of course, to approaching maturity). 
 
 In almost all businesses there are frequent pre- 
 payments, such, for instance, as taxes, insurance and 
 rent. At the time of making such a prepayment we 
 may charge it to either a property account or a nom- 
 inal account according as the circumstances seem 
 to make worth while. If, for instance, we were to 
 pay the premium on a five-year fire insurance policy, 
 we should recognize at the time of the entry that it 
 was not all a charge against this year's revenue, and 
 we should be likely, therefore, to charge it to a prop- 
 erty account because the policy is a good asset as 
 long as it remains unexpired. We should recognize, 
 however, each year — or, indeed, each fraction of a 
 year, if we attempt to determine profits oftener — 
 that a certain portion of that has expired and must 
 be written off the books. 
 
 It is not enough to trust to memory in providing 
 for depreciation at the end of any earning period. 
 In closing the books at such a time one should run 
 through the ledger or the trial balance carefully and 
 see whether any accounts treated as real include 
 
DEPRECIATION 279 
 
 items which have disappeared either entirely or in 
 part as assets, and now represent only explanations 
 of shrinkage which must be made good out of 
 product. 
 
 The method of entry for these different treat- 
 ments of depreciation will necessarily differ. So far 
 as depreciation is prevented by maintenance, the 
 only entry is, of course, to debit Maintenance for 
 actual costs; then, as .Maintenance is a nominal ac- 
 count, it is closed out into Profit and Loss, and the 
 assets remain at their original value — as they should, 
 since they have been maintained unimpaired. So 
 far as Maintenance has failed to keep up the value 
 of property, Depreciation should be debited as an 
 indication of shrinkage. The natural credit to make 
 at the same time, of course, is to the account repre- 
 senting the property that has declined; for that ac- 
 count should no longer stand debited with property 
 that has disappeared. When Depreciation has been 
 carried to Profit and Loss, therefore, things are as 
 they should be, — a nominal account debited for the 
 consumption of property in carrying on business, 
 and the real account written down to the value re- 
 maining. If, finally, a depreciation fund is set aside, 
 out of product, to replace the exhausted property, 
 the only change is in the addition of another entry 
 for the investment of the cash. In that case, the 
 business has converted one kind of property into 
 another, — possibly machinery worn out in convert- 
 ing itself into goods, goods converted into money, 
 and money converted into an invested fund; and in 
 the end everything is the same (neglecting profit or 
 loss in the operation) as in the beginning except that 
 
280 ACCOUNTING AND AUDITING 
 
 in place of a part of the old property the business 
 now has a fund provided for the purchase of new 
 property. 
 
 Whether such a fund should be invested in the 
 business itself or outside is a question not of account- 
 ing, but of business management. It must be real- 
 ized, however, that a fund tied up is in one sense no 
 real fund at all. 
 
CHAPTER XI 
 
 PROFITS 
 
 In the last chapter we discussed the general na- 
 ture of depreciation and the methods of determining 
 what allowances should be made for it. In general, 
 it may be said that the profit of a business is its 
 income from operation less expenses and allowances 
 for depreciation. To learn this profit seems a simple 
 task of bookkeeping. As a matter of fact, however, 
 the determination of each of these three elements is 
 likely to involve calculation and judgment of many 
 things not normally on books of account. In every 
 business debts are constantly accruing, either in its 
 favor or against it, long before they can well be en- 
 tered on the books. If, for instance, taxes are 
 assessed on May 1, and the close of the business year 
 is January 1, to the expenses otherwise determined 
 on January 1 must be added the proportionate charge 
 for the year's tax — ^that is, eight months' taxes ac- 
 crued but not due. Similarly, if any notes outstand- 
 ing bear interest, the charge is day by day increasing 
 against the firm. If the firm, on the other hand, holds 
 notes bearing interest, the amount of such interest is 
 accruing in its favor. If the business has taken dis- 
 count on notes accepted from its customers, every 
 day brings nearer the due date of those notes and, 
 therefore, increases their value; and any notes which 
 
 281 
 
282 ACCOUNTING AND AUDITING 
 
 the firm has had discounted for it by others are by 
 approaching maturity becoming heavier liabilities of 
 the business — because their present worth is more. 
 Only when all such accruing items have been con- 
 sidered is it possible to tell exactly what has been the 
 profit or loss for any earning period. Among large 
 items of this sort are likely to be rents and royalties. 
 It may chance that the business makes payment on 
 lease and royalty contracts at periods far removed 
 from its own fiscal dates. It is true, of course, that 
 if the amount of such rents and royalties is neglected 
 every year, and is constant year by year, no error will 
 be introduced into the books after the first year; 
 for the amount entered each year will be more or less 
 than the amount belonging to that year by the por- 
 tion brought over from the last year, but at the same 
 time it will be less or more than the proper amount 
 for that year by the amount carried over to the next 
 year; so that as the expense is steady one year 
 after another, the error on one side will exactly off- 
 set the error on the other. For the first year, how- 
 ever, the item may be serious and should be allowed 
 for, and when once allowed for, it must always be 
 allowed for or error creeps in; and in any case, if the 
 amount varies from year to year, considerable error 
 will be introduced if the exact figure is not obtained 
 for the exact period in question. 
 
 Persons unfamiliar with accounts may be in some 
 doubt as to why it is worth while to draw a hard and 
 fast line and say that certain profits belong to last 
 year and certain others to this. If it were true that 
 the persons who lost in this year would gain in the 
 subsequent years, or vice versa, it would not usually 
 
PEOFITS 283 
 
 matter seriously, even though the line were not 
 di^awn with absolute accin-acy; though even in such a 
 case it is desirable that a man shall know his income 
 with exactness, for most men determine their expen- 
 ditures with some regard to their supposed incomes. 
 When, however, the recipients of income this year 
 are somewhat different from those of other years, it 
 is absolutely essential, in order to attain justice, that 
 there shall be no overstating or understating of the 
 profits of any year. In very few corporations, ex- 
 cept those of a more or less private type in which the 
 stockholders are permanent, is it true that the profits 
 held over and understated this year will, when finally 
 distributed, go to quite the same persons as would 
 have benefited by the early distribution. Stocks of 
 all large companies are frequently changing hands in 
 the market, not only because of speculation but be- 
 cause of changes in permanent investment. If, in 
 any year, the profits of a business are overstated and 
 the amount of dividend paid is larger than is strictly 
 correct, the gain goes to the stockholders of record 
 at that time ; and this gain cannot, of course, be made 
 up by a payment of smaller dividends to subsequent 
 and diiferent stockholders. Profits hidden by care- 
 less or fraudulent accounting, on the other hand, are 
 not ultimately distributed fairly if persons ignorant 
 of those profits sell their stock at a price based on its 
 apparent rather than its real value. Watchful in- 
 vestors and speculators know o:ften that a business is 
 accumulating reserves which will ultimately result 
 in larger dividends ; and they can take advantage of 
 the ignorance of others and buy at an unduly low 
 price. They get dividends which should go to former 
 
284 ACCOUI^TING AND AUDITING 
 
 owners — or should have been paid for by a higher 
 price when the stock was sold. If, when a final set- 
 tlement is made between partners, the property on 
 hand is understated, the partner selling out receives 
 less than his due share. If an executor in settling 
 an estate undervalues the property of that estate, 
 and .by will the income belongs to one person and 
 the property to another, that which ought to be cred- 
 ited to the property may be included by this error in 
 items to be given to the recipient of the income. Only 
 an absolutely correct statement of values adjusted to 
 a definite time provides with certainty that each per- 
 son shall receive the proper sum in any bargain or 
 other settlement based on that statement. For this 
 reason accounts should be made exact and no ascer- 
 tainable value should be hidden. 
 
 It may seem to some as if the method of deter- 
 mining profit on merchandise, as shown in Chapter 
 IV., confuses the profits of two years and may antici- 
 pate future profits or neglect present losses. By the 
 method described, profit on sales is determined by 
 subtracting from purchases the valuation placed on 
 present stock and subtracting this remainder from 
 sales. It is obviously true that if the valuation put 
 on merchandise at the end of the year is excessive, 
 the cost of sales is by that much reduced, and profits 
 are by that much overstated. It is true, therefore, 
 that an overstatement of inventory does inflate this 
 year's profits; but that is not the same as sa^dng 
 that this year's profits are dependent on a realization 
 in the future of the inventory value now placed on 
 merchandise. If the inventory value is correct at the 
 day the inventory is taken — is based, that is to say, 
 
PROFITS 286 
 
 not on expected selling price but on actual cost or on 
 present wholesale price (whichever is lower), — this 
 figure subtracted from the total debits to merchan- 
 dise shows the actual cost of merchandise han- 
 dled during the year past ; and that cost of merchan- 
 dise, when subtracted from the receipts from sales, 
 shows the profit on the goods actually sold within the 
 year. If in the future the inventory value now 
 placed on the stock is not realized, a certain sum will 
 have been lost; but it is not true that the loss has 
 anything to do with the operations of the year just 
 considered. That loss should be borne by the year 
 in which it occurs, and it occurs not in buying, but 
 in selling. A running business always needs a work- 
 ^ing stock of goods, and the stock left on hand at the 
 end of the year is presumed to be essential for its 
 continuance into the new year. The new year must 
 take those goods at their value when it inherits, and 
 any loss sufered on the sale is of no concern to the 
 preceding year. Each year must stand on its own 
 transactions, and though we are never sure what 
 will be the ultimate profit on the total merchandise 
 purchased within ^ year, we may learn what is the 
 profit on that portion sold within the year, and that 
 is the only portion with which the year is concerned. 
 The task of valuation is to get things correct at the 
 time it is made, — and that involves allowance for 
 unsalable, shopworn, and otherwise depreciated 
 stock. It should stand at the figure which is to be 
 used in holding next year responsible for its in- 
 heritance. 
 
 In most countingrooms profits are in one particu- 
 lar misrepresented. It is common in many trades to 
 
m ACCOTJKTIl^G AND AIJDITIM 
 
 offer a discount for early payment of bills — this dis- 
 count ranging from one to seven or eight per cent. 
 Usually, as has been indicated in the chapters on 
 bookkeeping, discounts taken by customers are deb- 
 ited to Merchandise Discount, and discounts taken 
 by the business itself are credited to that account. Un- 
 less one analyzes the meaning of the prices entered 
 on bills, this seems to be an accurate and satisfactory 
 method, but it neglects the fact that the billed price 
 for the goods is not the natural price. The natural 
 price of most goods manufactured in a competitive 
 market — and nowadays that is the common market 
 — ^is the cost of production, and this means the direct 
 cost for labor, for materials, and for other manufac- 
 turing service, plus interest on the investment, the 
 salary of the person conducting the business, and 
 compensation for the risks involved. If a man can 
 afford, when he gets immediate cash payment, to sell 
 goods at $95, but actually on the bill enters the price 
 of $100 and adds a statement that five per cent, dis- 
 count will be allowed if payment is made within 
 thirty days, it is obvious that the difference between 
 the $95 and the $100 has nothing to do with the cost 
 of production of the goods. The extra five dollars, 
 if paid, is compensation to the merchant for two 
 things, — for interest because of delay in payment, 
 and for the additional risk he takes in trusting his 
 customer over a period of time. It is not true, there- 
 fore, that a business house loses when a customer 
 takes a discount; for allowance of that discount is 
 no more a loss than handing back change to a cus- 
 tomer who in buying goods over the counter presents 
 currency of excessive denomination. It is true, of 
 
PROFITS m 
 
 (jotirse, that if the customer did not pay until the end 
 of thirty days, the profit would be five dollars larger, 
 and this profit is lost if discount is taken; but it is 
 equally true that if a customer offered five dollars 
 for an article priced at four dollars and a half and 
 refused to take the fifty cents in change, the business 
 would be making a profit ; and, as a matter of fact, if 
 it gives him his change, it loses what otherwise would 
 be profit. Yet it would be absurd to say that change 
 measures loss. It is equally absurd to say that dis- 
 counts given are losses. The ordinary method of 
 charging discounts as losses, therefore, entirely mis- 
 represents facts. This would not be a serious matter, 
 however, if it were true that calling discounts losses 
 worked equally as between purchases and sales. In 
 both cases the discount is an amount subtracted from 
 the billed price of the goods : for sales, a neglect on 
 the part of the buyer to take discounts is a clear gain 
 to the seller — provided payment is finally made at 
 the full price; but it is not true, with regard to pur- 
 chases, that the taking of a discount is a gain to the 
 buyer; the fact is that the failure to take a discount 
 is a loss to the buyer. The situation can be under- 
 stood only if we realize ahvays that the natural price 
 of the goods is not the billed price but the discounted 
 price. If the selling firm collects more than the dis- 
 counted price, it is making an extra gain; on pur- 
 chases, however, it is not making a gain when it pays 
 the discounted price, but is making a loss when it 
 pays the billed price. Books of account, therefore, 
 should regard as losses only discounts neglected on 
 purchases, and should represent as gains not dis- 
 
288 ACCOUNTING AND AUDITING 
 
 counts taken on purchases, but discounts neglected 
 by customers. 
 
 It is natural to think that if the discounts taken 
 on purchases are as large in amount as the discounts 
 allowed on sales, the business has lost nothing by 
 neglecting to take discounts offered to it by its cred- 
 itors. A little thought shows that this is entirely a 
 misunderstanding of the situation. It is not neces- 
 sary, in order to make profits out of the neglect of 
 customers, that one shall on one's own side neglect to 
 take discounts offered by one's creditors. The two 
 things have no necessary connection. One may both 
 profit from the neglect of customers to take dis- 
 counts from the billed price, and avoid the loss from 
 neglect to make early payments on one's own pur- 
 chases. In view of the fact that the discount offered 
 for early payments for goods is usually at a consid- 
 erably higher rate than normal interest, it is the part 
 of wisdom for any business with good credit to bor- 
 row money at normal rates and take all discounts, 
 rather than to allow any to pass. If goods are sold at 
 such terms that the full billed price must be paid 
 in sixty days, and five per cent, discount will be al- 
 lowed if the bill is paid in ten days, it is obvious that 
 the five per cent, is allowed for fifty days' time — that 
 is, five per cent, discount is allowed if the bill is paid 
 fifty days earlier than the latest time mentioned. 
 This rate of five per cent, for fifty days is equivalent 
 to thirty-six per cent, a year. It is the height of fool- 
 ishness for a merchant to pa}^ thirty-six per cent, a 
 year if he can borrow at six per cent. This fact is 
 brought home to merchants usually, however, only if 
 their books show them what is the actual loss each 
 
PROFITS 289 
 
 year by neglect to take discounts. To set off dis- 
 counts neglected by customers against discounts neg- 
 lected by the business is to count a chance gain 
 against an unnecessary loss. No man will wisely put 
 those two things into the same scale ; for he will see 
 at once that he may as well realize chance gain and 
 at the same time escape the unnecessary loss. 
 
 The method of accomplishing this is to shift the 
 usual point of view with regard to discounts. We 
 have no interest in discounts taken, for the natural 
 price of goods is based on the assumption that dis- 
 counts will be taken. Profit and loss lies only in for- 
 feiture of discounts. Since merchants do not know 
 whether discounts will be taken, however, they must 
 bill goods at the full price. In any case, therefore, 
 whether the disccjunt is taken or not, the extra sum 
 should be deducted ultimately from the entry to 
 Merchandise. It is desirable that goods shall stand 
 on the books at the lowest price at which they can be 
 bought; but the usual method enters them at the full 
 price and then makes a contra entry for discounts 
 actually taken, disregarding the discounts not taken; 
 so usually the merchandise account on the books rep- 
 resents neither one thing nor another, for some goods 
 are entered at discounted cost and some at full billed 
 cost. Under this unfortunate method a firm with 
 such poor credit that it never takes discounts, since 
 it debits all purchases at the full price and then never 
 makes a credit for discounts offered, has a higher 
 valuation on its books for its merchandise than a firm 
 always taking discounts. This is an absurdity. The 
 only proper valuation for merchandise is the natural 
 price, or, as has been suggested, the lowest price at 
 
 A & A-19 
 
^90 ACCOUNTING AND AUDITING 
 
 which they are offered for sale. The proper method 
 is to enter Merchandise for full billed price, so that 
 the books of both parties may agree, and then at set- 
 tlement make a contra entry for the largest discount 
 offered, whether that discount was taken or not. This 
 leaves Merchandise with a proper debit or credit. 
 The other half of the entry will depend on circum- 
 stances. If discount is taken on purchases, the entry 
 is merely a debit to the creditor for the amount cred- 
 ited to Merchandise — that is, the amount of discount; 
 this, with the cash payment, closes the creditor's 
 account, as it should. If the discount is not taken, 
 the debit should be to Neglected Discount for the 
 amount credited to Merchandise; for this amount is 
 an extra payment made to the creditor above the 
 natural price of the goods and is a loss due to neglect 
 of prompt payment. The reverse of these entries 
 would be made for customers' accounts, — with the 
 substitution, however, of Collected Discounts for 
 Neglected Discounts. Collected Discounts is a gain 
 account. It must go in part to offset, at the end of 
 the year, losses from bad debts — for of course there 
 are no such losses on cash sales.* 
 
 Misapprehension sometimes arises with regard to 
 profits on contracts for future delivery. In case of 
 a dissolution of a firm while contracts are in progress, 
 the retiring partner naturally thinks that the profits 
 already gained should be divided as a part of the gen- 
 eral profits of the business. The continuing partner, 
 
 *The bookkeeping for these entries is easy to provide. Special columns 
 in the cash book for Neglected Discounts, Collected Discounts, Merchandise, 
 Dr., and Merchandise, Cr., furnish the medium without requiring moM 
 labor than that required by the common treatment of discounts. 
 
MOFITS S91 
 
 on the other hand, naturally thinks that the profit on 
 any contract is never really known until the last 
 stroke of work has been done. In all contract w^ork 
 unforeseen circumstances are likelv to arise and 
 wipe out profits previously in sight ; it is, indeed, in 
 part just for this reason that so much work is done 
 on contract, for clients believe that persons experi- 
 enced in a special line of work are better able to cal- 
 culate, and, therefore, to endure risks, than are 
 others. It is true, therefore, that there is no such 
 thing as known profit on a contract until the contract 
 has been absolutely completed; and theoretical 
 profits should not be entered on the books of con- 
 tracting firms. In the case of dissolution, where 
 some sort of settlement must necessarily be made, 
 and one partner or the other insists on allowance for 
 apparent profit or loss on contracts, a special agree- 
 ment should be made. It is never safe to assume that 
 merely because the present value of the work done 
 shows a profit of perhaps fifteen per cent, on its cost 
 the whole contract will show the same percentage, or 
 anything approaching it. The only correct method is 
 to reach an agreement between the partners as to 
 what is the probable cost of completing the work, to 
 add this sum to the cost of the work already done, 
 and to consider the difference between the total and 
 the contract price as profit or loss. Since, more- 
 over, a part of this profit will be actually earned in 
 a later period — that is, in completing the contract, — 
 only a portion of this profit can be said to belong to 
 the year in question. If the partners agree on such a 
 division of apparent profits, no reason can be given 
 why it may not be made; but for any partner to de- 
 
292 ACCOUNTING AND AUDITING 
 
 clare that the apparent profit is actual, and to insist 
 that he shall receive his pro rata share, is to reason 
 without regard to the common experience of busi- 
 ness. The continuing partner may justly demand 
 that he retain a considerable margin of apparent, 
 profits to cover contingencies, or that the retiring 
 partner give a bond to cover his share of any losses 
 that may prove to have been sneered on' contracts 
 in which he was interested. Expenditure on an un- 
 completed contract may usually be counted as a good 
 asset unless the contract is already known to involve 
 ultimate loss — in which case it should be written 
 down; but in no case, even in corporation accounts, 
 should profit be counted on a contract as of any year 
 before completion unless the work is so near com- 
 pletion that the danger line has been safely passed 
 and the cost of completion is virtually known — with 
 a safe margin. It must be understood, however, that 
 if what is nominally one contract be really several 
 contracts, each with its own contract price for com- 
 pletion, profit may be safely figured on each as soon 
 as settlement for it is made. Losses on other con- 
 tracts completed in future years do not affect the 
 actual profits on any contract completed in this year. 
 If any contracting firm has knowingly made some 
 unprofitable contracts in order to secure other profit- 
 able contracts, the situation is slightly altered; but 
 it would be hard to deny a partner's or a stock- 
 holder's right to profits made on the profitable con- 
 tracts if these were completed at the time of settle- 
 ment and the unprofitable contracts were still in 
 progress. The burden of proving that the several 
 
PROFITS 3d8 
 
 contracts were really one contract would be on the 
 objector. 
 
 One item which is likely in careless bookkeeping 
 to be treated as if it were profit, though in reality it is 
 not so at all, is premium on stocks and bonds sold by 
 an issuing corporation. As has already been indi- 
 cated, premium on bonds is due to the fact that the 
 bonds pay interest at a higher rate than is usual for 
 investments of equal security, and this higher rate, 
 being of the nature of an annual payment, has a 
 value in the market — just as any source of income 
 has an ascertainable value. A corporation which has 
 issued bonds at a premium, then, has simply bounij 
 itself to paying an unnecessarily high rate of interest 
 for a number of years. This high rate is not a loss, 
 however, for the premium is a present lump sum 
 given as compensation for the high interest to be 
 paid in the years covered by the life of the bond. 
 The premium is therefore just as much an obligation 
 to be met as is the face of the bonds — ^though it is to 
 be met not in a lump sum, as is principal, but in an- 
 nual installments. It should be treated on the books 
 in very much the same way as principal, therefore, 
 and appear on the balance sheet as a liability; since, 
 however, it is a liability not measured by the par 
 value of the bonds, and not represented by any other 
 common sort of demand or claim, it should appear on 
 the books under a title w^hich shall show exactly what 
 it is; and as each year's installment of interest paid 
 decreases the obligation remaining (since fewer an- 
 nual payments will remain to be made), this account 
 should be written off until at the maturity of tho 
 
294 ACCOUNTING AND AUDITING 
 
 bonds it will have disappeared. It is commonly called 
 ^'Premium on Bonds Issued/' 
 
 Premium on stocks issued is of somewhat dif- 
 ferent nature, for, although stocks are a liability of 
 the corporation in the sense that the account repre- 
 sents property for which the corporation is respon- 
 sible, the corporation is not under obligation to pay 
 back the money so obtained. Premium paid for stock, 
 then, is of the nature of capital invested by the sub- 
 scribers, and is really just so much added to the cap- 
 ital investment. To consider premium on stock as 
 profits is an error akin to treating as profits the orig- 
 inal par value. There is no sense in which such pre- 
 mium can be considered anything else than capital 
 investment, and it must always appear on the books 
 and on the balance sheet as capital, — ^preferably des- 
 ignated under a title indicating its origin, such, for 
 instance, as ^^ Premium on Stock Issued," or ^^ Pre- 
 mium Surplus." 
 
 It is obvious that discount on bonds issued is no 
 more a loss than premium is gain. We saw in the 
 chapter on depreciation that when a bond is bought 
 at a discount its approach to maturity raises its 
 value, for the low rate of interest is approaching ex- 
 piration; and the reason it sold at a discount was that 
 the rate was too low for the risk involved. The cor- 
 poration issuing the bond, in other words, accepted a 
 low price for the bond because some one lent money 
 and agreed to accept less than the rate of interest 
 common for security of that class. The corporation 
 gets back in a low interest rate what it loses in dis- 
 count. The exchange is a fair one. The discount is 
 a good asset — ^it measures the value of immunity, for 
 
PEOFITS 295 
 
 a period of years, from the normal interest rate. It 
 may appear on the balance sheet as *^ Discount on 
 Bonds Issued." As the bond approaches maturity, 
 however, the value of the asset declines, for the life- 
 time of the immunity is declining, and the account 
 must be written down. 
 
 Discount on stock, on the other hand, is simply 
 the measure of deficient capital — it measures the de- 
 ficiency of actual as compared with nominal capital. 
 This is shown in the chapter on the peculiarities of 
 corporation accounts. 
 
 Depreciation we have seen to be one of the ex- 
 penses of operation, and it must be clear that the 
 amount to offset depreciation — either when repairs 
 and replacements are able to keep the property in- 
 tact, or when certain smns are set aside for replace- 
 ment at the proper time — must be met out of the 
 product for the year: it is not, that is to say, to be tak- 
 en out of the profit, for profit consists of what is left 
 after all expenses have been met; and, since deprecia- 
 tion is one of the expenses, there is no profit until the 
 amount of allowance for depreciation has been sub- 
 tracted from the product. This distinction is funda- 
 mental; and neglect of it has often led in business 
 both to a misstatement of facts and to a serious mis- 
 understanding on the part of many business men as 
 to the real profitableness of an undertaking. It must 
 be clearly understood that all allowances for depreci- 
 ation are just as much costs of getting product as 
 are wages, interest, taxes, insurance, etc. : only when 
 all such charges have been absolutely met is there 
 any profit to be recognized. The reason that this sit- 
 uation is not fully realized is that very commonly the 
 
296 ACCOUNTING AND AUDITING 
 
 depreciation goes on out of sight and to great extent 
 out of mind. If a machine produces fifty thousand 
 articles per year and is worn out to the amount of 
 $500 in the process, it ought to be obvious that the 
 five-hundred-dollar shrinkage in the machine has 
 gone into the cost of the articles produced ; in other 
 words, instead of having a certain amount of money 
 in a machine and no goods as we had at the beginning 
 of the year, we have at the end of the year a smaller 
 value in the machine and an equivalent additional 
 value in goods or in what the goods have brought, — 
 that is, the machine has converted its iron and steel 
 and wood, in the form of machinery, into product 
 in the form of cotton goods, woolen goods, steel tools, 
 or what not. The machine is as truly consumed as 
 is the raw material. 
 
 When we have counted all the causes of shrink- 
 age in property, and all the causes of increase in 
 property — as shown by the earning accounts, such 
 as rent, commission, interest, sales, etc., — we have 
 a definite figure of profit or loss at the end of the 
 earning period. The task remaining is to dispose 
 of those profits so that they shall be available for 
 equitable distribution to the owners of the business — 
 whether a single proprietor, partners, or stock- 
 holders. To distribute all profits outright, at least 
 in a corporation, is almost universally considered 
 bad policy, for every business is subject to fluctu- 
 ations of fortune. Very few years fail to give results 
 somewhat higher or lower than the average of a se- 
 ries of years, and unless the owners are willing to 
 suffer considerable variations in the amounts actu- 
 ally withdrawn from the business they may well 
 
PROFITS 297 
 
 liold back in prosperous years a portion ot profits 
 to be used in lean years for eking out dividends. 
 The possibility always is at hand, moreover, that 
 some error has been made in the judgments on which 
 are based the calculations determining profit. As 
 we have seen, the figure for depreciation is, to great 
 extent, an estimate based on pure judgment. If new 
 machinery destined to supplant old is invented soon 
 after equipment is installed, a manufacturer may 
 find his assets shrunk in value by many thousands 
 of dollars. It is the part of conservatism, even after 
 one has taken out of product all one thinks necessary 
 for a probable shrinkage, to set aside a sum for 
 unforeseen and unpredictable contingencies. Con- 
 flagrations so serious that insurance companies 
 are not able to meet all their liabilities occur 
 now and then; earthquakes demolish property; 
 whole trades are destroyed by changing tastes, 
 changing habits, changing economic and political 
 conditions. All these things show that it is wise 
 for a corporation or other busine'^s organization to 
 set aside regularly out of profits in all years except 
 the poorest certain sums which shall enable them to 
 meet unforeseen losses. These sums ordinarily 
 would appear on the books as subdivisions of the 
 profit and loss account. As we have already seen, 
 the profit and loss account normally will have a credit 
 balance, and if dividends paid are less in amount 
 than the amount standing to the credit of that 
 accoimt, the balance is simply a surplus held back 
 for contingencies. That amount held back may re- 
 main either under the head of Profit and Loss, or 
 under some new title to indicate its purpose, such 
 
298 ACCOUNTING AND AUDITING 
 
 as Reserve, or Depreciation Reserve, or Security 
 Reserve. Sometimes such an account is called ^'Re- 
 serve Fund,'' or ^^Depreciation Fund." 
 
 It must in any case be realized that these accounts 
 are purely nominal. They explain the fact that of 
 the total assets of the business some are profits, and 
 that these are not to be distributed as profits, but 
 are held for special purposes. These accounts serve 
 to measure the amount of assets set aside from prof- 
 its as a margin of safety. If, on the other hand, the 
 corporation wishes to set aside specific assets for 
 specific purposes — to label them, so to speak, — it 
 will invest some of its assets in special funds and 
 will give each fund a name to indicate its purpose. 
 In such a case, the reserve will appear on the credit 
 side of the balance sheet, to show the origin of the 
 property (that is, profit reserved), and the property 
 in the fund will appear on the debit side of the 
 balance sheet as an asset. When the item does not 
 appear on the debit side, no specific property is set 
 aside: that is, the reserve is simply an excess of 
 assets somewhere, anywhere, in the property — but 
 not designated as a particular bit of property. 
 
 We have so far been working on the supposition 
 that the books represent affairs as they are. Unfortu- 
 nately, this is not always the case and a different 
 result is sought frequently by men who have the 
 highest ideas of truth and justice. Many men wish 
 to make sure that they have not overstated their 
 profits, and in making up their figures for the end of 
 a year they habitually take the precaution of record- 
 ing expenses as a little larger then they really be- 
 lieve expenses to be. The result of this is to assume 
 
PEOFITS 299 
 
 that the property is iu)t quite so valuable as it really 
 is; that is, in order to be on the safe side they assume 
 depreciation to be larger than it really is. Some- 
 times repairs and replacements have not only kept 
 machinery and other equipment in good condition 
 but have been of such nature and of such extent as 
 to make the property really better than it was before ; 
 and yet the full cost has been charged to mainte- 
 nance as an expense. On a railroad, for instance, it 
 is common to improve the line continually by put- 
 ting in heavier rails, better ties, better ballast, better 
 bridges, better buildings, and yet charge the cost to 
 operating expense. Obviously, so far as these expen- 
 ditures have produced a better road, the excess can 
 quite properly be charged to capital. When this is 
 not done, on the contrary, the charges are included as 
 mere repairs, the whole cost is taken out of the 
 product of the year, and profits are reported smaller 
 than they really are. The excess exists in the road; 
 but since this excess does not anywhere appear on the 
 books as an asset, it constitutes what is commonly 
 called a ^^ secret reserve." 
 
 It is unquestionably good business policy to pro- 
 vide ample reserve to improve constantly one's facil- 
 ities for doing business, — unless, indeed, the pro- 
 prietors intend to retire from business ; but since the 
 purpose of accounting is always to show facts, any 
 bookkeeping process by which reserves of any sort 
 are kept off the books is reprehensible. It is nothing 
 but a lie pure and simple, and however harmless it 
 may be in intent, it is unscientific. Those who defend 
 this method of creating reserves commonly do so 
 on the ground that stockholders would foolishly 
 
300 ACCOUNTING AND AUDITING 
 
 demand further dividends if they knew the f^cts. 
 Whether stockholders are wise or foolish, they have 
 the right to know the facts. 
 
 One reserve created with the full knowledge of all 
 interested persons is often so far misunderstood that 
 it is not commonly known to be profit. When a sink- 
 ing fund is created out of profits, in accordance with a 
 legal provision in a bond, for the redemption of debt, 
 it is reported on the balance sheet as a liability. It 
 is established on the books, of course, by a debit to 
 Profit and Loss, or Surplus, and a credit to Sinking 
 Fund. It appears to be the mere satisfaction of a 
 legal liability. As a matter of fact, however, that 
 legal liability is not really a new one, or an addition 
 to the liability covered by the bond itself ; it merely 
 specifies how the principal liability shall be dis- 
 charged. The sinking fund is profit when set aside, 
 and it continues to be profit even when used. Profit 
 may be invested in the payment of liabilities as well 
 as in the purchase of assets. If the fund has been 
 set aside out of profits the assets must be in the busi- 
 ness — else there were no profits to set aside. When 
 these assets are used to pay debt, they, with the debt 
 paid, disappear from the balance sheet ; but the sink- 
 ing fund remains on the balance sheet, for nothing 
 has happened to cancel it. It is now, as it always 
 was, a mere measure of reserved and labeled profits ; 
 but now that the assets which constituted the real 
 fund have been applied to the designated purpose, the 
 fund is set free and the label may be removed. To 
 invest surplus earnings in paying off debt no more 
 destroys their character as earnings than does pur- 
 chasing merchandise or other assets: in both cases 
 
PEOFITS i 301 
 
 the net earnings have made possible more net assets. 
 The situation is quite the same, except for the con- 
 venience of the label, as if from the start the sinking 
 fund had been called simply ^^ surplus." 
 
 We must now note that it is 'commonly worth 
 while to distinguish between diflPerent kinds of profit 
 and loss. We have been considering chiefly the 
 profits of normal primary operation; but many busi- 
 nesses have not only common outside operations, but 
 extraordinary occasional profits and losses. Ex- 
 amples of the common outside operations are out- 
 side bond and stock investments, and ownership of 
 real estate not used in the business. Let us first 
 examine extraordinary gains. 
 
 If the business owns land and buildings which 
 it has been using in the ordinary course of its trans- 
 actions, and, because of a change in conditions in the 
 town or city where it is located, its land has risen 
 largely in value and it sells at a high profit, that 
 gain, though distinctly profit, is not really profit of 
 the year in which it has been realized nor is it profit 
 of operation. It does belong to the proprietors 
 or stockholders; but if the books allow it to appear 
 as of the ordinary type, they are seriously misrepre- 
 senting the facts. Such gains may be, of course, dis- 
 tributed to stockholders; but the books should show 
 very clearly, and the declaration under which the 
 dividends are sent out should state very clearly, that 
 this is of an extraordinary nature, the like of which 
 is not expected to occur very often. 
 
 Because things of this sort are likely to happen 
 now and then, it is desirable that ordinary profits, 
 i. e., profits from normal sources, shall be carried to 
 
302 ACCOUNTING AND AUDlTlNa 
 
 an account distinguished from general Profit and 
 Loss. Such an account may be called ^'Earnings." 
 To it should be credited all earnings from the 
 primary operations of the business — that is, revenues 
 from the operations which the business was prima- 
 rily organized to carry on, — and to it should be debited 
 the expenses which have been incurred in securing 
 those revenues. Tlie balance of this account may 
 then be transferred to an account called ^'Income." 
 
 Similarly, to Income should be added normal 
 revenues from outside operations, like interest and 
 dividends on investments, and rents on real estate. 
 The balance of Income may then be transferred to 
 Profit and Loss, and there meet all extraordinary 
 gains, such as that assumed above on real estate. 
 
 These three accounts together give a complete 
 statement of the business of the year, showing how 
 far the business is successful in its primary opera- 
 tions, how far outside interests affect its profits, and 
 how much extraordinary relations have yielded it 
 profit or caused it loss. Many business men deem it 
 wiser in the case of extraordinary profit, such as that 
 assumed above on real estate, to carry the gain 
 directly to surplus or reserve accounts, and thus 
 avoid the temptation to distribute it as dividends: 
 they think that this should always be reserved and 
 held available to cover extraordinary losses and by 
 so much relieve the ordinary earnings from the 
 necessity of contributing to such reserves. This is 
 a matter of administrative policy which affects the 
 accounts only as the accounts must register it. 
 
 When we turn .to the other side of this aspect of 
 extraordinary circumstances and look at losses, we 
 
PEOFITB 303 
 
 see even greater need of making distinctions. If, 
 instead of an increase in value of real estate, the 
 business which we were just discussing should find 
 that its property had fallen heavily in value because 
 of changed business conditions, and that it could 
 no longer transact its business in the old quarters, 
 it would probably be forced to purchase or hire new 
 property at far greater expense than could be cov- 
 ered by the sum realized from the sale of the old. 
 This loss ought not to be charged as expense of the 
 year just passed, however; it would be a loss of capi- 
 tal, and would have no relation to the profits of the 
 year. Though this loss in the value of real estate 
 might amount to $100,000, the profit of the year 
 might still be $20,000; for the actual profits of con- 
 ducting operations are not affected by changes of 
 values not produced by tJiose operations. It might 
 be true that if the business were obliged to sacrifice 
 many of its assets in the purchase of the new real 
 estate required, its profits in succeeding years 
 would be very much lower, for it might not then 
 have enough working capital; but that fact would not 
 in the least alter the situation for the year just 
 past. The profits of this year would still be $20,000; 
 and the shrinkage for the future would be due to a 
 loss of capital assets because of changing conditions, 
 and to that only. It is feasible for a concern which 
 has suffered such a loss to distribute its $20,000 earn; 
 ings in the form of a dividend. It ought, however, 
 in doing so, to point out to all stockholders that, 
 although this is an earning, the enterprise has suf- 
 fered a loss of capital to the amount of $100,000. The 
 stockholders may prefer to forego dividends for a 
 
304 ACCOUNTING AND AUDITING 
 
 while and to restore their capital out of earnings. In 
 many cases this would be done. What shall be done, 
 however, is a matter of policy; and accounting has 
 only to record the facts. The accounts must show 
 the shrinkage of capital until capital is restored. If 
 the surplus, or reserves, are not large enough to 
 cover the shrinkage, a deficit must be shown on the 
 balance sheet — ^unless, indeed, the amount of capital 
 stock is reduced by calling in stock and issuing either 
 fewer shares or shares at a lower Dar value. 
 
CHAPTER XII 
 
 THE INCOME SHEET 
 
 We saw long ago that it is convenient to use the 
 trial balance as a basis for a six-column statement 
 which shall show profits and losses and resources and 
 liabilities. The loss and gain columns of a six- 
 column statement may in a sense be called the * in- 
 come sheet.'' As already suggested, however, cor- 
 porations making reports to their stockholders do 
 not usually use this form, but substitute a different 
 arrangement of the items. We saw in'the last chap- 
 ter that it is desirable to distinguish on the books 
 between different sorts of gain, and we may well 
 continue the distinction through the income sheet. 
 A good income sheet will make it possible to com- 
 pare the gross gain from the primary business with 
 the cost of conducting that business, so as to show 
 the ratio of net profit of that primary business to 
 the amount of business done; it should show the 
 income from external sources of revenue, so that 
 these may be compared with the investment in exter- 
 nal enterprises; it should show extraordinary and 
 chance losses and gains; and, finally, it should show 
 not only what is the final net income but what is done 
 with it, — that is, how much is distributed as divi- 
 dends and how much is laid aside for surplus or for 
 special funds. An income sheet is good or bad in 
 
 305 
 
 A & A-20 
 
306 ACCOUNTING AND AtJDiTlNa 
 
 form just in the degree by which it shows clearly the 
 relations between these various elements of loss and 
 gain. 
 
 An income sheet may take the form of either a 
 table or a group of accounts. We have seen that in 
 ledger accounts no subtraction is ever made. An 
 income sheet presented in ledger form, therefore, 
 will show three separate accounts, each with its bal- 
 ance added to the contrary side. A sheet constructed 
 on the tabular method, however, will show subtrac- 
 tions and no transfers of balances. Let us take first 
 the ledger form. If a corporation is engaged prima- 
 rily in trading, the first part of the income sheet is 
 usually called the ^^ Trading Account;" if in a manu- 
 facturing and selling business, this part is called the 
 ** Manufacturing and Selling Account;" if in render- 
 ing services, as is a railroad corporation, this part is 
 called the ** Operating Account." 
 
 It is not usually necessary to place the items com- 
 ing from outside sources of income in an account 
 entirely by themselves, for the addition to these of 
 the net balance of the Trading Account, the Manu- 
 facturing and Selling Account, or the Operating 
 Account, is usually desirable in the end, and intro- 
 duces no confusion. This combined account is usually 
 called the ^* Income Account." Its first item is 
 usually the net balance brought down from the Trad- 
 ing Account (or other account for primary income) ; 
 to this credit balance are added all other sources of 
 income; and all expenses or losses from normal out- 
 side relations are charged to this account. The net 
 balance of the Income Account is then carried as the 
 first item to Profit and Loss. 
 
THE INCOME SHEET Sor 
 
 To Profit and Loss, after the balance of Income 
 has been brought down, may be carried income from 
 extraordinary sources, — which may or may not be 
 available for dividends, according as the directors 
 vote to distribute that extraordinary gain or carry 
 it to surplus. If this is not destined for dividend 
 purposes, it should be carried at once to surplus. 
 Debited to Profit and Loss, of course, are extraordi- 
 nary losses, dividends declared, and any sums trans- 
 ferred to special reserve accounts. Unless the profit 
 and loss accoimt is to be used as a surplus or 
 deficit account, it will disappear in closing the books 
 at the end of the year. If it is so used, a balance 
 on the credit side is surplus, and on the debit side 
 is deficit. To use it as a surplus account is undesir- 
 able, however, for when it is so used no account shows 
 as a balance the net gain or loss for a single year. 
 The net gains or losses for each year are lost in the 
 mass of general profit and loss balance and must be 
 picked out if they are to be known. Profit and Loss 
 may better be opened afresh and closed for each 
 year ; any balance should be carried to Surplus or to 
 Deficit. 
 
 This Surplus or Deficit is clearly a connecting 
 link between the income sheet and the balance sheet. 
 The income sheet is intended to show gains or losses 
 occurring during the year, and the balance sheet to 
 show results at the end of the year. So far as gains 
 are not distributed, or are distributed in excess of 
 revenue, the balance remains at the end of the vear 
 and therefore belongs on the balance sheet. 
 
 This ledger form of income sheet is shown below: 
 
kCCOVmim AND AtJDiTINft 
 
 TRADING ACCOUNT 
 
 Purchases 
 
 525,000 Sales 
 
 
 
 675,000 
 
 Wages and salaries 
 
 Expenses 
 
 Bad debts 
 
 50,000 Inventory 
 25,000 
 3,000 
 
 
 
 100,000 
 
 Depreciation 
 Balance 
 
 5,000 
 67,000 
 
 
 
 
 
 675,000 
 
 675,000 
 
 
 INCOME ACCOUNT 
 
 
 
 
 Losa on mortgage 
 Balance 
 
 2,000 Balance Tra( 
 
 68,000 Interest and 
 
 ling Acc't 
 Dividends 
 
 67,000 
 3,000 
 
 
 70,000 
 
 70,000 
 
 
 PEOFIT AND LOSS 
 
 
 Loss by defalcation 
 
 10,000 Balance Income Acc't 
 
 68,000 
 
 Dividends 
 Depreciation fund 
 
 50,000 Surplus 
 10,000 
 
 
 
 2,000 
 
 
 70,000 
 
 70,000 
 
 In the case above, the loss on the mortgage is 
 considered to be normal, incidental to outside opera- 
 tions, and is therefore charged to income. The loss 
 by defalcation, however, is considered to be extra- 
 ordinary and therefore not charged to either Trad- 
 ing Account or Income Account. It reduces the 
 amount of surplus; for if this defalcation had not 
 occurred Surplus would have been credited $8,000, 
 whereas it is actually debited $2,000. The total in- 
 crease in reserve (after dividends have been pro- 
 vided for) is actually $8,000,— $10,000 is added to the 
 depreciation fund, but of this only $8,000 has come 
 from revenue, for $2,000 has been transferred from 
 the general surplus. 
 
 Now let us see the same income sheet arranged 
 in tabular form. 
 
5,000 
 
 
 
 508,000 
 
 3,000 
 2,000 
 
 67,000 
 
 
 1,000 
 
 
 68,000 
 50,000 
 
 10,000 
 10,000 
 
 18,000 
 20,000 
 
 THE INCOME SHEET 309 
 
 Sales $575,000 
 
 Purchases $525,000 
 
 Inventory . 100,000 
 
 Cost of goods sold , $425,000 
 
 Wages and salaries 50,000 
 
 Expenses ^ 25,000 
 
 Bad debts 3,000 
 Depreciation 
 
 Cost of sales 
 
 Trading profits 
 Interest and dividends on investments 
 Loss on mortgage 
 
 Other income 
 
 Net income, available for dividend 
 Dividend 
 
 Surplus for the year 
 Loss by defalcation 
 Added to depreciation fund 
 
 Net reduction of general surplus 2,000 
 
 These figures are the same as the others, and 
 show the same groupings, but they form a single 
 series, with both additions and subtractions, where- 
 as the others were split up into distinct accounts 
 with many contra items. 
 
 Very few corporations publish income sheets of 
 much value to one who is trying to interpret the 
 accounts from the outside. It is common for corpor- 
 ations to combine operating expenses, taxes, and 
 depreciation, and to subtract them in one lump sum 
 from the gross earnings. The result is a figure 
 which is virtually unmeaning.' Taxes are to great 
 extent independent of management, and their com- 
 bination with operating expenses, which are much 
 affected by good or bad management, produces a 
 figure which means neither one thing nor the other; 
 for it is an adequate test neither of the government 
 
310 ACCOUNTING AND AUDITING 
 
 demands on the corporation, nor of the economy of 
 management. Since, moreover, depreciation allow- 
 ances are, as we have seen, largely a matter of judg- 
 ment, and here they are not shown independently, 
 we know from these figm'es really nothing about the 
 policy of the corporation in this very important 
 particular. A fundamental principle of good report- 
 ing is that items which are the result of different 
 kinds of activity shall be kept separate. An income 
 sheet, to be of any value to a reader, must show the 
 operating figures absolutely independent of other 
 figures; then the reader may compare the total ex- 
 pense of operation with the total gross earnings, and 
 learn about what percentage is maintained between 
 the two. 
 
 The Interstate Commerce Commission, which is 
 by law authorized to prescribe the forms of report 
 for railroads, arranges the consolidated income fig- 
 ures for each railroad so that we see things in their 
 natural relations. The first figure is the gross earn- 
 ings from operation — which includes all earnings 
 coming from the direct operation of the road inde- 
 pendent of income from extraneous sources. The 
 next item is so-called operating expenses, which may 
 be defined as those expenses incurred in acquiring 
 the gross earnings previously shown. The difference 
 between these two figures is the **net earnings." It 
 is customary for persons attempting to judge of a 
 railroad's activity to find what is called the ^^operat- 
 ing ratio" — that is, the percentage between the 
 operating earnings and the operating expenses. On 
 some roads this percentage will run higher than 
 eighty, on others lower than fifty. On most roads 
 
THE IlSrCOME SHEET 311 
 
 it falls between sixty and seventy-five. If we know 
 the road to be in a part of the country where the 
 expense of maintenance, because of the climate and 
 level roadbed, is small, and where labor and fuel are 
 inexpensive, we expect to find a rather low operating 
 ratio. Unless, indeed, we know a road to be excep- 
 tionally well kept, or to be recovering from a period 
 of deficient maintenance, Ave suspect at once that 
 an operating ratio of seventy-five per cent, indi- 
 cates wastefulness in operation. If, on the other 
 hand, we find a road whose expenses are inevitably 
 large — because of the nature of the country through 
 which it runs, of the expense of its fuel (perhaps 
 because of long hauls), and of the high rates of 
 wages, — w^e are a little suspicious of an operating 
 ratio of lower than sixty per cent.; we suspect at 
 once that false economy has led to failure to keep 
 the roadbed and the equipment in good condition. 
 These illustrations are intended not to pass judg- 
 ment on railroads, but to indicate that the figures 
 desired on an income sheet are those that can be com- 
 pared, — that is, figures pertaining to the same thing, 
 as, here, earnings from operation and expenses of 
 operation. 
 
 Recently the Interstate Commerce Commission 
 has required roads to distinguish between strict 
 transportation operations • and other operations. 
 Consequently the operating revenues and operating 
 expenses heretofore treated each as one item now 
 comprise two items and the net result is shown for 
 both transportation operations and outside opera- 
 tions. These results recombined show net revenue. 
 
 From this net revenue is subtracted taxes. Until 
 
312 ACCOUNTING AND AUDITING 
 
 lately taxes were taken out only after other income 
 had been added. They are now deducted at this 
 point because primarily they are fixed operating 
 charges. 
 
 The next item on an Interstate Commerce Com- 
 mission income sheet is usually ^* other income." 
 This includes rents earned, interest on bonds and 
 dividends on stock owned by the road, and any in- 
 come from miscellaneous sources. The sum of the 
 net revenue and the other income produces gross 
 income. 
 
 We have now to subtract the expenses or costs 
 independent of operation — such, for instance, as 
 interest on bonds issued by the road itself. The 
 remainder is *'net income." Not many years ago 
 some roads were in the habit of reporting their own 
 declared dividends in a lump sum with interest on 
 their bonds. From one point of view these things 
 are similar, but from another they are widely un- 
 like, for bond interest is obligatory, whereas the 
 payment of dividends is voluntary; and the only 
 means we have of judging how far the distribution 
 of dividends* is justified is to see what relation they 
 bear to the amount available for dividends. All 
 involuntary expenses not already provided for should 
 be subtracted from gross income before voluntary 
 payments like dividends are introduced to confuse 
 the result. When taxes were included in this group 
 of expenses, the group as a whole was usually called 
 '* fixed charges," for these would usually continue 
 even if the road ceased operation. 
 
 The net income is of course available for divi- 
 dends. From this the dividends are subtracted, and 
 
THE INCOME SHEET 313 
 
 t) if J balance is surplus for the year. This surplus may 
 be reduced or eliminated by transfer to separate 
 reserve accounts or to the general surplus. An in- 
 come sheet constructed by this method is shown 
 below. 
 
 Gross earnings from transportation 
 Operating expenses for transportation 
 
 
 $32,046,656.56 
 20,545,533.12 
 
 Net transportation earnings 
 Expenses of outside operations 
 Receipts from outside operations 
 
 $412,859.64 
 336,509.44 
 
 11,501,123.44 
 
 Deficit from outside operations 
 
 
 76,350.20 
 
 Net revenue 
 Taxes 
 
 
 11,424,773.24 
 867,209.03 
 
 Net operating income 
 Other income 
 
 
 10,557,564.21 
 1,632,659.89 
 
 Gross income 
 Interest, rentals, etc. 
 
 
 12,190,224.10 
 9,881,088.47 
 
 Net income, available for dividend 
 Dividends paid 
 
 
 2,309,135.63 
 519,742.12 
 
 Surplus for the year 
 
 
 1,789,393.51 
 
 The form of income sheet just illustrated does 
 not cut up the total into groups quite similar to those 
 previously described, but it produces the result there 
 sought. In every case the accountant must decide 
 what is the clearest form. Persons not familiar with 
 bookkeeping are likely to be puzzled by the balances 
 transferred from side to side in the ledger form, 
 and therefore income sheets for general publication 
 are likely to serve their purpose best when pre- 
 sented in a single table, as above and on page 309. 
 
 For corporations engaged not in earning profits 
 but in administering funds for general w^elfare, such 
 as public libraries, hospitals, etc., income from ex- 
 traordinary sources — ^legacies, for instance — ought 
 
314 ACCOUNTING AND AUDITING 
 
 to appear in connection with the income sheet be- 
 cause if unrestricted they affect the total amount 
 which these institutions may currently expend for 
 public good. Yet if these legacies are not needed 
 for current expenses, they may be added to capital. 
 Both possibilities should show. For such institutions, 
 therefore, the income sheet is far more complicated 
 than for the ordinary type of commercial enterprise. 
 In any case it must be realized that income from 
 whatever source if not paid out in dividends or 
 absorbed by expenses must go ultimately to swell 
 a balance on the balance sheet; and, therefore, we 
 shall find the income sheet and the balance sheet 
 tied together by one common item in spite of the 
 fact that usually an income sheet may be said to 
 contain only nominal figures and a balance sheet to 
 contain only real figures. This common item arises 
 from the fact that the final balance of income is in 
 one sense no longer nominal, for it has become real 
 when at the end of the year the books are closed and 
 the amount remaining is carried as a claim of the 
 stockholders to property in the business. This 
 surplus (or reserve, or undivided profits, or balance 
 of profit and loss) belongs to the stockholders as 
 much as any items credited to any creditor of the 
 company; it differs from capital stock, which is recog- 
 nized as a liability, only in that the capital stock 
 belongs to individual stockholders, as shown by cer- 
 tificates of stock stating how much each stockholder 
 owns, whereas these surplus accounts represent sums 
 not yet divided among the stockholders but held for 
 stockholders as a whole. 
 
CHAPTER XIII 
 
 THE BALANCE SHEET 
 
 Let US now examine the balance sheet and see in 
 what form it will give the maximum information 
 about the condition of a business. The purpose of 
 the balance sheet, as we have seen, is to show the 
 amount of property in the business, or, primarily, its 
 solvency, — that is, how far its property is in excess 
 of the claims against it. With this fact in mind it is 
 easy to see that the sheet should be so arranged as 
 to indicate not only what is the ultimate solvency — 
 that is, how much in the course of time may be 
 realized on property as an offset against debts, — 
 but also how much of the property can be converted 
 at once into a medium for paying debts. Many a 
 corporation which has proved perfectly sound, when 
 given all the time it wanted to make collections and 
 to sell a part of its property, has been forced into 
 bankruptcy because its liabilities were immediate 
 and its assets were rather remote. In those cases 
 bankruptcy was simply a legal device to extend the 
 time for paying debts. In many such cases every 
 cent of indebtedness was paid. A balance sheet does 
 not really perform its services, therefore, unless it 
 presents items so arranged that one may see by it 
 what are called quick assets and compare them with 
 current liabilities. Indeed, the balance sheet will 
 
 315 
 
316 ACCOUNTING AND AUDITING 
 
 serve its purpose best if it is cut up into several 
 groups of items. The arrangement of these groups 
 may depend in part upon the purpose for which this 
 particular balance sheet is presented. A person who 
 is thinking of investing in a business, for example, 
 is concerned quite as much with its ultimate solvency 
 as with that which is immediate; but a person who 
 is thinking chiefly of lending to it is concerned more 
 with its immediate solvency. On general principles, 
 however, persons examining a balance sheet are 
 concerned much more with the really ultimate value 
 of the property than with its immediate use, and, 
 therefore, they are usually interested primarily in 
 its capital items. For that reason the capital items, 
 which constitute a group by themselves, are usually 
 placed first; these are followed by the current items; 
 then usually by items accrued, though not yet due; 
 and, finally, by items which are more or less subject 
 to chance, and may be called *' contingent." Let us 
 analyze a balance sheet with this grouping in mind 
 and observe its arrangement. 
 
 The first group, or capital items, on the assets 
 side comprises the fixed property, — such as real 
 estate, plant and machinery, permanent investments, 
 etc. The capital liabilities are not only capital stock, 
 or proprietor's investment, but also funded debt, or 
 bonds and mortgages running for a term of years. 
 Very commonly funded debt is actually permanent 
 though nominally it has a limited term; for most 
 corporations pay off debt by borrowing anew. In 
 many lines of business capital assets and capital lia- 
 bilities are nearly equal. The reason for this corre- 
 spondence lies in the fact that the primary function 
 
*HE BALAKOE SHEE* Si* 
 
 of capital is to furnish the means with which busi- 
 ness is carried on, and in many lines of business the 
 chief means is permanent property. A certain excess 
 of capital, however, is usually necessary in the form 
 of what is called ' 'working capital," or property 
 which is available immediately for current use. It 
 is likely to happen, therefore, that the capital liabili- 
 ties will be in excess of the capital assets, the differ- 
 ence being just this working capital. That is not 
 always the case, however, because, as we have seen, 
 siu*plus may have been accumulated, and this surplus 
 may have been invested in the form of capital assets, 
 such as real estate, stocks, and bonds. In that case, 
 of course, the capital assets will be actually in excess 
 of the capital liabilities, that excess arising from 
 surplus which is really capital, though not usually 
 included in the capital group of liabilities. Surplus, 
 indeed, will usually stand on a balance sheet in a 
 group by itself, for it may be either capital, if in- 
 tended to be permanent, or current, if temporarily 
 set aside with the intention of distributing it later 
 as dividends. 
 
 The current items would include usually on the 
 assets side Bills Eeceivable, Accounts Receivable — 
 as customers' accounts are commonly called — and 
 cash. Each particular line of business is likely to 
 have its own current assets slightly different from 
 those of other lines; a railroad, for instance, will have 
 sums due from other roads, and collections due from 
 agents and conductors. The current liabilities, on 
 the other hand, will include Bills Payable, Accounts 
 Payable — or sums due to creditors, — and other items 
 peculiar to different lines of business — such, for a 
 
318 ACCOUNTING AND AUDITING 
 
 railroad corporation, as sums due to other roads, and 
 audited claims. The position of supplies and ma- 
 terials on a balance sheet varies with different lines 
 of business and with different firms in the same line. 
 Some accountants assert that since a minimum of 
 supplies and materials, such as raw cotton in a cotton 
 mill, pig iron in a foundry, etc., is essential to the 
 conduct of business, such minimum is of the nature 
 of capital assets and should be so classified on the 
 balance sheet. Other accountants believe that, though 
 supplies are required for the conduct of business, 
 they can be so Teadily converted into cash that they 
 are equivalent to current assets, — even though there 
 is no intention of selling them. Indeed, the position 
 of these items is dependent, like a great many other 
 things in accounting, on the point of view. If we are 
 considering the business as an earning machine 
 whicn IS to go on, supplies are of the nature of cap- 
 ital, no doubt, and yet they are not permanent, as 
 we usually expect capital items to be. They are 
 working capital. If, on the other hand, we are con- 
 sidering the balance sheet chiefly as it throws light 
 on immediate solvency, the supplies are current 
 items, though presumably they cannot be sold for 
 cost if their sale is forced. The real purpose of the 
 current group of items in the balance sheet is not so 
 much to distinguish what can be immediately con- 
 verted into cash as to show those items which in the 
 ordinary conduct of the business can be turned over 
 readily for the purposes of the business; and surely 
 materials and supplies are quite as available for the 
 ordinary conduct of the business as are Bills Re- 
 
THE BALANCE SHEET ^ 319 
 
 ceivable and Accounts Receivable. For that reason 
 it seems best to place them in the current group. 
 
 The next group of items, which we may call 
 *^ accrued/' may be said in one sense to belong among 
 the current items. The real distinction between 
 these two groups lies in the fact that the current 
 items have been already entered on the books prior 
 to or at the date shown for the balance sheet as a 
 whole. The accrued items, however, are not sup- 
 posed to be entered at that time, for they have not 
 reached the period of culmination. To consider the 
 current items as a whole, therefore, we must really 
 add all accrued items to those contained in the cur- 
 rent group; the total will be the assets immediately 
 or soon available and the liabilities immediately or 
 soon to be satisfied. On the assets side the accrued 
 items may be rents, interest, and other earnings, 
 which the lapse of time has made good claims of the 
 company, though they are not yet due; and on the 
 liability side the same sort of items (usually includ- 
 ing taxes) will appear as accrued against the com- 
 pany, though they are not yet payable. 
 
 Concerning the treatment of the last, or contin- 
 gent, group of items, much difference of opinion has 
 arisen. If a small corporation has guaranteed large 
 liabiKties for some other corporation, that guarantee 
 may at some time prove a heavy drag on the guaran- 
 teeing company, and should therefore be reported 
 even though there is little probability that it will 
 ever cause trouble. It is rather common, for illus- 
 tration, for railroads to guarantee the bonds of their 
 subsidiary lines. Usually the subsidiary line is ex- 
 pected to earn enough to pay its own debts; but if 
 
the investing public has not faith in it, the control- 
 ling corporation may undertake to create a good 
 market for the obligations of the subsidiary line by 
 guaranteeing the payment of interest, or of both 
 interest and principal. These guarantees ought to 
 be reported in some form. A common device is to 
 report them at the bottom of the balance sheet as 
 contingent items on the liability side. As an offset 
 against these, so that the total liabilities of the whole 
 sheet shall not exceed the assets, it is possible to 
 report as an asset the claim which the railroad has 
 against the subsidiary road in case the guarantee is 
 fulfilled. This is satisfactory if it is true that the 
 asset reported in the contingency group is an ade- 
 quate offset to the liability. This often, however, is 
 not the case, and the road which offers the guarantee 
 gets in return for that guarantee simply a claim 
 against the earnings of the controlled road, and this 
 claim is not properly susceptible of statement as an 
 asset in quite the same terms as the liability which 
 it is supposed to cover. It is far better, then, instead 
 of reporting the contingent liability with other lia- 
 bilities, offset by an arbitrary asset on the other side, 
 to leave off the contingent item entirely from the 
 balance sheet and mention it in a foot-note with a 
 statement of the claim which justifies it. 
 
 Another sort of contingent item rather common 
 is that for notes endorsed and discounted, or sold to 
 another firm. Frequently, for instance, banks in the 
 large cities have made upon them more demands for 
 loans than they can well supply out of their own 
 funds, and at the same time banks in districts re- 
 moved from financial centers have more funds avail- 
 
THE BALANCE SHEET 321 
 
 able for loans than the demands of the communities 
 absorb. A natural combination is made, and banks 
 having many requests for loans sell to their corre- 
 spondents in other places some of the notes which 
 they have purchased at a discount, and by that means 
 utilize the funds otherwise lying idle in the vaults of 
 their correspondents. In other words, the banks 
 rediscount the notes which they themselves have 
 discounted. Usually in this case the banks which 
 took the notes originally and knew about the people 
 to whom the loans were made guarantee payment to 
 the banks which purchased these notes from them. 
 This guarantee is of the nature, then, of a contingent 
 liability of the large bank; but it is offset by the claim 
 which the bank has and believes to be good (else it 
 would not have made the loan) against the people to 
 whom the loan was originally made or ac:ainst the 
 endorsers of the notes. It is customary, therefore, 
 for national banks to report among their liabilities 
 notes rediscounted, and at the same time to include 
 in their loans (that is, their claims against business 
 houses for loans made) these same notes sent to 
 their correspondents for rediscount. The result is 
 that these notes appear on both sides of the balance 
 sheet. This device shows all the facts, and indi- 
 cates properly what assets offset the contingent lia- 
 bilities. Similarly, business houses that have dis- 
 counted with banks notes received from their cus- 
 tomers should show their liabilities for ultimate pay- 
 ment if their customers default. Such discounted 
 notes may well appear on both sides of the balance 
 sheet as contingent items. If the makers of these 
 notes default, the business must pay, and hence the 
 
 A&A-21 ^ ^' 
 
Sn ACCOUNTING ANJt) AUDITING 
 
 liability is contingent; but in that case the notes 
 revert to the business and become an asset on which 
 it will collect if it can. This method of statement 
 shows just how much is outstanding. The probable 
 losses from this source are intended to be covered 
 by Allowance for Bad Debts among current liabili- 
 ties (counted as current because it offsets certain 
 current assets). 
 
 In municipal accounts it is rather common for 
 contingent items to appear because often cities re- 
 quire that contractors shall make deposits in the 
 nature of guarantees that they will carry out prop- 
 erly their contracts for street construction and other 
 public work. If the contracts are properly ful- 
 filled, these sums deposited must be repaid; if not, 
 they will be used to offset the loss which the city 
 suffers from the failure of the contractor to per- 
 form his work properly. Usually, therefore, they 
 are only loans to the city. On the other side of a 
 municipal balance sheet there are likely to be items 
 of taxes so long due that there is probability that 
 they will never be collected. It is thought unwise 
 to write them off as uncollectible, and equally un- 
 wise to include them among current assets. The 
 contingent group on a balance sheet furnishes a con- 
 venient place for reporting items of this sort. All 
 contingent items must be judged with due consid- 
 eration of the nature of the contingency. 
 
 Attention has already been called to the fact 
 that normally one item on the balance sheet is de- 
 rived from the income sheet. The surplus, as shown 
 by the income sheet, is a liability of the company to 
 stockholders, and must be reported as such. As 
 
THE BALANCE SHEET 323 
 
 appearing on the income sheet, however, it is re- 
 lated only to the particular year in question; but if 
 any surplus has been accumulated in preceding 
 years, the surplus for the current year added to the 
 surpluses of other years will produce a new total 
 which will appear on the balance sheet, and, there- 
 fore, the figure on the balance sheet will be different 
 from that on the income sheet. The surplus on the 
 income sheet, in other words, is a surplus from one 
 year, but the surplus on the balance sheet is an 
 accumulated surplus of all years. The same thing 
 is true with regard to deficits, of course, for both 
 income sheet and balance sheet may have deficits as 
 well as surpluses; and a deficit on the income sheet, 
 combined with a larger surplus on last year's bal- 
 ance sheet, still leaves a surplus for this year's bal- 
 ance sheet, whereas a deficit on the income sheet, 
 combined with a deficit on last year's balance sheet, 
 produces a larger deficit on this year's balance 
 sheet, and a deficit on the income sheet, combined 
 with a smaller surplus on last year's balance sheet, 
 produces a deficit on this year's balance sheet. As 
 was indicated in the last chapter, moreover, a deficit 
 on the balance sheet is still consistent with one kind 
 of surplus on that sheet. A surplus, as we saw, may 
 originate not only out of profits, but from a contri- 
 bution of capital, as when stock is sold at a pre- 
 mimn; and a deficit raay have originated in either 
 operations or extraordinary outside losses ; so if both 
 have occurred, confusion should be avoided by report- 
 ing them separately. The desirable thing is to report 
 them not only so that each shall be clearly shown, but 
 so that each shall be read in connection with the other. 
 
S24 ACCOUNTING AND AUDITING 
 
 If both must appear, therefore, one as a surplus capi- 
 tal contribution, and the other as an operating deficit, 
 each should have an appended note calling attention 
 to the extent of the other ; otherwise a careless reader 
 of the report may be much impressed by one and fail 
 to observe the other. 
 
 In the minds of many persons, a balance sheet is 
 confused with a statement of resources and liabili- 
 ties. Theoretically, a balance sheet and a statement 
 of resources and liabilities are the same thing; but 
 practically they are not always so. A balance sheet 
 ought theoretically to show not only what is the 
 exact state of affairs, but what is the exact condition 
 of the books; and yet not always can the books 
 show for each particular branch of the business just 
 what is the state of affairs. It is impossible, for 
 instance, to reduce on the books the amount of 
 claims against customers; and yet the accountant 
 may believe that possibly five per cent, of those 
 claims will never be paid. The bookkeeping diffi- 
 culty is that he is never sure which particular claims 
 will fail of payment, and, therefore, he cannot be 
 sure which accounts ought to be written off. He 
 must still maintain those claims on his books at the 
 full value, though he knows that as a whole they 
 will yield only ninety-five per cent, of the full value. 
 A device must be provided therefore to reduce 
 assets by the amount of expected shrinkage in these 
 claims; and yet if that reduction is made by sub- 
 tracting from any figure of assets, the balance sheet 
 is out of accord with the books. We saw long ago 
 that subtraction is practically never performed in 
 
THE BALANCE SHEET 325 
 
 bookkeeping, and, therefore, we fall back on the 
 device of increasing the other side. The desirable 
 thing to do here, therefore, is to show on the credit 
 side an account representing the probable loss from 
 bad debts, and consider this a liability of the busi- 
 ness. This is commonly called ''Reserve for Bad 
 Debts." Its appearance on the liability side of the 
 balance sheet indicates that the business is respon- 
 sible to make good this shrinkage, and that the 
 amount has been subtracted from income to satisfy 
 that responsibility. In a sense this liability is quite 
 as much a subtraction from assets as is the liability 
 to creditors from whom purchases have been made. 
 No one objects to reportirig the assets at the nom- 
 inal figure, even though heavy liabilities are out- 
 standing, if only the liabilities are properly shown 
 on the balance sheet. So when it is realized that 
 this reserve for bad debts is exactly similar in nature 
 — so far as the responsibility of the business is con- 
 cerned — to debts due outside creditors, this form 
 of reporting probable shrinkage in claims against 
 customers is unobjectionable. The only difficulty in 
 this connection is that this is just what some per- 
 sons are unable to realize. They are in danger of 
 believing that this reserve for bad debts is simply 
 profits set aside as an extra reserve fund for safety's 
 sake, and that it probably will never be needed for 
 the purpose designated. In such a case, obviously, 
 the amount will be thought to be a sort of contingent 
 siu^plus; whereas, as a matter of fact, this amount 
 must be made good not out of the profits but out of 
 product, — that is, there can be no profits until this 
 amount has been covered. For this reason it would 
 
326 ACCOUNTING AND AUDITING 
 
 be better to call this account ' 'Allowance for Bad 
 Debts." This suggests the fact that it represents 
 a probable loss. 
 
 The difficulty just suggested with regard to re- 
 serve for bad debts is found almost universally in 
 interpreting balance sheets w^herever the one who 
 reads the sheets is not quite familiar with the ac- 
 counting policy of those who construct them. There 
 is no uniformity of custom with regard to reserve 
 accounts appearing as liabilities on balance sheets 
 of corporations. Some corporations set aside annu- 
 ally from profits a sum which they entitle '^ Reserve 
 for Depreciation." This is merely profits which are 
 held back in order that the corporation may be on a 
 secure footing, so that in case of inventions dis- 
 placing machinery it may have a fund available 
 for making good that loss; but such inventions are 
 not expected, and such depreciation is not believed 
 to be really necessary, — it is pure profit held for an 
 improbable contingency. Other corporations, on 
 the other hand, do not, with the progress of depre- 
 ciation, reduce the book valuation of their prop- 
 erty, but think they have made adequate provision 
 for such depreciation by establishing among their 
 liabilities a reserve account which measures the 
 amount of depreciation of assets. That is, they have 
 deliberately and intentionally, and they believe jus- 
 tifiably, left on their books as a valuation of assets 
 a higher figure than is real, and have attempted to 
 offset this overstatement of assets by establishing 
 on the liability side of the accounts an item measur- 
 ing the depreciation. To put this in another way, 
 knowing, as they do, that a credit is an offset to a 
 
THE BALANCE SHEET 327 
 
 debit, and that the balance between them is the 
 actual figure of property, they leave their asset 
 accounts at the original figures and credit a reserve 
 account for the amount of depreciation. It is true 
 that by combining the asset account and the reserve 
 account one does produce a figure which is the exact 
 value of the property; but unless one knows that 
 this reserve account is merely a sum to be deducted 
 from assets and is not, as it appears to be, a sum set 
 aside out of profits, one is likely to be misled in 
 one's judgment of the value of the property owned. 
 Such a depreciation account or depreciation reserve 
 must, like our reserve for bad debts just discussed, 
 come out of product before there is any profit; 
 whereas the other kind of reserve for depreciation 
 suggested a moment ago — a mere labeling of profits 
 to show that they are to be kept for a remote con- 
 tingency — is an indication that the assets of the busi- 
 ness are intact, and are by the amount of this account 
 greater than the amount of capital subscribed. It 
 is unfortunate that such differences of accounting 
 methods prevail among corporations; the only con- 
 clusion we can draw is that one must know what is 
 represented by any such reserve account before one 
 is in a position to tell even from the company's own 
 books what is the value of property on hand. 
 
 A so-called statement of resources and liabilities 
 differs from a balance sheet in that it pretends only 
 to show supposed facts in a simple way, regardless 
 of the technicalities of bookkeeping. It will show, 
 for instance, the prohable value of accounts receiv- 
 able, rather than book figures. This seems, at first 
 thought, better than a balance sheet. The difficulty 
 
328 ACCOUNTING AND AUDITING 
 
 is that it is based wholly on someone's judgment. It 
 gives, moreover, no statement for the basis of that 
 judgment. Most business men prefer their own 
 judgments to somebody's else. They like to know 
 what the books show. Then they can make allow- 
 ances to suit themselves. "When Accounts Receiv- 
 able is shown on one side of the balance sheet and 
 Allowance for Bad Debts on the other, the reader 
 sees both the book figures and the judgment of the 
 managers. A statement of resources and liabilities 
 is a good thing to report, but it should supplement 
 and not supplant the balance sheet. In any case, 
 however, corporations should be required by law 
 to indicate clearly whether depreciation and shrink- 
 age have been subtracted from the cost of their 
 property, or have been treated as a liability to be 
 met out of earnings. The clearest form for showing 
 this is a statement of resources and liabilities which 
 shall contain not offsets, but an exact statement for 
 each kind of property, claim, and liability. The pub- 
 lication of such a statement with the balance sheet 
 gives very satisfactory information about a business. 
 It is often a great convenience to have a balance 
 sheet so arranged that a comparison may be made at 
 a glance with the sheet for the preceding year. The 
 use of such a comparison will be discussed in the 
 next chapter. Sometimes new accounts are opened 
 each year for property subject to constant change. 
 An account might be kept, for example, to contain 
 additions to plant. These new accounts may then 
 be reported on the balance sheet as distinctly be- 
 longing to the year in question, and may then be 
 consolidated with the old accounts as they stood at 
 
THE BALANCE SHEET 329 
 
 the beginning of the year. This arrangement makes 
 it possible for one to see at a glance just what has 
 happened to the important accounts in the course of 
 the year's business. The result is produced quite 
 as well, however, without the maintenance of sepa- 
 rate accounts in the ledger, if only separate columns 
 are provided on the balance sheet to indicate in- 
 creases and decreases for the year just passed. 
 
 The balance sheet shown below presents all the 
 desirable devices suggested in this chapter. 
 
330 
 
 ACCOUNTI^^TG AND AUDITING 
 
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CHAPTER XIV 
 
 THE INTEEPRETATION OF BALANCE SHEETS 
 
 Certain information can be had from a balance 
 sheet standing independent of all other figures, but 
 usually we are concerned in studying such a sheet 
 to learn rather what is the course of things than 
 what is the actual present situation. Many figures 
 on a balance sheet show an outsider very little about 
 the prosperity of the business as a whole; for many 
 of these figures come, as we have seen, from a valua- 
 tion put upon property, and unless we can for our- 
 selves examine that property we are not in a posi- 
 tion to judge as to the correctness of the sheet. Tak- 
 ing any one balance sheet, therefore, we are obliged 
 usually to assume a certain degree of correctness in 
 the figures, and the correctness which we assume 
 will be determined largely by our judgment of the 
 character of the men who have made the figures. 
 When, on the other hand, we have two or more bal- 
 ance sheets, we can learn from them, if we assume 
 that the same methods are employed in getting 
 balances^ for the second sheet as for the first, what is 
 the apparent tendency of the business. We can 
 learn from such a comparison of balance sheets, for 
 instance, whether the amount of cash is increasing, 
 whether more money has been borrowed, whether 
 
 33X 
 
332 ACCOUNTING AND AUDITING 
 
 more property has be^n invested in the business, 
 whether larger reserves are maintained for emer- 
 gencies. Such comparisons are usually worth mak- 
 ing, for they enable us to learn what sort of re- 
 sources the business is accumulating and what" sort 
 of liabilities it is incurring or satisfying. For some 
 lines of business the best sign of health is an increase 
 of investment in permanent property, but for others 
 it is an increase in assets readily convertible into 
 cash. 
 
 Let us examine first the method of drawing con- 
 clusions about the general tendencies of a business, 
 and then later analyze in some detail the different 
 accounts on a balance sheet and see what light they 
 throw on solvency. We have all along seen the neces- 
 sity for a debit whenever there is a credit, and vice 
 versa. It must be true, therefore, that for every 
 expenditure some resource can be found, and that 
 for every resource utilized some destination can be 
 found; for otherwise we should have some unex- 
 plained fact on the books. Only three kinds of 
 sources are available from which expenditures can 
 be made, and only three kinds of explanations are 
 possible for the disappearance of resources. The 
 three sources from which expenditures can be made 
 are earnings — ^which do not appear on the balance 
 sheet except when a balance has been left over after 
 the payment of dividends, — items appearing on the 
 balance sheet at the beginning of the year, and new 
 investment of capital or loans during the year; for 
 since the operations of the business consist in turning 
 over its property so that profit shall be earned, notn- 
 ing has been available to spend except as it has 
 
INTERPRETATION OF BALANCE SHEETS 333 
 
 arisen from the conversion of old assets, from the 
 use of new property entrusted to the business, or 
 from revenue. Similarly, the three possible des- 
 tinations of expenditure are the cost of conducting 
 business, the payment of .liabilities as they appeared 
 on the balance sheet at the beginning of the year, 
 and the creation of new assets. Yet all six of these 
 sorts of items — three sorts of resource and three 
 sorts of expenditure — ^have effect on the balance 
 sheet; for four of them are exclusively balance-sheet 
 items, and the revenue and expense items, if they do 
 not (with the dividends) exactly cancel, must go 
 from the income sheet to the balance sheet as sur- 
 plus or deficit. So a comparison of balance sheets 
 for two years will show, except for items which 
 cancel each other (such as old bills receivable paid 
 and new ones received, or earnings paid as divi- 
 dends), a complete statement of operations for the 
 year. If, for instance, the gross profits of the year 
 have been $200,000, the expenses $150,000, and the 
 dividends $25,000, we have remaining $25,000 of 
 profits which ought to appear now not only as addi- 
 tional surplus on the balance sheet, but also some- 
 where among the net assets — either alone or produc- 
 ing a larger balance of net assets than were shown 
 a year ago. Similarly, if our liabilities are smaller than 
 a year ago, we have not fully explained the trans- 
 actions of the year just passed unless we can point 
 to the sources from which those liabilities were liqui- 
 dated. This liquidation may have come from surplus 
 profits, from some new investments of capital, or 
 from the diversion of some old assets to the annul- 
 ment of liability. It is true, of course, that though 
 
334 ACCOUNTING AND AUDITING 
 
 Bills Receivable at the beginning of the year may 
 have amounted to $50,000 and still remain c.t $50,000 
 at the end of the year, our transactions in Bills Re- 
 ceivable may have been several times that amount; 
 but this is not a matter of consequence in drawing 
 conclusions at the end of the year, for assuming the 
 notes to be equally good, our situation is not altered 
 by that fact. Such a comparison of balance sheets 
 does not show the magnitude of business done; it 
 merely shows th^ ultimate changes resulting from 
 the year's operations. Our only concern is the de- 
 creases and increases in the balance of each account. 
 The conversion of merchandise into notes, and of 
 those notes into cash, and of that cash into more 
 merchandise, is of no consequence, except so far as 
 the amount of merchandise in the end is greater 
 than that at the beginning, or so far as a profit de- 
 rived from the exchange of old merchandise for new 
 has gone into some other account. Let us now 
 attempt from two balance sheets to learn what has 
 gone on in the year which lies between them. 
 
 It is usually convenient for this purpose to 
 arrange decreases and increases in a table of two 
 columns. The first column may well be headed 
 *^ Resources Utilized," and the second, ^^Disposition 
 of Assets." The first will include the value of prop- 
 erty which the business has converted into other 
 forms, the amount obtained from outside, and the 
 amount of profits which have remained after the 
 payment of dividends — or it may include net profits 
 if the figure of dividends is entered in the other 
 column. The column headed * * Disposition of Assets ' ' 
 will include the value of all property procured by 
 
INTERPRETATION OF BALANCE SHEETS 335l 
 
 utilizing assets, the amount of debt liquidated, and 
 the amount of net loss or deficit if the business has 
 been unprofitable. It must be noted that this sheet 
 for indicating operations of an earning period is 
 not confined to dealings with the outside world, but 
 is intended quite as much to show the shiftings of 
 value from one department to another within the 
 business. It ought to show in summary form the 
 explanation of every change that has been made, — 
 and every change has not only a cause but an effect. 
 If, for instance, the cash on hand at the end of the 
 year is less than that on hand at the beginning of 
 the year, it is obvious that the business has utilized 
 a certain part of this asset, and the amount of shrink- 
 age should appear under the head of ^^ Resources 
 Utilized." (The amount of cash expended was, of 
 course, very much more than this, but since the cash 
 balance has shrunk by only this sum, the other items 
 offset one another and do not need to be explained 
 here.) Question at once arises as to what became 
 of that cash. We cannot, as a matter of fact, learn 
 from an examination of the balance sheet just what 
 this particular cash was devoted to; but we can tell 
 what were the total changes in assets and liabilities, 
 and we know that the total amount of resources 
 utilized must equal the total amount of disposition 
 of assets. We do not attempt, therefore, to label 
 this cash as devoted to any particular piu*pose; but 
 when our table is complete we shall see that this cash 
 utilized, plus other resources utilized, will equal the 
 total disposition shown by the other column. 
 
 We may now, after this illustration of the method 
 to be applied in the construction of such a sheet, take 
 
336 ACCOUNTING AND AUDITING 
 
 the principal items one by one and see how they 
 should be treated. Let us use for practice the balance 
 sheet given at the end of the preceding chapter (page 
 330) . The first item on the assets side is Real Estate. 
 We find that the comparison of this balance sheet 
 with the preceding one shows an increase in real 
 estate of $2,000. This change in value indicates not 
 Avhere the business obtained a resource to use, but 
 what it did with some resource which it either had 
 at the beginning of the year or received during the 
 year. It explains the expenditure of money. This 
 $2,000 increase in real estate, then, will be entered 
 under the head of *' disposition of assets." (See page 
 341.) If, on the other hand, the valuation of real 
 estate had shrunk $2,000, it would have been obvious 
 that this shrinkage should appear as a resource util- 
 ized; for if the value on hand at the end of the vear 
 is not so much as it was at the beginning, the man- 
 agers have either sold real estate or have consumed 
 it in the conduct of the business; in either case they 
 should have other assets to show for it — unless, in- 
 deed, the business has suffered loss, and even this is 
 a ** utilization of assets," though the unfortunate 
 utilization of a good thing to produce a bad one. 
 
 The increase in plant and machinery measures 
 also, of course, a disposition of assets, for the busi- 
 ness had to give something for that increase. 
 
 The decrease in investments shows that these 
 assets were utilized — ^that $2,000 of the good of them 
 has been exhausted. The amount is written in the 
 column headed ** utilization of resources." 
 
 Our next item is Bills Eeceivable. If the amount 
 is increased at the end of the year, as compared with 
 
mTERPRETATION OF BALANCE SHEETS 33? 
 
 the begiiming, it is obvious that the business has 
 accumulated certain property in this form, and 
 although this is now a resource, it is not a resource 
 which has 'been utilized during the year past; on the 
 contrary, some other resource must have been util- 
 ized to secure for us such an increase in bills receiv- 
 able — such as a sale of merchandise, or payment in 
 cash. In any case we know that an increase in bills 
 receivable has cost something, and since an increase 
 explains for what we have made some disposition of 
 assets, the amount should go into the disposition 
 column. In the case in hand, however. Bills Eeceiv- 
 able is found to have suffered a decrease; so it is 
 obvious that some of the notes on hand at the be- 
 ginning of the year either have been paid off, and 
 have thus brought in other property, or have been 
 written off as bad debts. Under the first supposi- 
 tion, this decrease explains the source from which 
 other property has been obtained, and under the 
 second it explains in part how the business happened 
 to have a deficiency at the end of the year; under 
 either supposition the decrease indicates a utiliza- 
 tion during the year of resources existing a year ago. 
 We write it in the first column. 
 
 The account for customers has increased $3,000; 
 that is, customers owe more than they did a year ago. 
 Clearly they do not owe for nothing: the business 
 must have given something (merchandise, of course) 
 for this asset. The increase, therefore, measures the 
 disposition of assets: it shows what has become of 
 some of the other property entrusted to the business. 
 The amount is therefore entered in the second 
 column. If, on the other hand, this account had 
 
 A & A-22 
 
338 ACCOUNTING AND AUDITING 
 
 shrunk, it would have showm that by this amount the 
 assets in the business a year ago had been utilized 
 in this year's operations. 
 
 Let us now, with these first cases in mind, get a 
 comprehensive view of the theory of this tabulation. 
 Novices at this sort of thing are usually confused at 
 first because they forget what they are seeking. The 
 purpose of this classification is to explain things 
 done in the year past. We cannot from such a table 
 see what went to any destination, for the thing is no 
 longer connected with its origin: we know only 
 where value is today. Prom the where, today, 
 we wish to learn changes in the year past, 
 A decrease in the amount of an asset today in 
 comparison with that of a year ago shows that some 
 of that resource has been utilized in the year's in- 
 terval; an increase in an asset shows that during the 
 year past some other asset must have been ex- 
 changed for this — i. e., this shows a disposition of 
 assets; an increase in liabilities shows that a resource 
 was utilized — for the business used its borrowing 
 capacity; and a liability discharged shows that assets 
 were given for payment, and therefore disposed of. 
 
 Our next item is Merchandise. Since this shows 
 a larger figure than at the beginning of the year, it 
 is obvious that the present inventory is larger than 
 the old, and therefore that in the past other re- 
 sources have been sacrificed to procure this present 
 resource. The amount of increase should go, then, 
 into the column headed ^^disposition of assets," for 
 it explains for what purpose other assets were dis- 
 posed of. If, on the other hand, the item of inventory 
 showed a decrease, it would indicate that goods on 
 
li^TEBPRETATIOK- OF BALANCE SHEETS 389 
 
 hand at the beginning of the year had been utilized; 
 so the item should go into the first column. 
 
 If this still proves puzzling to the reader, he may 
 find himself able to do his thinking more clearly if 
 he changes the titles of his columns. If, instead of 
 *^ utilization of resources," he thinks of *' where 
 got," he may see that a shrinkage of inventory 
 should go into the first column ; for it explains where 
 the business got some of the resources that it util- 
 ized. Similarly, ^' where gone" may be substituted 
 for ' ' disposition of assets. ' ' Then it is apparent that 
 an increase in inventory shows a ^* where gone" for 
 the year past; it shows what has become of some of 
 the assets entrusted to the business. So, also, in- 
 creases of liabilities show *^ where got," and de- 
 creases show *^ where gone." 
 
 Eeturning now to our balance sheet, we see that 
 a decrease in discounted notes indicates cancellation, 
 or collections, therefore ^^ resources utilized" or 
 *^ where got." Since, however, it is exactly offset by 
 a similar contingent item on the other side, we may 
 as well omit it from our table. 
 
 The deficit on operation is clearly a *^ where 
 gone. "Indeed, the sole purpose of the deficit account 
 is to show that some assets have disappeared, 
 **gone," in operation. It is also a disposition of 
 assets, for the business consumed assets in running at 
 a loss. 
 
 Let us turn now to the other side of the balance 
 sheet. The first changed item is Bonds. Since this 
 has increased, the corporation has borrowed money, 
 and a resource (borrowing power) has been utilized. 
 So the item is written in the ^^ where got" colunm. 
 
340 ACCOUNTING AND AUDlTIi^G 
 
 If, on the other hand, the amount of outstanding 
 bonds had decreased, it would have been evident that 
 some assets had been devoted to this use, and the 
 amount would have gone into the second column. 
 
 The increase in Bills Payable, similarly, shows 
 that the company has utilized one of its sources of 
 obtaining property from outside, and the amount 
 should appear in the first column. If, on the other 
 hand, the amount of bills payable had decreased, it 
 would have shown that the company had paid off a 
 certain portion of these debts, and since it could not 
 have paid them off without the giving of value, this 
 payment would have explained a disposition of 
 assets, and the amount would have appeared in the 
 second column. 
 
 The decrease in the account for creditors shows 
 that debts have been paid, and therefore that assets 
 have been disposed of. The amount shows *^ where 
 gone." 
 
 The increase in accrued interest as a liability 
 shows that the business has had the use of money 
 that it has not yet paid for, and it should have assets 
 to correspond — or the interest is a cause of the loss 
 on operations, that is, the deficit. This increase 
 shows, therefore, ^Svhere got," or utilization of re- 
 sources. It is entered accordingly. 
 
 If an operating surplus had increased, earnings 
 must have been in excess of dividends, and conse- 
 quently the company must have had this resource as 
 a means of raising necessary funds. The amount 
 would have been extended, therefore, into the first 
 column. If, on the other hand, surplus had been de- 
 creased, that fact would have meant thaf a part of 
 
INTERPRETATION OF BALANCE SHEETS 341 
 
 the assets had been disposed of in the payment of 
 dividends or repairs or some other operating ex- 
 igency, so that the undistributed profits remaining 
 would have been smaller than at the beginning of 
 the year, and the amount would have been entered 
 under ^^ where gone.^' 
 
 When all changes as shown by the comparison of 
 balance sheets have been entered as has just been 
 indicated, the amounts of the two columns should 
 correspond exactly; for not more disposition can 
 have been made of assets than has been warranted 
 by the resources utilized. If there has been no error 
 in calculation, the proof will be exact to a cent; for 
 everything has been done by double entry. 
 
 SUMMAEY OF TRANSACTIONS FOE THE YEAE 
 
 UTILIZATION OF RESOURCES DISPOSITION OF ASSETS 
 
 Investments, decrease $ 2,000 Eeal estate, increase $ 2,000 
 
 Bills receivable, decrease 5,000 Plant and machinery, increase 1,000 
 
 Bonds, increase 2,000 Customers, increase 3,000 
 
 Bills payable, increase 5,460 Merchandise, increase 4,000 
 
 Interest accrued, increase 40 Deficit, increase 2,500 
 
 Creditors, decrease 2,000 
 
 $14,500 $14,500 
 
 The real purpose of this statement is not so much 
 to get figures showing the changes in individual 
 accounts as to present in definite form a summary 
 which shall enable one to judge whether the prop- 
 erty of the business is this year in a more desirable 
 shape than it was last year. If current liabilities 
 have increased $20,000, and current assets have de- 
 creased $10,000, the situation is not so favorable as 
 it was a year ago, unless at that time available assets 
 
342 ACCOUNTING AND AUDITING 
 
 were lying idle. It is not enough, however, to know 
 merely that total cin*rent assets and total current 
 liabilities bear an improved relation to each other. 
 If a year ago a small stock of goods was on hand, 
 and this year a large stock of goods is accompanied 
 by a limited sum in cash, the business is not in quite 
 such good shape as it was a year ago — unless, in- 
 deed, it is growing faster than goods can be secured 
 and an increased stock is necessary. If a year ago it 
 had a large amount of cash and few notes and 
 accounts receivable, but this year has a small 
 amount of cash and many notes and accounts 
 receivable, the appearance is unfavorable; for it 
 seems to indicate poor collections. One must 
 realize, however, that a large increase of collectible 
 items may come from a large increase of business and 
 may accompany a shrinkage of cash; for the same 
 percentage of collections would show an increase of 
 unpaid bills, and increased purchases may explain 
 the decrease in cash. If, on the other hand, sales 
 have increased only ten per cent., but bills receivable 
 and accounts receivable have increased thirty per 
 cent., it is obvious that sales are made to a class of 
 customers less able or less willing to pay bills 
 promptly, and, therefore, the business is taking the 
 risk of heavy loss on bad debts. Generally speaking, 
 merchandise is a better asset than such debts; 
 though, of course, since profit is made generally from 
 the sale of merchandise, the desirable thing is to 
 convert merchandise into a proper number of good 
 debts ; but an increase of these debts out of relation 
 to the amount of sales and to the amount of mer- 
 chandise on hand is an indication of weakness. If a 
 
INTEEPRETATION OF BALANCE SHEETS 343 
 
 year ago the business had a small investment in real 
 estate, plant and machinery, with few bills payable 
 and accounts payable, but this year has a very large 
 investment in such assets and many bills payable 
 and accounts payable, it is obvious that those lia- 
 bilities have been incurred in the acquisition of those 
 assets; and usually this would be an unfavorable 
 sign, for it means an accumulation of liabilities ma- 
 turing soon, and only fixed assets, which might not 
 sell readily, as a means of payment. If, on the other 
 hand, it were known that money could be borrowed 
 at any time on long terms, through the issue of 
 bonds, the situation would not be dangerous. It 
 would be known in that case that the bills payable 
 and accounts payable were merely temporary and 
 that soon the balance sheet would show a disappear- 
 ance of those items and a substitution of capital lia- 
 bilities in the form of funded debt ; and a funded debt 
 payable in the futiu*e is naturally invested in such 
 permanent things as real estate, plant and machin- 
 ery. It is impossible to lay down any hard and fast 
 rules in regard to the proper tendency of items in a 
 balance sheet. We must know the line of business 
 before we can say whether things are going as they 
 ought or not; but it is always desirable in passing 
 judgment on the solvency of a business to make such 
 an analysis as that here suggested in order that we 
 may have at a glance a summary explanation of 
 important changes. We do wish to know why this or 
 that important change occurred and what other 
 items were affected. 
 
 It is worth while to dwell upon some specific 
 items in connection with the balance sheet and see 
 
344 ACCOUNTING AND AUDITING 
 
 what a person attempting to determine solvency 
 should consider in relation to them. Attention has 
 already been called to the need of allowance for de- 
 preciation in connection with Real Estate, Plant and 
 Machinery, Investments, and Merchandise. Except 
 for Merchandise, nothing more needs to be said about 
 these accounts. As was suggested in the chapter on 
 profit, the normal price of merchandise is not always 
 the billed price, but that price less the largest dis- 
 count offered. So one must realize in considering an 
 inventory that the basis should be never more than 
 the net price, or, if the goods have fallen in market 
 value, not even so much as that. It is well for any- 
 one attempting to interpret a balance sheet to note 
 the relation between the present inventory of mer- 
 chandise and that of other years. If he finds that 
 merchandise valuation is constantly increasing, but 
 sales are steady, decreasing, or increasing in a slower 
 ratio than the inventory, he has reason to believe 
 that the inventory is padded — either deliberately, 
 or because of neglect to allow for unsalable goods. 
 If a manager were always to count as a good asset 
 merchandise purchased long ago, and never recog- 
 nize the fact that certain merchandise has, with the 
 lapse of time, become imsalable, the greater his store 
 of unsalable goods, the bigger his merchandise in- 
 ventory. If this thing were to go on for a series of 
 years, it might be found in the end that an inventory 
 of one hundred thousand dollars might represent 
 goods which on the market were worth only ten 
 thousand dollars. 
 
 It should be realized always that both bills 
 receivable and the accounts of customers are likely 
 
INTERPRETATION OF BALANCE SHEETS 345 
 
 to prove worth less than the book value, — how much 
 less will depend on the discretion used in giving 
 credits. From some points of view, bills receivable 
 are preferable to book accounts, for a bill receivable 
 at least acknowledges the debt; since, however, 
 under some conditions goods sold and not paid for, 
 even by a note, may be replevined, certain book 
 accounts are better than bills receivable. Judgment 
 in each case must be determined by circumstances. 
 It should be realized also that customers' accoimts 
 are likely to represent claims for a considerably 
 smaller sum than the amount recorded on the books. 
 If discounts are allowed for early payment of bills, 
 the customers' accounts are subject to these dis- 
 counts and only if none of the discounts offered are 
 accepted will the claims yield their full face. One 
 must always realize, therefore, that allowance for 
 discounts is as important as allowance for bad 
 debts. This, however, is not, as is allowance for bad 
 debts, a presumable loss to the business, but one of 
 its bookkeeping debits due to the fact that bills have 
 been booked at more than the natural price. 
 
 On the other side of the balance sheet only one 
 allowance needs to be made; for liabilities, unlike 
 resources, are bound to be met in full unless the busi- 
 ness goes into bankruptcy. The single exception is 
 discounts offered for early payments to creditors. 
 If the discounts presumably to be taken on sums due 
 to creditors equal the discounts presumably to be 
 taken by customers, the items do not need to appear 
 on the balance sheet — unless to show that they have 
 been considered. This statement is not incon- 
 sistent with the theory of discounts previously 
 
346 ACCOUNTING AND AUDITING 
 
 stated. We are here concerned not with profits, but 
 with assets and liabilities; and though it is true that 
 discounts neglected by our customers do not protect 
 us from loss on discounts which we neglect (as shown 
 on page 288), discounts to be taken by us reduce our ' 
 liabilities in the same degree (dollar for dollar) that 
 discounts to be taken by our customers reduce our 
 assets. If one sort of discount is likely to be larger 
 than the other, both should appear. 
 
 It is well in this connection, though the items do 
 not appear on the balance sheet, to compare the 
 amounts of discount neglected (or the amounts 
 taken, if only those are recorded) for the last year 
 with those for preceding years and with purchases 
 and sales. It is evident that when rates of discount 
 offered are unchanged, Collected Discounts decreas- 
 ing (or allowed discounts increasing) on goods sold 
 is a good sign; for though it means less direct profit 
 from this source, it indicates an improvement in the 
 general business standing of customers. A con- 
 servative manager would rather have low profits on 
 sales to sound customers than larger apparent profits 
 on sales to questionable customers. Theoretically no 
 discounts on purchases should ever be neglected ; but 
 if the firm is poor and has little credit, no escape 
 may be found. In such a case Neglected Discounts 
 decreasing, or increasing more slowly than pur- 
 chases, shows an improving conditio 
 
CHAPTER XV 
 
 THE DETEKMINATION OF COSTS 
 
 All our discussion up to this point has been based 
 on the assumption that by general accounting prin- 
 ciples we can know or can easily calculate the 
 amount of debit or credit to any account; in many 
 cases, however, a cost is so well mixed with other 
 costs that elaborate records are necessary to dis- 
 tinguish which portion of the total cost belongs 
 properly to one item and which to the others. In 
 manufacturing it is not usual to buy raw materials 
 for one particular product and to put labor at work 
 in producing that single product; it is customary to 
 purchase supplies in large quantities, and to employ 
 laborers either on day work or on piece work so 
 that the debit to Wages is to be divided ultimately 
 among many articles. The natural entries, there- 
 fore, are for the amount of material consumed and 
 for the wages involved in product as a whole. Though 
 sometimes distribution to separate products may be 
 made by a mere division of the total cost among 
 the number of items produced, various types of 
 articles are commonly produced under conditions 
 involving di:ffering amounts of raw material and dif- 
 fering amounts for wages, and for each of these care- 
 ful record must be kept so that it will be possible 
 when the work is completed to know what has been 
 
 347 
 
348 ACCOUNTING AND AUDITING 
 
 the cost of that product both for raw material and 
 for labor. These two elements of cost are commonly 
 called ^^ prime cost," for they are direct and involve 
 no complex distribution of joint cost over various 
 articles. Above these, however, are many additional 
 costs which cannot be found individually for each 
 item of product. The total expense for insurance, 
 rent, repairs, interest on capital, and various items 
 of this sort, is for the joint benefit of many products, 
 and must be distributed at some time over the total 
 amount of product, so that each article shall bear its 
 share of the total cost of these items. If these last 
 costs, which are usually called *^ overhead costs" or 
 *^ burden," are not distributed over the total product, 
 or at least if the prices charged for the product do not 
 include an allowance for these costs, the business is 
 necessarily run at a loss. It is desirable that these 
 overhead costs shall be charged to the individual 
 items of product in exactly the right proportion, for 
 if not the business may be selling some goods at less 
 than their actual cost to manufacture. This suggests 
 the necessity for som^e sort of cost accounting in all 
 manufacturing and other lines of business where 
 many items of product or service are rendered at 
 costs which do not readily attach themselves to each 
 individual item of result. 
 
 The purposes of cost accounting are three: (1) to 
 guide the managers in determining what is the 
 proper price to be put on each article of product; 
 (2) to enable the managers to learn whether an}'- part 
 of their product is more or less profitable than other 
 parts, — for sometimes, owing to peculiar conditions, 
 a business cannot afford to make certain articles at 
 
bETERMHSTATlON OJ^ COSTS f^ 
 
 the same price as its competitors, and had therefore 
 better give up such manufacture, or may have such 
 advantage over competitors in some articles that it 
 may well concentrate all its activities on these alone; 
 (3) to indicate economies, for if cost accounting is 
 accurate it makes possible comparisons between one 
 period and another for most elements in the manu- 
 facturing process and shows whether the maximum 
 yield is obtained, not only with raw material con- 
 sumed and with labor, but with the general facilities 
 which cause overhead expense. 
 
 The importance of a proper distribution of over- 
 head charges may be best illustrated, perhaps, by a 
 simple case of manufacture where one process yields 
 several kinds of product. If we are to know not only 
 what is the proper price to make on our goods, but 
 what is the most profitable product, and what is the 
 greatest economy of expenditure, we must know 
 what is the best disposition to make of each part of 
 the joint product. In a saw-mill one stroke of the 
 saw produces not only a board, but a slab, or an 
 edging. Taking the log as a whole, perhaps a dozen 
 trips of the saw-carriage produce several boards, two 
 slabs, and many edgings. Under some conditions, it 
 may be cheaper to use the edgings and the slabs in 
 the engine-room as fuel than to attempt to sell them 
 on the market. In such a case the only salable 
 product is boards. If, on the other hand, there is a 
 good market for edgings, it may be worth while to 
 bundle them and ship them; but it may not be worth 
 while to attempt to sell the slabs. Finally, it may be 
 worth while to sell boards, edgings, and slabs. Be- 
 fore one can tell whether one should sell only boards, 
 
360 ACCOtJNTING A^B AUDITING 
 
 or boards and edgings, or all three products, one 
 must know not only what one can get for edgings 
 and slabs, but what will be the cost of getting them 
 on the market. For each one of these items of 
 product there is one cost which is peculiar to it and 
 needs to be met only in case that product is to be 
 sold. If, for instance, edgings and slabs are to be 
 burned, they do not need to be sorted or carefully 
 piled or measured, and they are worth something as 
 fuel. They will go directly from the saw-table into 
 a heap from which they will be passed to the fire 
 box. To sell edgings, however, requires at least the 
 cost of sorting them from the slabs, and usually of 
 cutting them into firewood lengths and bundling 
 them. To sell the slabs requires only that they shall 
 be cut into firewood lengths and separately piled. 
 Only when the cost of. separating, piling, and bun- 
 dling is known can the manager know whether he 
 ought to sell these by-products rather than consume 
 them. All cost accounting, to serve its purpose, 
 then, must distinguish as far as possible every cost 
 which is peculiar to any product, and must distin- 
 guish the return from each kind of product; then a 
 comparison may be made between return and cost 
 for each kind of product, and the manager can learn 
 not only the absolute but the comparative profitable- 
 ness of that enterprise, — that is, whether he had 
 better abandon that department of his product and 
 concentrate his whole energy on some other depart- 
 ment that yields a higher profit. 
 
 Let us turn first to the method of learning prime 
 costs — ^that is, costs which are peculiar to any one 
 line of product and are not confused with a^y joint 
 
Mteeminatiok- of cost^s sSi 
 
 elements. The common practice is to require all 
 work done in a shop to be based on written orders 
 from someone in authority. As soon as production 
 is ready to begin, a written order is made out in the 
 central office to indicate what materials are to be 
 used in its production — or at least what materials 
 are to be turned over to the workman for his use. 
 Such an order is sent to the storehouse, and when 
 the goods are issued by the storekeeper the order is 
 receipted by the workman. On the return of the 
 order to the office, the books can show exactly what 
 materials have been issued, and after allowance has 
 been made for material returned to the storehouse, 
 can indicate by a calculation based on the purchase 
 price of the goods exactly what is the material ele- 
 ment in the cost of the product. Similarly, for all 
 work to be done, an order is issued to each work- 
 man, and when his work has been completed that 
 order is signed by the foreman accepting the work 
 and this authorizes the payment of wages. This 
 signed order furnishes information to the office as to 
 the labor-cost of this product. 
 
 Let us now examine this in somewhat more de- 
 tail. A carefully worked-out scheme of accounting 
 will provide that all stores or supplies purchased 
 shall be entered in a stores ledger, so arranged that 
 each kind of article kept in the storeroom has an 
 account of its own, which may be debited for all 
 stores entering the storehouse and credited for all 
 stores issued. The storekeeper is held responsible 
 for all goods which he receives, and must give a 
 receipt for them, and he receives a receipt for all 
 goods which he issues. This makes it possible at all 
 
S52 ACCOIJNTma AND AUDI*m(J 
 
 times to know what stores are on hand and to pro- 
 vide against the waste of material. Each general 
 order may, of course, comprise many sub-orders, or 
 job orders, for if the office requires a case of shoes 
 to be made, sub-orders are needed for every kind of 
 material, such as sole leather, counters, vamps, 
 uppers, etc., and labor orders for cutting, stitching, 
 finishing, treeing, etc. The labor items occurring on 
 job order slips are carried not only to the cost books, 
 which are arranged to show the cost of each order 
 or group of orders, but are carried also to the time 
 book so as to credit each workman for his wages. 
 The cost book contains a separate page or series of 
 pages for each general manufacturing order, and all 
 sub-orders or job orders (for detailed portions of 
 work on the general order) are entered under the 
 proper heads so that when a job is completed the 
 total cost of that job, both for material and for labor, 
 is found by simple addition. This may serve, roughly, 
 as an outline of the method of accounting for prime 
 costs. The details will differ largely in different 
 factories because of differing conditions, and it is 
 impossible in a book of this general type to cover 
 the subject in its various complex forms. 
 
 We may now pass to the general subject of the 
 distribution of burden, or overhead cost. It is ob- 
 vious that so far as we may attach all overhead costs 
 to a single element, we may keep the accounting sim- 
 ple; if, for example, we should find that all overhead 
 costs bear some definite relation to wages, we could 
 distribute those overhead costs on the basis of the 
 wages expense on each job. This, indeed, is a com- 
 mon method of distributing burden. It has, how- 
 
DETEEMIXATION OF COSTS 353 
 
 ever, one fundamental objection. It charges as 
 much overhead cost to a job requiring $4 worth of 
 labor employed in hand cutting of uppers in a shoe 
 shop, for example, as to one employing $4 worth of 
 labor to run a high cost machine which must be 
 insured and involves taxes, repairs, depreciation, 
 and much power-cost. Such distribution of burden 
 is obviously unfair, for the most important over- 
 head costs in connection with the cutting of uppers 
 by hand are those connected with the housing of 
 the workman and his material — that is, rent, heat, 
 light — and the administrative costs of directing his 
 labor, but besides these the machine involves in- 
 terest, depreciation, repairs, insurance, and taxes. 
 If we were to charge goods produced by hand 
 labor with the same proportion of overhead expense 
 that we charge to goods produced largely with high- 
 cost machinery, we should find probably that we 
 could not sell our hand-made goods at the market 
 price, and that the demand for our machine-made 
 goods would be very heavy because of the low price; 
 and yet our business would be losing money, for our 
 distribution of costs would be on the assumption 
 that the hand-made goods would bear their share of 
 the overhead costs, and since those hand-made goods 
 would not be sold, they would not make up the de- 
 ficiency in burden borne by the machine-made goods. 
 The only useful accounting, then, is to see that the 
 overhead costs are borne by the particular product 
 involved in their use. 
 
 Another device commonly adopted for the dis- 
 tribution of overhead costs is a proportion based not 
 on wages, but on hours of labor. This is obviously 
 
 A & A-23 
 
354 ACCOUNTING AND AUDITING 
 
 less satisfactory than the distribution based on 
 wages; for it would carry as much overhead cost to 
 the product of the labor of a boy working by hand 
 for seventy-five cents a day as it would carry to 
 the product of the labor of a skilled workman 
 getting six dollars a day and working with a very 
 high-cost machine. This is in reality the height of 
 absurdity, and unless practically all work is done 
 under the same conditions, both of wages and of the 
 utilization of expensive equipment, one might almost 
 as well not attempt to distribute overhead cost at all 
 as to distribute it all on this basis. If, however, the 
 benefit of any particular portion of burden is clearly 
 shared by any product in the ratio of labor, this basis 
 may be used for that portion, but the desirable thing 
 is to keep as low as possible the number of bases; 
 then the accounting* is simple. 
 
 The scientific method, at least for all shops where 
 many types of goods are produced under varying 
 conditions, is to take into account the several ele- 
 ments involved in the production of every article — 
 and this, as will be seen later, is not nearly so serious 
 a task as might at first thought appear, — and group 
 them so that those assignable on the same basis may 
 be treated in a lump sum. The general overhead 
 costs may be grouped roughly as follows: first, ad- 
 ministration and superintendence, — that is, the cost 
 of running the office with its accounts and records, 
 and the cost of directing the labor into proper chan- 
 nels so that the maximum product is got with the 
 minimum of expenditure; second, the costs for the 
 buildings which house the workmen, the supplies, 
 and the machines ; third, the costs connected with the 
 
DETEEMIXATIOX OF COSTS 355 
 
 macliinery itself; and, finally, the costs of power. A 
 large portion of these expenses, it will be noted, 
 attach themselves directly to machinery, for the 
 amount of space required is determined largely by 
 the size and character of the machinery, the amount 
 of interest and insurance and taxes is determined by 
 the cost of the machines plus the cost of the build- 
 ings (which can be distributed in large part on 
 the basis of machinery), and the amount of power 
 required is determined directly by the machinery. 
 If, then, we attach these items to machinery and 
 distribute them on the basis of each machine's pro- 
 portion of that cost, so that each manufacturing 
 order will be debited for these costs on the basis of 
 its use of the machine, we shall have very few over- 
 head costs remaining to distribute on any other basis. 
 Let us attempt, therefore, to attach as many of these 
 overhead costs as we may to the machines utilized in 
 manufacturing processes. 
 
 It is true, of course, that the buildings are to 
 protect workmen as well as to protect machines, but, 
 where the work is done by machinery, for housing 
 purposes the workman and the machine form a unit, 
 and, consequently, we may simplify our task by con- 
 sidering that space occupancy is a machine expense 
 (allowing, of course, room enough for the workmen 
 to get about and utilize the machines). Let us first, 
 then, find all the costs connected with space and dis- 
 tribute it to the machines in proportion to their 
 space occupancy. The first cost in connection with 
 space is the rent, and that is cost to the manufactur- 
 ing end of the business, even though the building is 
 owned by the proprietors; for they as owners are 
 
356 ACCOUNTING AND AUDITING 
 
 entitled to collect rent from the manufacturing 
 processes quite as much as if the building were leased 
 to outsiders. If the product does not compensate 
 the business for the use of its real estate, the business 
 is not profitable, and prices must be fixed at such a 
 point that the product will give that compensation. 
 Starting, then, with ground rent, we add interest on 
 the cost of the buildings, depreciation which is in- 
 evitable with the lapse of time (at least, on the build- 
 ings themselves, even though the ground rent may 
 be actually rising), repairs which are necessary to 
 keep the buildings in an efficient state, insurance 
 against loss by fire, and taxes. These together com- 
 prise the total expense to the business for protection 
 against exposure of its machinery and of the men to 
 run it; and this expenditure must be borne by the 
 product of the machines in proportion to the amount 
 of space required by these machines. If any ma- 
 chine, then, occupies one one-hundredth of the total 
 floor space of the shop, its share of floor-space cost 
 will be one one-hundredth of the total figure which 
 we have just obtained. We must next add the cost 
 of heating; this, however, should be based not so 
 much on floor space as on cubic capacity. Lighting, 
 on the other hand, need not necessarily be on the 
 basis of space at all, for some large machines may be 
 operated with very little lighting; the basis here, 
 therefore, will be the number of lights required for 
 this machine, as compared with the total number of 
 lights required for all machines. 
 
 The second group of costs attached to machinery 
 comprises those connected with the mere possession 
 of the machine itself, and includes interest on the 
 
DETERMINATION OF COSTS 357 
 
 cost, depreciation due to obsolescence, repairs re- 
 quired to keep it in condition, insurance, and taxes. 
 These costs, it will be observed, continue even though 
 the machine is not in actual use ; though the repairs 
 included here comprise only the slight items of 
 periodic care to protect it from rust and dust. 
 
 The next group of machine costs are those con- 
 nected with the operation of a machine when run- 
 ning. These include the consumption of oil, waste, 
 and other supplies, depreciation due to wear, repairs 
 necessitated by the giving out of small parts, and 
 the cost of the small tools and other equipment 
 attached to the machine for its manipulation. The 
 actual cost in connection with these tools, however, 
 is not the original cost of the tools themselves, but 
 simply interest, depreciation, repairs, insurance, and 
 taxes, on their value. The last item in this group is 
 superintendence; though this item has no direct con- 
 nection with the cost of the machine itself or its 
 operation, we are endeavoring to attach to machinery 
 as many as possible of the overhead costs, and if 
 several machines are run under one superintendent, 
 and they require equal shares of his care, we may 
 well distribute his wages among the orders on the 
 basis of their use of machines. If, on the other 
 hand, various machines in any room require dif- 
 ferent amounts of attention from him, it would be 
 difficult, probably, to say what share belongs to each, 
 and this cost of superintendence would be introduced 
 elsewhere. 
 
 The last group is the costs connected with power. 
 These, it must be noted, include not merely the cost 
 of fuel and of employees to take care of the engine. 
 
358 ACCOUNTING AND AUDITING 
 
 but many incidental costs connected with the power 
 establishment. Among these would be the space of 
 the power plant — either for the portion of the shop 
 occupied by the engine room, or the space cost of a 
 separate building. If there is a separate building, 
 the five elements which we have previously seen in 
 other connections (interest, depreciation, repairs, 
 insurance, and taxes) must be figured on the whole 
 power establishment. Next we have the same five 
 elements on the power plant itself, that is, the 
 boilers, engines, etc., including shafting, belting, 
 pulleys, and other transmission elements not already 
 included elsewhere. Finally, we should have, be- 
 sides the fuel and the wages of engineer and fireman, 
 costs for water, oil, waste, etc. When we have deter- 
 mined the full power cost of the whole establish- 
 ment, the amount chargeable to each machine is de- 
 termined by the ratio of its horse-power consump- 
 tion to the total horse-power consumption of the 
 establishment. 
 
 If we now add all these costs together — that is, 
 the four groups of space cost, machine cost, use cost, 
 and power cost — we have the total running cost per 
 year for our machine. If this is now divided by the 
 number of working hours in a year — making allow- 
 ance, of course, for the fact that no machine can run 
 all the time, but suffers some loss of time because 
 of the need of repairs, cleaning, etc., — we shall have 
 what is commonly called the '* machine hour rate." 
 It is obvious that every job requiring the use of any 
 machine for one hour is costing more than its prime 
 cost (cost of material and labor) by the amount of 
 this machine hour rate, for the total cost of the ma- 
 
DETERMINATION OF COSTS 359 
 
 chine for the year divided by the number of working 
 hours has given us this hour cost for that machine. 
 The accounting for this additional cost to each order 
 based on this utilization of machinery is very simple, 
 for if on all order slips sent in by workmen an entry 
 is made showing the number of the machine and the 
 nmnber of hours it was utilized, the office can readily 
 enter on the cost book the overhead charge which 
 should be added to the prime cost ; this is found by 
 multiplying the hour rate by the number of hours. 
 We have now distributed a large portion of the 
 total overhead cost. We have remaining chiefly the 
 items of administration, superintendence, some addi- 
 tional costs connected with stores, and space-cost for 
 parts of the factory which do not utilize machinery. 
 So far as in any part of the shop all work is done by 
 hand, space-cost for that portion may be distrib- 
 uted on the basis of labor-time, for a man working at 
 six dollars a day takes as much space, heat, and light, 
 usually, as a boy working at seventy-five cents a day. 
 The full remaining space-cost of the establishment 
 may be provided for if the space occupied by stores, 
 by superintendence, and by the administration, is 
 charged to each of these departments. Stores must 
 be charged for freight and cartage, and for interest, 
 depreciation, taxes and insurance on average stores 
 kept in stock; the total gives an additional sum 
 which, when converted into a percentage, may be 
 added for each order to the amount already charged 
 for stores. Then the administration expenses, in- 
 cluding a share of space cost, may be distributed 
 over all the product on the basis of a fixed propor- 
 tion of administrative costs to other costs. If in the 
 
360 ACCOUNTING AND AUDITING 
 
 experience of this shop it is found that of the total 
 manufacturing costs, including not only prime cost 
 and overhead cost but administration, ninety per 
 cent, is for combined prime cost and burden, and ten 
 per cent, for administration, to each order one-ninth 
 of the cost shown on the cost book for items already 
 figured should be added for administration. This 
 process will absorb all the joint or overhead cost for 
 the factory and leave each order charged with ap- 
 proximately its proper proportion — that is, as nearly 
 so as it is possible for any estimates and calculations 
 to provide. 
 
 It should be noted that, though a good deal of 
 this sounds like mere estimating, most of it is based 
 on known facts. We do not, for instance, know what 
 is the actual depreciation of any machine in any 
 period, but that is a thing which can never be known 
 under any circumstances, and yet some provision 
 must be made; we do not know what will be the 
 actual annual cost for repairs, but we do know after 
 a business has been running a few years what is the 
 actual cost for rejiairs as an average, and we have no 
 reason to suppose that the amount will be particu- 
 larly higher or lower during any period; we cannot 
 know what is the actual coal consumption during the 
 hours any particular job is on a machine, but we do 
 know from past experience what is the normal ratio 
 of fuel to power, and may use that with sufficient 
 accuracy for the present purpose; we do not know 
 what is the actual administrative cost while this 
 order is going through the shop, but if we know what 
 has been in the past the ratio of administrative cost 
 to manufacturing cost, we may, unless notable 
 
DETERMINATION OF COSTS 361 
 
 changes have occurred, use that ratio with a pretty 
 close approximation to truth for any particular 
 period. Of course, since the purpose of careful cost 
 accounting is to eliminate as much as possible all 
 waste, it is constantly hoped that the costs this year 
 will in all particulars be lower than in previous 
 years, and, therefore, it is usually safe to use as a 
 basis the figures for earlier years, for the present 
 year's variation is likely to be on the safe side. All 
 the bases may be revised, moreover, as often as the 
 managers think worth while; and the accounting fur- 
 nishes information for the revisions. 
 
 The preceding discussion does not attempt to 
 cover all the desirable distributions of overhead 
 costs, of course, for the subject is so full of detail 
 that nothing less than a large volume would cover 
 all the points which might arise even in one factory. 
 Nothing is attempted here more than a general out- 
 line of the plai-. Many employers scofif at such a 
 system, for they say that, since a large part of this 
 determination of costs is at best only an estimate, it 
 is well enough to let it all go as an estimate and 
 satisfy oneself with the absolute results which, at 
 the end of the year, show only whether one has made 
 a profit or a loss. The best answer to that criticism 
 is the fact that in many large shops the kind of plan 
 outlined above is actually ^practiced, and has been 
 practiced for many years, and that the managers are 
 satisfied that, though the cost of accounting in such 
 detail is heavy," it is far more than offset by the 
 greater precision in making prices, in directing the 
 manager as to w^hat particular lines of work he had 
 best push, and in preventing waste. It is true also 
 
363 ACCOUNTING AND AUDITING 
 
 that in many establishments cost accounting systems 
 have been attempted with great detail, and have been 
 thrown out by the managers after a short trial be- 
 cause apparently not profitable; but in many such 
 cases it has been found on investigation that the 
 system was not scientifically devised in the first 
 place, and that the men left in charge, having no 
 sympathy with it, made no effort to give it a fair 
 trial, or were incompetent to carry out the scheme 
 with anything approaching good judgment. 
 
 It should be noted that although the original cal- 
 culations necessary to apportion overhead costs on 
 the plan outlined above are laborious, when they 
 have once been carried out the system is more or less 
 automatic. When, for instance, the space cost of 
 the whole establishment has been found, it does not 
 need to be found again until some change has arisen 
 in the conditions; and the space cost for each par- 
 ticular machine is simply a certain proportion of the 
 whole. Similarly, when the total power cost for the 
 establishment has been found, that total is used for 
 all machines by a simple calculation of proportion. 
 
 One circumstance is not provided for in the 
 scheme outlined above. Our calculation has been 
 based on the assumption that all machines are run 
 full time. In many shops certain equipment is neces- 
 sary in spite of the fact that it is in demand only a 
 few hours a day. Obviously some provision must be 
 made for that sort of thing, for if overhead charges 
 are distributed on the basis of full time for all ma- 
 chines, and then some machines are part of the time 
 idle, the product will not absorb all the overhead 
 costs at the end of the year. It is desirable, there- 
 
DETERMINATIOiSr OF COSTS 363 
 
 fore, to keep a record of the actual running time of 
 each machine, and then in calculating the charges 
 to recognize the fact that the orders utilizing that 
 machine must pay for the idle time. This is a prin- 
 ciple recognized practically everywhere. Proprietors 
 of public halls, for instance, do not determine their 
 charge for an evening on the basis of three or four 
 horn's out of a possible 8,760 hours per year; for such 
 a hall is used commonly only two or three hundred 
 times a year; if those who use it do not pay their 
 proportion of this idle time, the proprietors do not 
 receive adequate compensation for the use of their 
 capital and sufficient in addition to cover deprecia- 
 tion and other expenses. 
 
 In connection with idle time we find that careful 
 record is demanded by the same three considera- 
 tions that make any cost accounting imperative. Only 
 when idle time is known can prices be fixed properly 
 as between various articles of product ; only then can 
 one learn how to provide for the elimination of waste 
 in the extremely important matter of the utilization 
 of equipment ; only then can one know whether it is 
 more profitable to do all parts of manufacturing 
 work in one's own shop or to send out a part of the 
 work to be done elsewhere — or even to abandon some 
 kinds of work entirely. 
 
 The determination of prices is likely to be affected 
 differently according to the circumstances under 
 which the idle time is suffered. If the shop is in 
 competition with other shops much larger or turning 
 out such a kind of product that all their machinery 
 is used for full time, it cannot compete in low prices 
 unless allowance is made for the part-time use of its 
 
364 ACCOUNTING AND AUDITING 
 
 machines and the loss is taken out of profits. This 
 may be illustrated roughly by supposing that in the 
 shop in question, since some drilling is now and then 
 necessary, a drill must be maintained in constant 
 running order, but since the amount of drilling is 
 comparatively small, one drill working a quarter of 
 the time can do all the work. If this shop is in com- 
 petition with another which has a large patronage, 
 so large that the work turned out by the other ma- 
 chines requires enough drilling to keep one drill con- 
 stantly occupied, the prices prevailing in that com- 
 munity are determined by the shop running its drill 
 full time; and the shop having only partial use for 
 its drill must, if competition is keen, take the loss 
 for idle time out of its profits. If, on the other hand, 
 the work in this community requiring drilling is 
 small, so small that one drill can do all the work for 
 the community in a quarter of its time, the minimum 
 demand of the community requires the maintenance 
 of a drill, and that cost may be charged to the com- 
 munity in the prices set on the work done in that 
 shop. Even if it were known that no competition is 
 to be suffered, and that prices can be made always to 
 include the cost of idle time for work requiring any 
 drilling, it would still be worth while to keep sepa- 
 rate record of the actual amount of idle time on that 
 machine; for only so would the manager know 
 whether conditions were improving with regard to 
 the use of that machine or not ; and only so would he 
 know whether his estimate for idle time used in cal- 
 culations for the work of this year needed revision 
 in making his calculations for a subsequent year. 
 
DETERMINATION OF COSTS 365 
 
 It is desirable, therefore, that for each machine a 
 record shall show the work done each year. 
 
 The burden to be borne by any order in connec- 
 tion with the utilization of machinery is not neces- 
 sarily the same for all hours, even though there be 
 no idle time. Some work requires a considerable 
 Xjreparation of the machine, such as adjustments and 
 fitting special tools. Obviously, the cost for two 
 hours spent in adjusting a machine to a job is less 
 than for two hours' actual work on that job; for the 
 two hours of preparation involve only two of the 
 four groups of cost discussed in an earlier paragraph, 
 — that is, space cost and machine cost. The cost is 
 as great for space, heat, light, insurance, taxes, in- 
 terest, and obsolescence, for two hours setting up a 
 machine as for two hours while the machine is run- 
 ning; but of machine-use cost and power cost, set- 
 ting-up involves nothing. It is necessary, therefore, 
 in order to make complete records, to distinguish be- 
 tween what may be called ^^ occupied time" and 
 *^ running time." What we have heretofore treated 
 as one machine rate may well be split into two rates. 
 If we add together the space cost and the machine 
 cost for a year for any machine and divide by the 
 number of working hours, we get what may be called 
 a *' minimum rate," — that is, what it costs the shop 
 each hour to maintain that machine ready for use, 
 whether running or not. If we add together the 
 machine-use cost and the power cost — that is, the sec- 
 ond and third groups of costs connected with each 
 machine — and divide by the number of working hours 
 in the year, we get what may be called an *^ addi- 
 tional rate," — that is, what must be charged to each 
 
366 ACCOUNTING AND AUDITING 
 
 order for the actual extra cost of running the 
 machine. If a machine were occupied all the time, 
 the charge to each order would be merely the mini- 
 mum rate multiplied by the number of hours the job 
 was at the machine, plus the additional rate multi- 
 plied by the number of hours the machine was actu- 
 ally running at that job. The same result would be 
 obtained, of course, if w^e were to multiply the run- 
 ning hours by the sum of the additional rate and the 
 minimum rate, and were to add to this the minimum 
 rate multiplied by the number of hom's the job was 
 occupying the machine in preparation. 
 
 The moment we introduce idle time, however, we 
 realize that each job must bear its proportion of all 
 the necessary idle time on machines required by that 
 job. If a machine is normally running but half time, 
 just as a public hall may be occupied but half time, 
 the jobs requiring the use of that machine must pay 
 for twice the number of hours actually engaging the 
 machine, — else the full space cost and machine cost 
 of the machine will not be compensated by its 
 product. It is clear, however, that for idle time we 
 need figure only what we have called the *^ minimum 
 rate," for no machine-use cost or power cost is 
 incurred by idle machinery. To get the desired fig- 
 ures we have only to require that on the order slip 
 or time slip handed in by each workman, and show- 
 ing what machine he used, he shall show for how 
 much of that time the machine was actually running. 
 In the accounting department the occupied time is 
 multiplied by the minimum rate, and the running 
 time by the additional rate. The total is the earnings 
 of that machine for that specified time, and is the 
 
DETEEMINATION OF COSTS 36f 
 
 correct charge to that order on this score. If, how- 
 ever, this machine, taking the year through, is occu- 
 pied half time, the order should be charged an addi- 
 tional sum equal to the minimum rate charged; for 
 this order must pay its sharq of idle time, which, in 
 this case, is just the same as the occupied time. If 
 the machine is occupied three-fourths of the time, 
 the charge to the order for idle time is one-third the 
 charge for minimum rates (for since one-third as 
 much time is idle as is occupied, one-third must be 
 added to absorb the full cost of maintaining the ma- 
 chine). These amounts are added on the cost book 
 to the other costs as shown from other sources — that 
 is, the prime costs of material and stores, and the 
 other elements of burden comprising administrative 
 costs, secondary stores costs, administration, etc. 
 The result is the total manufacturing cost for that 
 article. 
 
 The figures of the order slips handed in by 
 workmen must be carried also to another record. 
 Since it is desirable to know the actual accomplish- 
 ment of every machine, a ledger is commonly kept 
 for accounts with all machines. On this ledger 
 are entered the occupied hours, the running hours, 
 and the idle time. In this case, however, the idle 
 time will not be an estimate but the actual idleness. 
 It will be the diference between the occupied hours 
 and the possible hours. As a matter of fact, how- 
 ever, the actual idleness does not need to be com- 
 puted each day, for, of course, the number of occu- 
 pied hours at the end of any month subtracted from 
 the total number of shop hours will give the idle 
 hours; and hence this item need be entered only ai 
 
368 ACCOUNTING AND AUDITING 
 
 convenient intervals. At the end of the year this 
 machine ledger account makes it possible to learn 
 whether the estimate of idleness was erroneous, 
 whether conditions within the shop have improved 
 so far as to prove good management, w^hether it is 
 desirable that the machine shall be abandoned and 
 its work done elsewhere. 
 
 We have now completed our study of manufactur- 
 ing costs. Many items besides those suggested here 
 may prove in any particular factory to be necessary 
 in a cost calculation. It is impossible to construct 
 any scheme which shall fit all factories. All we can 
 do here is to consider the principles. 
 
 In the main, the method of distributing selling 
 costs is similar to that for distributing the burden 
 in manufacturing. An obvious element of burden 
 in selling is space cost. This will be determined by 
 the same method as for manufacturing costs — that 
 is, chargeable to the selling department is a certain 
 proportion of the total space occupied by the estab- 
 lishment, of interest on the investment in buildings, 
 of insurance, of taxes, of depreciation and repairs 
 on buildings, of lighting, and of heating. A certain 
 part of the general administrative expense of the 
 business must be borne by the selling department. 
 The wages of persons employed exclusively in that 
 department, with advertising costs, costs of station- 
 ery, postage, commissions, traveling expenses, etc., 
 can be known directly and should be charged to that 
 department. Most selling costs are capable of deter- 
 mination by percentages, and if it is found that nor- 
 mally selling cost is fifteen per cent, of manufactur- 
 ing cost, that percentage should be added to the cost 
 
DETERMINATION OF COSTS 36d 
 
 of each order — unless peculiar circumstances in con- 
 nection with that order require a larger siun or show 
 that the order should be relieved of a portion of the 
 general charge. If, for instance, a special advertis- 
 ing campaign has been conducted for a single article, 
 most of the cost of that campaign should be charged 
 to the sales of that article — ^but not necessarily all 
 of it, for the general reputation of the firm may 
 have been improved so much that other articles share 
 in the benefit. So far as any work is done for the 
 use of the shop itself, and, therefore, involves no 
 selling expense, the cost should be deducted from 
 manufacturing costs before the percentage for sell- 
 ing expenses is figured. 
 
 Since it is convenient to have a reference list of 
 costs for all articles, it is well to have for each article 
 of product a book or a series of cards which shall con- 
 tain a summary of all costs as shown by^past experi- 
 ence. This would show, normally, in summary form, 
 something like the following table : 
 
 stores (from order slips) $ 6.27 
 
 Stores costs (percentage of above) .12 
 
 Wages (from order slips) 3.27 
 
 Superintendence (percentage of above) .24 
 
 Minimum rates (from order slips) .33 
 
 Idle time (ratio to above) .66 
 
 Additional rates (from order slips) .85 
 
 Department and general expenses (percentage of total above) .50 
 
 Total producing cost 12.24 
 
 Selling cost special ,30 
 
 Selling cost general (percentage of producing cost) 1.22 
 
 Total cost 13.76 
 
 This all sounds very complicated, but the book- 
 keeping is comparatively simple, though, of course, 
 a good deal of labor is required in handling the de- 
 
 A & A-24 
 
370 ACCOUNTING AND AIJBITING 
 
 tails. We saw that the first element of burden is 
 space cost. If a ledger account is kept for space 
 cost, it is a simple matter at the close of the year to 
 transfer to that account all expenses which have 
 gone to make up that space cost, such, for instance, 
 as rent, lighting, heating, building repairs, deprecia- 
 tion, taxes, and insurance, so far as those items 
 relate to buildings and ground space occupied. Then 
 Space Cost may be credited by the distribution of 
 this total to accounts representing the various de- 
 partments of the business concerned, such as Stores, 
 Minimum Rates (which is ultimately to be closed 
 into Manufacturing), Administration, Power, and 
 Selling. These credits to Space Cost will always 
 absorb the debits and leave Space Cost with no bal- 
 ance. Similarly, to Minimum Rates should be 
 charged the elements connected with the cost of ma- 
 chinery (interest, insurance, taxes, depreciation, 
 possibly superintendence), and its share of space 
 cost, as already indicated. These debits to Minimum 
 Rates will then be offset in part by a credit to Idle 
 Time; for since we have charged Minimum Rates 
 with the total costs of burden connected with the 
 equipment of machinery, and Idle Time is respon- 
 sible for a part of that cost, it should relieve Mini- 
 mum Rates of a part of that burden, and should 
 be debited for the actual cost of idleness as shown 
 by the machine ledger (number of hours idleness for 
 each machine multiplied by the minumum rate for 
 that machine). Since Idle Time is thus debited, by 
 Minimum Rates, for its share of space cost and 
 machine cost, it must also be credited for the amount 
 charged to orders — that is, by a credit to Manufac- 
 
BETERMIKATION OF COSTS 3^1 
 
 turing for the idle time on the cost book. If orders 
 prove to have been charged with a smaller sum for 
 idle time than the cost warrants as already indi- 
 cated, Idle Time will have a debit balance and show 
 a loss; but if more, as will be the case if idle time 
 is being eliminated through better management or 
 through improved conditions, it will show a credit 
 balance, and, therefore, a gain. The only purpose 
 of keeping this idle time in an account by itself is 
 to learn whether the amounts charged to orders are 
 actually more or less than the final cost of such time. 
 Minimum Rates is next to be credited for the amount 
 entered on the cost book as minimum rates and 
 charged to manufacturing orders; for the things 
 debited to this account, as indicated above, have pro- 
 duced that value charged to orders. The correspond- 
 ing debit is to Manufacturing. Power, in turn, is 
 debited for wages, fuel, depreciation, taxes, insur- 
 ance, space cost, stores, etc., and is credited by Addi- 
 tional Rates. Similarly, Additional Rates is charged 
 with superintendence, machine repairs, oil, power, 
 etc., and it is credited by a transfer to Manufactur- 
 ing. All these manufacturing expenses in time reach 
 the manufacturing account, and the final debits to 
 Manufacturing, for pay roll, stores, minimum rates, 
 additional rates, idle time, administration, etc., show 
 the total manufacturing costs. 
 
 It is notable that all these accounts are now 
 balanced except Manufacturing, which contains in 
 itself a summary of all the others. The purpose of 
 keeping these others is simply to show the amount 
 on each score and make possible a comparison with 
 other years. 
 
^72 ACCOUNTING AND AUDITING 
 
 A manufacturing account under this system, 
 though strictly nominal, for it represents expenses, 
 ought practically always to be in one sense real, for 
 it should represent the value of property manu- 
 factured. If an inventory were to be taken of un- 
 finished goods in the shop, and the basis of valuation 
 were the cost so far incurred, it should agree with 
 the balance of the manufacturing account as shown. 
 It is desirable to keep up the adequacy of this inven- 
 tory wherever possible. Whenever transfers are 
 made from the shop to the stock room (that is, the 
 room in which finished goods are kept). Stock is 
 debited for the goods at the exact figure of cost, as 
 shown by the cost book, and Mamifacturing is cred- 
 ited for the same figure. The balance of Manufac- 
 turing will then show the cost or value of goods still 
 in the shop. If, similarly, when goods are sold. 
 Stock is credited for the cost price of the goods sold, 
 and Trading account is debited at the same price, 
 the balance of Stock represents the cost of finished 
 goods on hand in the stock room. If, finally, when 
 goods go to the shipping room. Trading is credited 
 at the selling price, the balance of Trading will at all 
 times show the profit on goods sold. Here, then, 
 is a complete system showing at all times the inven- 
 tories, the costs, the relation of the separate items 
 of cost to the various groups of cost, and affording 
 a means of comparison for each item of cost with 
 the figures for other years. The principles here 
 shown are applicable in practically every case; the 
 only variations will be those required by the peculiar 
 circumstances of each individual shop. 
 
 It is to be noted, moreover, that this principle of 
 
DETERMINATION OF COSTS 373 
 
 distribution of burden is applicable in many other 
 things than manufacturing. In most lines of enter- 
 prise, whether of a commercial, political, or chari- 
 table nature, it is desirable to know what is got for 
 what is spent. Only when an attempt is made to 
 distribute joint costs over the product or service 
 rendered can a manager know whether he is getting 
 his money's worth or whether further economies 
 should be sought. Nothing could be further from the 
 ordinary commercial enterprise, at least in purpose, 
 than the conduct of a charitable hospital. It must 
 be realized, however, that even more than in a com- 
 mercial enterprise is it desirable in a hospital that 
 the most shall be got for the money; for the donors 
 have given money in trust for the public welfare, and 
 if the managers cause any part of that money to 
 produce less than the maximum public benefit, they 
 are either intentionally or by neglect cheating the 
 public of its belongings. Even in such institutions, 
 therefore, cost accounting is essential. If undue 
 space is provided for administrative officers, doctors, 
 and nurses, cost is unduly increased. If the patients 
 in private wards do not compensate the hospital 
 sufficiently for their accommodations and for their 
 food and treatment, the charity public is cheated. 
 Only careful cost accounting will show when the 
 costs are met. 
 
CHAPTER XVI 
 
 SETTLEMENTS BASED ON ACCOUNTS 
 
 An accountant is likely to be concerned indirectly 
 in many business operations which are out of the 
 usual course. He needs to know something of law 
 and custom in relation to circimistances that may 
 never arise, for though he is not responsible for 
 carrying out any operations, he is responsible to see 
 that his books preserve the information that may be 
 required by those in authority. An accountant is 
 not primarily responsible to make a fair distribution 
 of profits between partners, for instance; but his 
 books should be so kept that the person making the 
 division can learn the desired facts. The same thing 
 is true with regard to trusteeships, executorships, 
 and the settlement of the affairs of a bankrupt. Let 
 us take these in order. 
 
 In partnerships, the books must show the facts 
 with regard to all a partner's relations with the busi- 
 ness; for partnership agreements may provide for 
 so many elements in the final distribution of profits 
 that books which do not properly distinguish between 
 these various elements may prove at any time 
 deficient. If a partnership agreement does not specify 
 how profits are to be distributed, the presumption 
 is, unless there is some extraneous evidence to the 
 contrary, that the partners are to share equally in 
 
 375 
 
376 ACCOUNT^ING AND AUDITING 
 
 both profits and losses. Sometimes a partnership 
 agreement provides that profits are to be distributed 
 in the ratio of partners' investments — and, of course, 
 it is assumed that the lengtli of time the capital is 
 in the business is one of the elements of the invest- 
 ment itself. Sometimes a provision is made that 
 interest on capital shall be allowed partners as the 
 first element of profits, and that after this provision 
 is made the profits shall be distributed on some other 
 basis. Sometimes provision is made for definite 
 salaries to be allowed to partners. This is common 
 where a considerable disproportion exists between 
 the amount of 'investment by different partners and 
 the amount of personal profit which they are ex- 
 pected to appropriate; especially is this common 
 where one man furnishes the capital for an enter- 
 prise which he little understands and another with 
 little or no capital furnishes the knowledge of the 
 business and the managing ability. Sometimes 
 provision is made that a minimum investment shall 
 be maintained by each partner and that if any part- 
 ner falls behind in his investment he shall suffer a 
 penalty — usually through the medium of an interest 
 charge. Primarily, an accountant is not expected 
 to pass judgment on the equity of a partnership 
 agreement; but since it is his task to see how the 
 agreement works out in practice as applied to the 
 figures of any particular business, he ought to be 
 able to make recommendations to his superiors. Let 
 us see the operation of the various provisions for 
 distribution already indicated. 
 
 A division of profits without regard to capital 
 or salaries is, of course, easy to administer because 
 
SETTLEMENTS BASED ON ACCOUNTS 377 
 
 one has merely to determine net profits and divide 
 it equally among partners. A glance at the books 
 in any case should show whether that is likely to be 
 approximately fair. If the capital accounts of part- 
 ners show that any one of them has an investment 
 far lower than that of the others, or that his invest- 
 ment is for a shorter period, resulting commonly 
 from a withdrawal of funds in the course of the year, 
 it is obvious that some other provision should be 
 substituted for equal division among partners, — 
 unless, indeed, it is understood that the partner short 
 in capital renders special service in other respects. 
 A division of profits on the basis of investment 
 alone is almost equally simple; for if one partner 
 has an investment of $15,000, another of $10,000, 
 and another of $5,000, it is obvious that the division 
 of profits should give one-half to the first (for he has 
 invested one-half of the total $30,000), one-third to 
 the second, and one-sixth to the third. It is equally 
 obvious that if the personal services of the three 
 partners are of equal importance, the r^tio of divi- 
 sion is unfair, for a certain sum ought to be pro- 
 vided for salaries alone and then the remainder 
 apportioned on the basis of capital. If the books 
 show that the amount of partners' investments has 
 varied from month to month, some scheme of equali- 
 zation is necessary. A common device is to figure 
 interest on those investments and find the ratio be- 
 tween the interest on the investment of each and the 
 total interest of all the investments, and then to 
 apportion profits accordingly. If the withdrawals 
 are usually at monthly intervals, however, it is com- 
 mon to multiply the net investment each month by 
 
378 ACCOUNTING AND AUDITING ^ 
 
 the number of months it remains in the business and 
 get as a result a sum for each partner equivalent to 
 an investment for one month. A comparison of 
 these equivalent; investments will show how profits 
 are to be distributed between partners. If, for 
 example, the total investment of the first partner 
 multiplied by the months which each portion was in 
 the business gives $150,000, of the second, $75,000, 
 and of the third, $50,000, profits should be divided 
 on the basis of six-elevenths (150/275), three- 
 elevenths, and two-elevenths, — instead of one-half, 
 one-third, and one-sixth, as we found when time was 
 neglected. 
 
 When provision is made, as is common, that the 
 first charge against profits shall be interest, at a 
 fixed percentage, on the partners' investments, in- 
 terest is figured on each partner's investment for the 
 time it is in the business, and he is credited on his 
 account with the amount — which, of course, is 
 charged to Interest. 
 
 Similarly, when provision is made for salaries, or 
 for interest and salaries, credits are made to the 
 partners' accounts and debits to Salaries, or Ex- 
 pense, or Profit and Loss, as the case may be. The 
 remaining profit is then, as before, divided between 
 the partners equally unless there is provision for 
 some other basis. 
 
 When provision is made for penalties to be 
 charged to partners whose capital is deficient, a com- 
 plication arises which, without advance provision 
 in the partnership agreement, may cause unfortunate 
 differences. If, for instance, provision is made that 
 each partner shall maintain at least a minimum 
 
SETTLEMENTS BASED ON ACCOUNTS 379 
 
 investment, and that any partner whose investment 
 is below that minimum shall be charged interest on 
 the deficiency, question may arise, at the time of 
 making the charge to the partner for this interest, 
 as to the account to be credited. The other partners 
 sometimes demand that the interest charge to the 
 delinquent partner shall be credited directly to them 
 in proportion to their shares of profits. The delin- 
 quent partner, on the other hand, claims that such 
 credits shall be made directly to the profit and loss 
 account; and as he, because he is a partner in the 
 business, is entitled to a share in the profits of the 
 business, he is entitled to his share of the profits 
 resulting to the business from charging him interest 
 on his deficiency of capital. Unless there is specific 
 provision to the contrary, it is obvious that, on the 
 basis of all accounting methods, the interest charged 
 the delinquent partner is an earning of the business, 
 and he as a partner is entitled to share in it. If the 
 partners desire that penaltiqs for delinquencies shall 
 accrue directly to other partners, provision for this 
 should be made in the partnership agreement. 
 
 Unless provision is made to the contrary in the 
 partnership agreement, it is understood that losses 
 shall be shared on the same basis as gains. Under 
 one circumstance the books are likely to show that 
 this works great hardship. If a firm has not good 
 credit because of poverty, it cannot always borrow 
 all the money it needs for the economical conduct of 
 its business, and for any partner to abstract or with- 
 hold from the business capital which he ought to 
 maintain is to hamper the business and possibly not 
 only to keep from it profits which might otherwise 
 
380 ACCOUNTING AND AUDITING 
 
 accrue, but absolutely to cause it loss. It is clearly 
 unfair that under these circumstances losses should 
 be shared on the basis of capital investment; for then 
 the partner straining his utmost to keep up th^ 
 operating capital of the firm suffers most in the divi- 
 sion of losses, and the partner who has withdrawn 
 his capital suffers least. All partnership agree- 
 ments should provide, therefore, that each partner 
 shall maintain a minimum capital, and that on defi- 
 ciencies he shall be charged a rate of interest not only 
 as much as the market rate but really much more; 
 this will withdraw from him the temptation to sacri- 
 fice a business in which he has only a share and devote 
 his capital to operations from which he will derive 
 the sole profit. In fixing the rate, too, one should 
 realize that if this charge for deficiency in capital 
 is to be carried through the profit and loss account, 
 the delinquent partner will receive a share of the 
 profit from his own penalty, and the rate should 
 be placed at a point that will make it effective. 
 
 It should be further observed that often partners 
 loan to their own ^business sums of money which — 
 as is distinctly understood not only by them but by 
 the other partners — are not invested; such loans, 
 therefore, are not entitled to profit and should not 
 share in losses — unless, indeed, the partnership goes 
 into insolvency, in which case the loan of the part- 
 ner will suffer even more than the loans of out- 
 siders (for since the partner is himself responsible 
 to the full extent of his property for the debts of 
 the firm, he can demand nothing by way of payment 
 until all outside debts have been met) . 
 
 It is obvious from this discussion of the various 
 
SETTLEMENTS BASED OiST ACCOUNTS 381 
 
 methods of distributing profits that the bookkeeper 
 must be careful to distinguish between the various 
 relations of each partner to the partnership. It 
 will be found in practical experience that if a busi- 
 ness has suffered loss, and especially if it is to be 
 dissolved (so that final settlements must be made 
 betw^een partners), distribution of assets must fol- 
 low a definite order, and no sum must be given to 
 any partner on account of one of his relations until 
 all sums have been paid to other partners on account 
 of prior relations. For this reason there must be 
 no risk of confusion on books between a partner's 
 investment account, his personal (or salary and 
 withdrawal) account, his interest account, and his 
 loan account. It is impossible in a book of this sort 
 to discuss the various difficult complications arising 
 from practical problems, and we must content our- 
 selves here with the observation that if these vari- 
 ous relations just indicated are properly distin- 
 guished on the books, a person familiar with the law 
 will have no difficulty in making final settlements. 
 We saw in the chapter on the peculiarities of 
 corporation accounting that provision must often 
 be made for good will. It is not usually desirable in 
 a partnership that partners shall be given credit for 
 the amount of good will belonging to the business, 
 even though it be known that this is a large item; 
 for any sum shown by the books as credited to a part- 
 ner in excess of the minimum required by the part- 
 ners' agreement may be by him withdrawn. It is 
 obvious, however, that good will is not subject to 
 withdrawal; for it exists only in connection with the 
 running of the business, and the moment it is with- 
 
m ACCOUNTING AND AUDITING 
 
 drawn from actual connection with the business it 
 disappears. Partnership agreements sometimes pro- 
 vide, however, that in case of the decease of a part- 
 ner his heirs shall be entitled to recover from the 
 firm the deceased partner's share of the good will. 
 Here, however, it is to be noted that the good will 
 is not withdrawn from the business, for the remain- 
 ing partners purchase that good will from the heirs 
 of the partner deceased and they maintain it in the 
 business. In such a case, of course, the proper thing 
 is to figure the good will on the basis provided by 
 the partnership agreement and credit the amount 
 to the deceased partner. When payment is made, 
 his account is balanced, and the good will appears 
 on the books as an asset; for the original entry must 
 have been a debit to Good Will and a credit to the 
 account of the deceased partner. This gdT)d will may 
 properly stand as an asset on the books; for unless 
 overstated it represents a value which, though in- 
 tangible, is quite as real as that of tangible things, 
 and, since it has cost the present partners some value, 
 on the theory that the only proper basis for capital 
 charges is cost or sacrifice it may stand on the books 
 as an asset. It is true, of course, that the good will 
 which properly belongs to the remaining partners 
 is a true asset, but since it may not be withdrawn 
 by them, though it may be transferred, it should 
 not appear as credited to their accounts — and, there- 
 fore, cannot appear at all. 
 
 In an early chapter attention was called to the 
 fact that single entry is not scientific bookkeeping, 
 for it does not show sources of profit nor causes of 
 loss. An accountant is often asked to provide inf or- 
 
SETTLEMENTS BASED ON ACCOUNTS 383 
 
 mation necessary for a partnership settlement from 
 books kept only by single entry. It is desirable 
 here, therefore, to make a sliglit examination of sin- 
 gle entry. Under the strict single-entry method no 
 accounts are kept except for property and claims. 
 When merchandise is sold, the only record made is 
 a debit to the customer; when a note is received 
 from a customer, the only entry is a credit to the 
 customer; when cash is paid for wages, no entry 
 is made on any book which will lead to the ledger, 
 but the item is w^ritten on the cash book in order 
 to enable the bookkeeper to see how much cash he 
 ought to have on hand. Usually, in practice, a little 
 of the double-entry method is incorporated in single- 
 entry books, and credits are made to Bills Payable, 
 for instance, when notes are issued, and debits to 
 Bills Receivable for notes received. Even then, 
 however, the books are not double-entry books, for 
 no attempt is made to produce equality between the 
 two sides of the ledger. Under the single-entry 
 theory, since assets can always be counted, no need 
 exists for entry on the books. The method of learn- 
 ing profit or loss under single-entry is the method 
 pursued in proving the six-column statement by 
 double-entry; that is, a comparison of the balance of 
 resources and liabilities at the end of the year with 
 that at the beginning of the year shows (except 
 for withdrawals and new investment of capital by 
 partners) the profit or loss of the year's operations. 
 Under double entry, it will be remembered, the books 
 give two methods of learning profit, — one by a com- 
 parison of assets and liabilities, the other by a com- 
 parison of losses and gains. The single-entry method 
 
384 ACCOUNTING AND AUDITING 
 
 of determining total profit or loss is quite as good as 
 the other, if it can be assumed that no errors have 
 been made on the books ; but since it shows no details 
 and gives no indication of the sources of profit 
 or causes of loss, it is entirely inadequate, and 
 furnishes no basis at all for any accounting properly 
 so called. When, therefore, one has to learn from 
 single-entry books what profit has been made by a 
 partnei^hip, one has only to draw up a statement 
 of assets and liabilities for the year in question and 
 compare it with a similar statement for the year 
 before — making allowance, of course, for with- 
 drawals .-and investments by partners. If a state- 
 ment for the present time compared with that of the 
 earlier time shows no change, it is obvious that the 
 profit equals the withdrawals of partners — that is 
 to say, the partners have withdrawn during the year 
 just the profits made. If, on the other hand, there is 
 no increase of assets and the partners have added to 
 their investment during the year, as shown by their 
 capital acounts (which, of course, must be main- 
 tained even in single entry, to show how much of the 
 capital belongs to each partner), the business has 
 lost the siun of such additional investments. If 
 the difference between the statements of resources 
 and liabilities shows increased assets, the actual 
 profit is that increase plus all withdrawals by part- 
 ners — for in spite of the sums withdrawn profits still 
 exist in the business, and so the total profits have 
 been present profits plus withdrawals. 
 
 Let us turn next to trusteeships. Their peculi- 
 arity is that the distinction between capital and 
 revenue is under them likely to be much more im- 
 
SETTLEMENTS BASED ON ACCOUNTS 385 
 
 portant than in ordinary business transactions. If, 
 for instance, the trustee is executor or administrator 
 under a will, and the will provides that the ^^ corpus" 
 of the estate — that is, the body of the estate as dis- 
 tinguished from income — shall be paid ultimately to 
 one person, but the income of property shall be paid 
 to one or more others, the trustee must realize that 
 the corpus of the estate is the value of the estate at 
 the moment of death. Very few business relations, 
 however, reach culmination day by day. If, for 
 example, the testator held bonds on which interest 
 is regularly collected or real estate on which rent is 
 regularly collected, the interest and the rent accrued 
 on the day of death (though not yet due) belong to 
 the inheritor of the corpus of the estate, but all in- 
 come from these sources accruing later and begin- 
 ning to accrue on the day of death belongs to those 
 who hold the life-interest, or income. It is necessary 
 for the trustee in keeping his books of account, there- 
 fore, to see that all the elements of the estate are 
 valued as of the day of death, even though collected 
 later, 'and that all sums earned later are shown on 
 his books as income. 
 
 Under the law of most states the title of all 
 personal estate vests immediately on death in the 
 executor or administrator, and therefore he should 
 keep books of account showing his responsibility to 
 the estate. Real estate, however, under the law of 
 most states, does not vest in a trustee, but passes 
 at once to the beneficiaries under the will or under 
 the general law, and, therefore, the trustee does nov 
 ordinarily need to record real estate on his books. 
 His first entry, after making an appraisal of tht 
 
 A & A-25 
 
^g6 ACCOtJNTlKG AJ^D AUDITING 
 
 estate, then, is a debit to the accounts representing 
 specific kinds of property, and a credit to the per- 
 sonal estate of the deceased. When any changes 
 occur, such, for instance, as collections of rents and 
 interest, he debits Cash, as in ordinary cases, and 
 credits the personal estate for that sum which had 
 accrued at the time of death, and credits Income for 
 •its due share. When any payments are made to bene- 
 ficiaries entitled to the income of the estate. Income 
 is, of course, debited for those payments, and Cash, 
 or the other necessary property account, is credited. 
 If at the time of death rentals have accrued on real 
 estate which is under the will or under the general law 
 transferred directly to beneficiaries, the trustee will 
 collect the rental on the next date of payment and 
 will credit to Income the sum accrued since death. 
 The sum accrued at the time of death will have been 
 already debited to Eentals Accrued at the time the 
 books were opened, and credited to personal estate. 
 Many problems of executorship involve careful and 
 complicated computations of the exact division be- 
 tween income and principal. Their solution should 
 be undertaken only by persons familiar with the 
 mathematics of investment. 
 
 We may turn next to insolvency. In case a 
 trustee is required to settle the affairs of an estate, 
 individual, partnership, or corporation, in insolvency, 
 he must see that he has acquitted himself not only in 
 reality but on his books for all responsibility as- 
 sumed. The first step is usually to make an esti- 
 mate, for general guidance, as to the probable yield 
 of assets. This is usually made in the form of what 
 is called a *' statement of affairs." Such a state- 
 
SETTLEMENTS BASED ON ACCOUNTS 387 
 
 ment usually has the liabilities on the left side of the 
 sheet, because, since its purpose is to show how far 
 the property is likely to liquidate liabilities, the 
 first concern is to show what is the amount of such 
 liabilities. Usually several classes of liabilities, with 
 different degrees of security, are to be met. The 
 order in which items shall appear is not, of course, 
 of great moment, and the desirable thing is not so 
 much to show totals as to show for each class of 
 liabilities how it will probably fare in final settle-' 
 ment. Any assets that must of necessity apply to 
 specific liabilities, such as securities pledged as 
 collateral, should be connected with those liabilities. 
 So far as any liabilities are wholly secured, they do 
 not affect the solvency of the business, and need to 
 appear on the statement only to show that they have 
 not been forgotten or that they absorb certain assets 
 which otherwise would be useful in liquidating other 
 liabilities. The primary purpose of a statement of 
 affairs, therefore, is to show the unpledged assets in 
 their relation to the unsecured debts. Naturally 
 the first item is commonly the amount due to unse- 
 cured creditors. Next is usually stated the amount 
 of secured liabilities, with the estimated value of 
 the security pledged; any excess value of the security 
 is therefore free and available to set among the 
 resources on the other side of the sheet, — unless, 
 indeed, some of this surplus may be specially claimed 
 by creditors partially secured. (See page 389.) 
 Next among the liabilities come simis due to credit- 
 ors partly secured, and from this is subtracted the 
 estimated value of the security pledged for those lia- 
 bilities; the balance, or excess liability, is added to 
 
388 ACCOUNTING AND AUDITING 
 
 the sums due to unsecured creditors. Next are 
 added the liabilities on notes, the contingent liabil- 
 ities, and finally the liabilities to preferred creditors, 
 such as those for taxes, for fees in insolvency, for 
 wages, etc. From this last class are deducted funds 
 found on the other side to be available for the pay- 
 ment of such preferred claims; for since these claims 
 are legal preferential claims, they absorb the first 
 free assets, and if sufficient free assets are available 
 to provide for them, they disappear as unsecured 
 liabilities. On the assets side of the sheet the gen- 
 eral list of property is given first. Next follow the 
 accounts receivable, which are classified as good — 
 of which the amount is extended into the total 
 column, — the doubtful — for which an estimate is 
 made as to the probable yield and the amount ex- 
 tended into the total column, — and the bad — which, 
 of course, will yield nothing for the total column. 
 Next follow the bills receivable with their estimated 
 value; then the surplus from any values pledged to 
 the secured creditors, as shown by the subtraction 
 from the second item of liabilities. From the total 
 of these may be seen readily whether any sums are 
 immediately available to be laid aside for the pref- 
 erential claims — as previously indicated; and if so 
 they are at once deducted and applied to such claims 
 on the other side. The total free assets now compared 
 with the total unsecured liabilities will show probable 
 deficiency. This, of course, is added as the last item 
 on the resource side to balance the statement. A 
 form is given below. 
 
SETTLEMENTS BASED ON ACCOUNTS 
 
 389 
 
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390 ACCOUNTING AND AUDITING 
 
 The next task of the trustee is to realize on the 
 property. A common form of recording this on books 
 of account is what is called a '^realization and liqui- 
 dation account.'' If it is undesirable to close at once 
 on the books all asset and liability accounts into the 
 realization and liquidation account, an artificial ad- 
 justment account may be credited for the necessary 
 debits to Realization and Liquidation, and debited for 
 its credits. The first entry under this plan will 
 debit Realization and Liquidation for all assets at 
 their book value — ^f or the book value naturally repre- 
 sents the theoretical basis on which the realization 
 will proceed. The adjustment account will be credited 
 for the same sum. Next, Realization and Liquida- 
 tion will be credited for all liabilities to be liqui- 
 dated, and the adjustment account will be debited 
 for the same sum. The result of these two entries 
 is that Realization and Liquidation shows the book 
 value of assets with which liabilities must be liqui-* 
 dated, and the amount of such liabilities to be liqui- 
 dated. (See page 392.) Among the liabilities, 
 however, would not, of course, be included the pro- 
 prietor's capital, for since this is an inside relation 
 it does not need liquidation in the ordinary sense. 
 As soon as any sum has been realized — ^by the col- 
 lection of accounts receivable and bills receivable or 
 the sale of merchandise, for instance, — Realization 
 and Liquidation should be credited, for that sum 
 has gone to reduce the amount which the trustee is 
 responsible to realize on. As soon, on the other hand, 
 as any of the sums so realized have been applied to 
 the liquidation of liabilities. Realization and Liqui- 
 
SETTLEMENTS BASED ON ACCOUNTS 391 
 
 dation is debited for those sums, for the trustee has 
 performed to that extent his task of liquidation. 
 Since, moreover, whenever realization or liquidation 
 has been carried out, the original property and lia- 
 bilities on the books are now disposed of, entries 
 should be made to the adjustment account and to 
 the asset and liability accounts on the books so as to 
 bring the books into accord with the latest situation. 
 If, for instance, $5,000 is collected by the trustee on 
 bills receivable, and with it $5,000 of bills pay- 
 able is liquidated, the first entry is to debit Cash and 
 credit Realization and Liquidation, for the realiza- 
 tion, the second, to debit Realization and Liquidation 
 and credit Cash, for the liquidation, the third, to debit 
 Adjustment and credit Bills Receivable, to close Bills 
 Receivable on the books, the fourth, to debit Bills 
 Payable and credit Adjustment, to close Bills Pay- 
 able. If, in the process of realization and liquida- 
 tion, expenses are incurred, as is practically inevi- 
 table. Realization and Liquidation is debited and 
 Cash is credited; for these expenses paid are, from 
 the point of view of the trustee, equivalent to liabili- 
 ties liquidated. This charge does not need to appear 
 on the old books in connection with any old account or 
 on the adjustment account, for it has no relation to 
 the old business except as Realization and Liquida- 
 tion registers the settlement of old affairs. Realiza- 
 tion and Liquidation is shown below for the condi- 
 tions of the statement of affairs shown on page 389. 
 It is assimaed that the estimates made there prove 
 accurate ; otherwise the loss and deficiency would be 
 affected. 
 
392 ACCOUNTING AND AUDITING 
 
 BEALIZATION AND LIQUIDATION 
 
 (Assets at book value) $ 91,000 (Liabilities on the books) $ 57,000 
 (Liquidation of liabilities, (Contingent and accrued 
 
 first claims) 19,800 liabilities) 16,950 
 
 (Percentage paid to unse- (Realized from assets) 46,000 
 
 cured creditors) 26,050 (Loss on realization) 45,000 
 
 (Legal claims) 150 
 
 Deficiency (unliquidated 
 
 liabilities) 27,950 
 
 $164,950 $164,950 
 
 This Realization and Liquidation, as usually pre- 
 sented, is far from clear; for it is a mixture of unlike 
 things. Debits to it may be assets to be realized on, 
 or liabilities liquidated, o:^ expenses of liquidation; 
 and credits may be either assets realized or liabilities 
 to be liquidated. The result is that no one can tell 
 whether all liabilities have been liquidated unless 
 he examines the detailed records. The purpose is 
 served more clearly by opening separate accounts 
 for each of the three elements of the combined ac- 
 count, and calling them ^^Realization," ^^Liquida- 
 tion," and ^^ Expense of Liquidation." The balance 
 of Liquidation shows how many liabilities at any 
 time remain unliquidated. The balance of Reali- 
 zation shows at any time how far the realizations 
 have approached the book value of assets. Expense 
 of Liquidation shows the costs. If, when all assets 
 have been realized and utilized as far as they will 
 go in paying debt, Liquidation still has a credit bal- 
 ance (showing debts outstanding), the capital of the 
 business has been exhausted and some creditors are 
 still unpaid. These three accounts are shown below. 
 
SETTLEMENTS BASED ON ACCOUNTS 393 
 
 REALIZATION 
 
 (Assets at book value) $91,000 (Realized from assets) $46,000 
 
 (Loss on realization) 45,000 
 
 $91,000 $91,000 
 
 LIQUIDATION 
 
 (Liquidation, first claims) $19,800 (Liabilities on the books) $57,000 
 (Liquidation, percentage to (Contingent and accrued) 16,800 
 
 unsecured creditors) 26,050 
 
 Deficiency 27,950 
 
 $73,800 $73,800 
 
 EXPENSE OF LIQUIDATION 
 (Payment) $150 (Legal fees) $150 
 
 When affairs have been settled, it is convenient 
 to have in one table or one account a complete state- 
 ment of deficiency, if any has resulted. What is 
 ultimately affected by the deficiency will depend in 
 part upon the amount of that deficiency. If the 
 business has accumulated a surplus of $20,000, and 
 the deficiency proves to be but $10,000, clearly only 
 the surplus account is affected; if, on the other hand, 
 the deficiency is $50,000, surplus is $20,000, and part- 
 ners ' capital, $70,000, the deficiency has wiped out 
 the surplus and made a severe inroad into capital, 
 so that the net result is a remaining partners' capi- 
 tal of $40,000. If, finally, the deficiency is for $100,- 
 000, and the other accounts are as just indicated, the 
 deficiency has wiped out the surplus, the capital, 
 and, if the partners are now insolvent, a part of the 
 debts due to outsiders. 
 
 One interested in the business, moreover, desires 
 to know not only what has been the ultimate result 
 
394 ACCOUNTING AND AUDITING 
 
 of the deficiency, but also from what it has origi- 
 nated. A deficiency account may indicate whether 
 the loss has arisen from a shrinkage of assets, from 
 a destruction of assets, from outside claims made 
 against the business because of its usual operations 
 — such as bankruptcy of business houses whose notes 
 the firm has accepted and has discounted or other- 
 wise transferred to others on endorsement, — or from 
 accommodation endorsements for outsiders by way 
 of friendship — which, of course, are not normal or 
 (in a sense) legitimate business operations. This 
 can be easily shown by a deficiency account giving 
 on one side capital items, or items connected with 
 capital, and on the other side the changes in assets 
 affected by realization and either shrunk or des- 
 troyed, with the liabilities thrust upon the business 
 from outside — that is, claims not arising from its 
 operation, but demanding the surrender of assets 
 for which the business has received no adequate 
 return. Assuming the capital to be shown on the 
 books as $34,000, this form of deficiency account 
 would be as follows : 
 
 (Compare with pages 389 and 393.) 
 
 DEFICIENCY 
 
 Eealization (loss) $45,000 Capital $34,000 
 
 Liquidation (new liabilities) 16,800 Balance (net insolvency) 27,950 
 Expense of Liquidation 150 
 
 ' $61,950 $61,950 
 
 As has been suggested in other connections, 
 though a ledger form for such a statement is con- 
 venient for the accountant, it is not always clear to 
 persons not familiar with books of account. This 
 
SETTLEMENTS BASED ON ACCOUNTS 395 
 
 deficiency account may be very easily presented in 
 ledger form, but is likely to be more intelligible if 
 in the form of a statement with subtractions where- 
 ever they naturally belong. It is always possible 
 to draw such a statement so that its relation to other 
 statements with which it is connected shall be ob- 
 vious. In this case, therefore, the amount of defi- 
 ciency, as sho\^ai by the deficiency account, should 
 agree in amount and in detail with the statement of 
 affairs and the realization and liquidation account. 
 Commonly, accountants make reports which, though 
 intelligible to persons familiar with bookkeeping, 
 mean practically nothing to anyone else, for not only 
 are the contra items meaningless, but the items which 
 are common to various sheets are given titles which 
 hide common relations, and the novice is unable to 
 see the information that he wants either in any one 
 of these accounts or in the relations between them. 
 Below will be found a form, for the situation de- 
 scribed above, which is clear and intelligible for all 
 readers familiar with commercial terms and with 
 simple figures. ^ 
 
 Depreciation on assets, as shown by Kealization: 
 Book value 
 Eealization 
 
 $91,000 
 46,000 
 
 $45,000 
 
 Liability for commercial endorsements 
 Liability for accommodation 
 
 1 
 
 14,000 
 2,000 
 
 Total losses 
 
 
 $61,000 
 
 Capital invested 
 
 Profits accumulated , 
 
 30,000 
 7,000 
 
 
 Withdrawals of capital 
 
 $37,000 
 3,000 
 
 
 Capital as per books 
 Accrued expenses 
 
 $34,000 
 950 
 
 
 Net nominal capital 
 
 
 33,050 
 
 Deficiency, or net insolvency 
 
 
 $27,950 
 
CHAPTER XVn 
 
 AUDITING 
 
 Under the general title of ^^ auditing" are usually 
 included several kinds of work that ought to bear 
 another name. Auditing strictly so-called shoiild 
 include only thorough examinations of books to make 
 sure that the final conclusions presented in the in- 
 come sheet and the balance sheet are warranted by 
 the original documents. Among special examina- 
 tions which ought properly to be given some other 
 name are examinations by professional auditors to 
 gather for outsiders certain specific information 
 about businesses in which they are interested. If a 
 man is contemplating an investment in a business as 
 a partner or a stockholder, for instance, he may em- 
 ploy an auditor to learn whether the sales are as large 
 as stated, whether the property is as valuable as 
 stated, and whether the* business of the past warrants 
 certain conclusions with regard to the future. Such 
 a study of the books requires work similar, as far as 
 it goes, to that of an ordinary audit, but it is com- 
 monly called simply an ' ' examination. " Of a similar 
 nature may be an examination for a person invited to 
 lend money to a business, for he desires to know the 
 probability not only of solvency, but also of earnings; 
 he wishes assurance of the payment of his debt with- 
 out legal procedure in bankruptcy. 
 
 397 
 
398 ACCOUNTING AND AUDITING 
 
 The two main purposes of an audit are to detect 
 fraud and to detect errors. It has happened often 
 that books have been seriously misleading not be- 
 cause anybody intended to mislead, but merely be- 
 cause ignorance led to erroneous accounting or book- 
 keeping. If it is suspected that anyone concerned 
 with the books has fraudulent intention, the exami- 
 nation will proceed on somewhat different lines from 
 that when only innocent error is feared; but the 
 difference of method cannot be very extensive, for 
 fraud has often been detected where there was no 
 slightest suspicion before the audit. The method of 
 an audit, then, should be based on the realization 
 that many men perfectly honest are likely to make 
 errors, and that many men apparently honest are 
 likely to commit fraud. The examination should be 
 so conducted that neither error nor fraud can escape 
 detection, and in such fashion that one bent on com- 
 mitting fraud cannot in the progress of the audit 
 cover up his tracks so that by false entries on the 
 books he transfers his error from work which the 
 auditor has not yet examined to that which he has 
 passed. As a matter of fact, there are very few 
 errors committed with fraudulent intention which 
 might not also chance to creep in by carelessness or 
 ignorance. Many men are so loath to stand com- 
 mitted of innocent error that they are likely by what 
 they consider a perfectly innocent method to attempt 
 to cover up their mistakes while an auditor is en- 
 gaged in examining the books; and by making entries 
 surreptitiously in work which the auditor has already 
 passed they may upset a large part of the value of 
 the work which he has already done. For an auditor 
 
AIJDITi:^G 399 
 
 to refuse to trust anyone, to insist on seeing every- 
 thing absolutely correct, and to refuse to allow 
 changes in work which he has passed, is only to pro- 
 tect himself against waste of labor and is not to cast 
 doubt or suspicion on the work of those regularly 
 engaged on the books. 
 
 The errors which auditing is to discover are of 
 two sorts. The first are mere errors of bookkeeping 
 which result in wrong figures. These are purely 
 technical, of course, and their discovery and correc- 
 tion are easy, for they do not involve judgment. The 
 second class of errors, those which arise from neglect 
 of some accounting principle, either through forget- 
 fulness of some element in a problem or through bad 
 judgment in the use of that element, are more or less 
 difficult of detection; for the auditor very commonly 
 is not thoroughly informed about the details of the 
 business and cannot always see in his mind's eye all 
 the elements of the problem before him. It is the 
 auditor's function, however, to watch carefully to 
 see that proper accounting principles are applied in 
 all cases which come to his attention. 
 
 The detection of fraud is much more difficult, for 
 a person imdertaking to commit fraud is usually in a 
 position — and, of course, has the intention — to cover 
 up his tracks. Of frauds, again, two classes are to 
 be observed. The first are the fraudulent entries 
 made by subordinate employees in violation of orders 
 given to them by their superiors. The commonest 
 form of this kind of fraud, of course, is that which 
 leads to the possibility of extracting cash. Actual 
 theft of property other than cash is less common, 
 and much harder to detect; but since it always re- 
 
400 ACCOUNTING AND AUDITING 
 
 quires, if carried on largely, assistance in disposing 
 of the property, collusion is likely sooner or later to 
 be detected. Fraud committed by members of a 
 partnership against their colleagues or by officers of 
 a corporation against the stockholders is often diffi- 
 cult for an auditor to detect, for the person commit- 
 ting the fraud is trusted by others, and he has infor- 
 mation about the conduct of the business which is 
 beyond the auditor's power to secure. In such cases 
 an auditor's ability to discover fraud lies chiefly in 
 his general knowledge of business conditions; for he 
 can make comparisons between figures which he can 
 get for this particular business and figures warranted 
 by his general experience. When he finds any con- 
 siderable discrepancy between general figures and 
 the figures disclosed for this business, it is his duty 
 to investigate. 
 
 The extent of the work an auditor shall do must 
 be determined for him in every case by the form of 
 contract which engages him. In the ordinary course 
 of his work he is likely to come across many transac- 
 tions which it is impossible for him to pass judg- 
 ment upon. In such a case he may well request a 
 partner or an officer to sign a statement assuming re- 
 sponsibility for that entry. In the auditor's final 
 report he may well call attention to the fact that this 
 item is one upon which it was impossible for him to 
 pass judgment, and that it is vouched by a person in 
 authority. The auditor is not performing his duty, 
 however, if he falls back on such a statement signed 
 by a partner or officer in any case which he is able 
 to investigate for himself; for since the purpose of 
 the audit is to certify the correctness of the books 
 
AUDITING 401 
 
 from an outside examination, in every case in which 
 he accepts the statement of an officer as to correct- 
 ness, he is by so much failing to perform the work 
 which he was hired to perform; and, therefore, such 
 statements should be used only in cases where it 
 would naturally be the auditor's task to verify the 
 item but from peculiar circumstances he is unable 
 to do so. 
 
 The first task in auditing is to learn what is re- 
 quired by the documents to be on hand at the date of 
 audit. If the books were known to be correct at 
 the beginning of the period (because a previous audit 
 has proved their correctness, or because the business 
 was started at that time, or because those engaging 
 the audit are willing to accept the books as correct 
 at the beginning of the period), and the property 
 now on hand is found by the auditor to agree with 
 the property required by the records to be on hand, 
 the audit is complete so far as its primary purpose — 
 the discharge of responsibility — ^is concerned. It is 
 obvious, however, that since the purpose of the audit 
 is primarily to see that the property called for by the 
 books is on hand at the end of the period, and since 
 it is in most cases impossible for both parts of the 
 examination — namely, the conclusions from the 
 books and the counting of property — to be performed 
 at one sitting, the auditor must take precautions that 
 no changes shall be made in either the books or the 
 property while the audit is in progress. The whole 
 art of auditing with respect to property is so to con- 
 duct the work that the conclusions from the books 
 and the counting of property shall be brought to a 
 culmination at the same moment, and that, there- 
 
 A & A-26 
 
4m ACCOTTNTING AKD AUBITINa 
 
 fore, no doctoring of either shall be possible. The 
 auditor must therefore know and preclude the possi- 
 bilities of making changes in the books to represent 
 what is not a fact, and of padding the assets so that 
 they shall appear to be greater than they really are. 
 He must conduct his work in such a way that no 
 loopholes shall be left and that at all times the work 
 which he has performed lies under his own hand and 
 cannot be changed without discovery. 
 
 An important medium for helping the auditor to 
 make sure that the accounts have not been altered 
 during the progress of the examination is a note- 
 book in which memoranda of important figures may 
 be made. Since it is important at some definite mo- 
 ment to see that the property on hand agrees with 
 that called for by the books, and yet one cannot 
 usually go through all the books at one sitting, the 
 only precaution against interference with the books 
 lies in making a memorandum, on outside papers, of 
 the total of the books, so that a comparison with the 
 originals at any time in the later progress of the 
 audit will show whether changes have been made. 
 These working papers constitute virtually another 
 set of books written up under the auditor's own di- 
 rection, but containing only summaries of important 
 details. The specific items to be entered in such 
 working papers will be considered in connection with 
 the separate steps of an audit. 
 
 It is foolish for anyone to attempt to audit books 
 until he has become familiar with the ordinary opera- 
 tions of the business, with the books which are ordi- 
 narily kept, and with the system of organization 
 which determines who is responsible for all entries. 
 
AtJDITING 403 
 
 The first step, therefore, is for the auditor to look 
 over the business carefully and see just what is done. 
 The second is to leam just what books are kept and 
 what each book is designed to do. The third is to 
 leam who is responsible for the entries in all books. 
 With this information at hand the auditor may plan 
 the course of his audit and know all the time what 
 materials he has at hand and what loopholes have 
 been left for errors of carelessness or of fraud. It is 
 worth while to spend a large amount of time in study- 
 ing the situation before attempting any handling of 
 the direct figures; for when one has become engaged 
 in the handling of books and the checking of figures 
 one is likely to be so much impressed with the imme- 
 diate task in hand that one forgets the larger aspects 
 and may fail to see a loophole in the general system. 
 One should note not only what books are actually 
 kept, but whether any book which is necessary to 
 make a secure plan of accounting has been omitted, 
 or whether any person is left in charge of two books 
 which ought to be so thoroughly separated that one 
 can be used as a check on the other. ^ 
 
 Ordinarily the first step in the actual audit is to 
 transcribe on one's working papers the summary of 
 all transactions. The most serviceable form for this 
 is usually, of course, the trial balance. This trial bal- 
 ance should be copied item for item into the working 
 papers, and if this is a first audit the trial balance at 
 the beginning of the period audited should also be 
 taken in order that without reference to the books 
 themselves the auditor can see what should be the 
 net changes for the period under examination. If 
 this is a second or later audit by the same auditor, he 
 
404 ACCOUNTING AND AUDITING 
 
 should use as his initial trial balance the copy he 
 took at the close of the last period audited. If the 
 trial balance includes, as it usually does, some con- 
 trolling accounts — that is, accounts representing, in 
 the general ledger, groups of accounts in subordinate 
 ledgers — the audit cannot be complete unless a list 
 is made of all balances shown on the subordinate 
 ledgers, for otherwise the auditor leaves open to the 
 bookkeeper the opportunity to make changes in the 
 subordinate ledgers during the course of the audit. 
 If, on the other hand, the auditor has a complete trial 
 balance with a separate list (which, of course, must 
 agree with the balance of the corresponding con- 
 trolling account in the general ledger) of individual 
 accounts, he has the whole condition of the business 
 as represented by the books in his own hands, and 
 no changes made later can escape him if he uses due 
 diligence. It is well to add to these figures, how- 
 ever, the monthly totals of all books posted in lump 
 sums — such as the cash book, the purchase book, and 
 the sales book. 
 
 The next step is for the auditor to examine the 
 property on hand at the close of the period. In gen- 
 eral, this property should be listed on the working 
 papers, for in a large business anyone having charge 
 of property may with fraudulent intention present 
 some property twice unless the auditor is careful to 
 list or mark for identification each bit as he passes it. 
 A common method is to stamp or check by some pri- 
 vate mark each evidence of property passing through 
 the auditor's hands. If such property is also listed, 
 there is little danger that any shall be counted twice. 
 It is usually possible to copy the trial balance, to 
 
AUDITING 405 
 
 copy the balances of subordinate ledger accounts, 
 and to count the property, at one sitting — though, of 
 course, many clerks may be needed to put through all 
 this in one day. When this cannot be done the audi- 
 tor should keep within his control all matters on 
 which the examination is not completed. Then as 
 he has knowledge of the results of all transactions — 
 in his summary of the books and of the property — 
 he may begin in the ordinary course to examine spe- 
 cific items and learn whether the details as shown by 
 the books produce the summary of the situation as 
 recorded in his own working papers. To that 
 examination we will now proceed. 
 
 It is well before we attempt to find means of pro- 
 tection against fraud to note what are the commonest 
 devices for covering fraud; for some sorts of fraud 
 may be perpetrated through several different books, 
 and after we have once grasped the principle we can 
 follow through the checks in the various books with- 
 out repeating our discussion of the fraud which they 
 are intended to detect. Let us take, first, frauds 
 attempted by subordinates against the orders of their 
 superiors. 
 
 As has already been suggested, most fraud is at- 
 tempted in connection with cash. The most obvious 
 scheme of this sort is to report cash receipts to be 
 less than the actual amount received, and thus leave 
 a sum to be appropriated by the cashier. Always, 
 of course, the bookkeeper realizes the possibility that 
 the payments of cash will later be discovered and 
 that then the discrepancy will appear. His decep- 
 tive task is so to make his entries that the pajTnent 
 will be recorded as a credit to the person paying, but 
 
406 ACCOUNTING AND AUDITING 
 
 Hot the receipt as a debit to Cash. In the natural 
 course of events, if f br a cash receipt the personal ac- 
 count is credited and no debit of any kind is given, a 
 discrepancy appears in the trial balance; but if the 
 precaution is taken to reduce the credit balance (or 
 increase the debit balance) of some other account on 
 the subordinate ledger, so that the total balances 
 shall still agree with the balance on the controlling 
 account in the general ledger, no discrepancy will ap- 
 pear unless the falsified account chances to receive 
 careful examination. This device has been com- 
 monly used by defaulting bookkeepers who knew 
 which accounts were little likely to be questioned. 
 In such a case, of course, the bookkeeper is careful in 
 sending a statement to the customer falsely debited 
 to include only the correct figure. By this device the 
 books are kept in balance, the proper credit is given 
 to the customer paying the bill, and, instead of a debit 
 to Cash, the books show a false debit to another cus- 
 tomer. If the bookkeeper can at his convenience 
 shift this false debit so as to keep it constantly in a 
 quiescent state, the trick may escape detection. 
 Only the customer's verification of his balance as 
 shown by the books of the firm will detect false en- 
 tries if they are made skilfully. Sometimes al)Ook- 
 keeper produces the desired credit to a customer's 
 account, without debiting Cash, by treating the pay- 
 ment as if it were an allowance for returned goods or 
 for discounts; thwi he may appropriate the cash 
 without throwing the books out of balance. If the 
 bookkeeper is left a free hand in charging off cus- 
 tomers' accounts to Bad Debts, moreover, it lies 
 within his power at any time to put remittances into 
 
AUDITING 407 
 
 his own pocket and close a customer's account as if 
 it had proved worthless — provided, as should never 
 happen, he has not only the handling of the books but 
 also the handling of remittances. All these devices 
 show the correct balance for the remitting customer's 
 account, and therefore are little likely to be detected 
 through the customer himself. 
 
 Another method of diverting cash to the pockets 
 of the bookkeeper or cashier is to credit Cash for 
 larger payments than are actually made. Unless the 
 business is closely watched, this can be done by debit- 
 ing creditors for the full face of bills even when dis- 
 counts were taken or goods were returned. The 
 difference between the net price paid and the gross 
 price entered on the bills is set free for the cashier's 
 pocket, and no discrepancy is shown in either the 
 cash account or the account of the customer imless 
 the details of the customer's account are passed 
 upon. 
 
 If the bookkeeper and cashier are left a free hand 
 for the payment of interest, taxes, insiu'ance, etc., 
 they may represent payments to be larger than the 
 actual amount called for and divert the excess to 
 their own pockets. It is possible, indeed, that, un- 
 less the transactions are watched carefully, a creditor 
 may be debited a second time for a bill paid once, and 
 the second payment be diverted to the cashier's own 
 use, — provided only some other account is falsely 
 debited at the time of the entry to the credit of Cash. 
 If a debit is made to another customer, the books will 
 show no discrepancy between debits and credits, and 
 the only precaution the bookkeeper needs to take in 
 covering his tracks is that the false amount be trans- 
 
408 ACCOUNTING AND AUDITING 
 
 ferred to some other account before this account 
 chances to be examined. Many bank defalcations 
 have been continued for years because they were 
 hidden in unquestioned balances in so-called inactive 
 accounts. 
 
 A device which has been used many times to cover 
 defalcations is borrowing from the future through 
 remittances received in the daily course of business. 
 If, for instance, a cashier receives daily large sums 
 of money, he may fail to enter those sums on the 
 books for perhaps twenty-four hours, and may use 
 part of them to cover a defalcation of the past; and 
 he knows that he will have at his disposal among the 
 remittances of tomorrow enough to cover the short- 
 age of today. So long as the books are never quite 
 written up to date, the cashier has at his disposal, if 
 the business is so organized as to give him access 
 both to money and to the books, a sum which has not 
 up to that time been recorded. 
 
 The detection of forgery is not here considered as 
 properly within the auditor's function; but, of 
 course, if he has reason to suspect crookedness, he 
 should be on the lookout for anything which should 
 lead to its discovery. 
 
 We may now turn to errors of fraud committed 
 by officers. Among the common devices to misrep- 
 resent the condition of a business is the inclusion of 
 bad debts and bad bills receivable as good. Some- 
 times a manager fails to report the issue of notes 
 which are still outstanding, even though these notes 
 were issued for cash. The failure to credit Bills Pay- 
 able in such a case is covered by a credit to some 
 other account that in the nature of the case is not 
 
AUDITING 409 
 
 examined in detail in the ordinary course of business. 
 It may happen that a considerable loss is hidden by 
 a failure to record on the books the fact that notes 
 received from customers have been discounted at 
 banks, and that these notes have not been paid at 
 maturity; for in that case the business is liable for 
 their payment, and yet, if Bills Receivable, instead 
 of Bills Discounted, was credited at the time the 
 notes were discounted, nothing on the books will 
 show that the business is liable unless a new entry 
 has been made at the time of maturity debiting Pro- 
 tested Notes and crediting the former holder of the 
 notes. Through neglect of this entry liabilities may 
 be represented as less than they really are. 
 
 If the accounting is not careful, goods received 
 just before the time of taking account of stock may 
 be counted in the inventorv before thev have been 
 entered on the books. In such a case the profits of 
 the business and the net assets will be misrepre- 
 sented; for merchandise will not have been debited, 
 and yet the inventory will be treated as a quasi 
 credit. 
 
 With this preliminary survey of the frauds likely 
 to be attempted, let us turn to the methods of ex- 
 amination. A few general rules should be held con- 
 stantly in mind. Alterations and corrections should 
 receive careful scrutiny, for they may have arisen 
 from an attempt to correct an error or to hide a 
 fraud; and not always does a bookkeeper get the cor- 
 rect result when he is trying honestly to correct an 
 error. It is extremely easy in making corrections to 
 commit a new error. Ambiguous figures — that is, fig- 
 ures which are not perfectly clear to read — should be 
 
410 ACCOUNTING AND AUDITING 
 
 given careful attention, especially when carried to 
 another book; for a figure which the bookkeeper 
 meant for ^^7" may have been added or posted as a 
 *^1" or a *^9." In checking figures, care must be 
 taken to avoid confusion of dollars and cents. Even 
 a person checking by the eye is usually influenced 
 unconsciously by the imaginary sound of the figures, 
 so that if he reads '^117.00," he may check ^^1.17"; 
 or he may check 200.25 as 225.00. The word ^'dol- 
 lars'' or *' point" should always be used; then the 
 expression wiU be ''one hundred seventeen point" 
 or "two hundred dollars twenty-five." This is espe- 
 cially necessary when one person is calling off to an- 
 other who does not see the original figures. The 
 auditor must be sure that he understands exactly the 
 purpose and use of every special column in every 
 book, for if a column is designed for one use, and 
 then fraudulently or carelessly put to another, it is 
 the auditor's business to detect the misrepresenta- 
 tion. 
 
 Before we study in detail each of the separate 
 books and separate kinds of entries, it is worth our 
 while to examine the various auditing processes 
 which must be used. In the following pages will be 
 found a summary statement of the principal work 
 to be performed in each book, and it will be a saving 
 of time and space if in many cases we use terms 
 which are more or less technical or even if we manu- 
 facture terms to indicate processes which have no 
 special name. Let us see what is the nature of each 
 of the common processes and what terms we shall 
 hereafter apply to them. 
 ■ Wherever possible an entry should be compared 
 
AUDITING 411 
 
 with the original document which gave rise to it, — 
 for instance, a credit for goods purchased should be 
 compared with the original bill. Whenever in the 
 following pages the word '^verify" is used in con- 
 nection with any book, it will mean that the items 
 there shown are to be compared with the original 
 documents. 
 
 All payments should be compared with the re- 
 ceipts for payment. Such receipts, whether they are 
 endorsements on returned checks or are formal re- 
 ceipted bills, are called '^vouchers." A receipted 
 bill is a better voucher than an endorsed check, for it 
 shows not only how much money was paid but what 
 it was paid for. Sometimes a check given for one 
 payment is fraudulently offered, when endorsed and 
 paid, as voucher for another. 
 
 Sometimes no original document or voucher can 
 be had, and then it will be necessary to consult origi- 
 nal records which may be in auxiliary books; for in- 
 stance, since the actual shipment of all goods is sup- 
 posed to be entered on a shipping book, sales should 
 be shown there. Freight and express receipts 
 should be preserved to show that shipment was 
 made; such receipts do not usually show more than 
 the number and kind of packages, however. When- 
 ever an entry is supported by the evidence of such an 
 auxiliary book, it may be said to be '* confirmed.'' 
 
 In order to make sure that some account was deb- 
 ited for every credit, and vice versa, especially in 
 connection with books posted in totals — such as the 
 purchase book and the sales book, — the auditor 
 should go over all footings. 
 
 Whenever a book contains several columns so 
 
il2 ACCOUNTING AND AUDITING 
 
 used that each of them is footed and posted on one 
 side and the total of the various columns is posted on 
 the other side, footing should be performed not only 
 vertically for each column, but also horizontally so 
 as to make sure that the grand total agrees with the 
 sum posted. This is called ^* cross footing." 
 
 Whenever a book has special columns for differ- 
 ent accounts, like the special-column cash book, the 
 auditor should examine the extensions to see that the 
 amounts stand debited or credited to the proper ac- 
 counts and in the proper columns. This is examin- 
 ing the ** distribution." 
 
 Of course, all items appearing in books of original 
 entry must go ultimately to some ledger. It is not 
 always necessary that postings to the subordinate 
 ledgers shall be examined, for the controlling ac- 
 counts in the general ledger show what should be the 
 total debits and credits to the subordinate ledger, and 
 if the total is found to agree the individual postings 
 may be assumed correct, — at least if the tests to be 
 described later are applied. All postings to the gen- 
 eral ledger, however, should be examined. At the 
 time of examination they should be ^* checked" — that 
 is, actually marked both in the book of original entry 
 and in the ledger. The check should be of a sort to 
 distinguish it from checks made during the ordinary 
 progress of bookkeeping. An auditor should never 
 give a second posting check to any item, or pass it if 
 once checked, under any circumstances; for, though 
 the assumption may be that it was checked the first 
 time by mistake, there is an equally good assumption 
 that it was checked in error for some other item, and 
 that, therefore, the other item will remain unchecked. 
 
AUDITING 413 
 
 If, therefore, in the course of checking, an item once 
 checked is about to be checked again, note should be 
 made of the fact so that when the books are gone 
 through finally, to see whether any items are still 
 unchecked, the cause of error can be discovered. 
 
 When all posting is thought to have been exam- 
 ined, error may still persist unless the auditor goes 
 through all the books to see that no item remains in 
 any book unchecked; for since checking is bound to 
 be more or less wandering, from one book to another, 
 some items may chance to be overlooked at first. It 
 may sometimes happen that an item remains un- 
 checked in the ledger or in some other book because 
 of peculiar circumstances which do not appear at 
 first glance. On the discovery of such an item the 
 entry should be copied, on the auditor's working 
 papers, with full information. If books are kept by 
 double entry, an unchecked item is sure to throw the 
 books out of balance unless it is offset by some other 
 unchecked item on the other side. If such another 
 is found and they cannot be explained so that their 
 meaning is beyond question and is clearly legitimate, 
 they should be reported. If, on the other hand, no 
 mate to an unexplained posting can be found, the 
 auditor should discover why it does not throw out the 
 trial balance; if it is an obvious error he should have 
 it corrected, and if it looks suspicious he should call 
 attention to it in his final report. 
 
 Sometimes an auditor may be unable to pass upon 
 an item even though the bookkeeping is entirely 
 regular, for sometimes a transaction is of so peculiar 
 a nature that it is beyond his power to interpret and 
 he is unable to get from any officer an explanation 
 
414 ^ ACCOUISTTHSTG AND AUDITING 
 
 which seems to him to justify him in passing it with- 
 out further question. In such a case he should make 
 a memorandum of the item in detail and report it to 
 his clients. He may well call attention in his report, 
 moreover, to explanations offered him, and give the 
 name of the officers offering them and the date when 
 they were offered. 
 
 It is an auditor's business to make sure, after he 
 has checked original entries into the ledger, that the 
 balances standing on the ledger, and, therefore, re- 
 ported on the trial balance and the balance sheet, cor- 
 rectly represent the ledger figures. He must, there- 
 fore, figure the ledger balances and compare them 
 with the trial balance. This is '^verifying" balances 
 and the trial balance. 
 
 An auditor should always make sure that a con- 
 trolling account in the general ledger agrees with the 
 balance of accounts in the corresponding subordi- 
 nate ledger, and he should learn this for himself by 
 figuring the balances on all subordinate ledgers and 
 making the comparison. 
 
 It is obvious that a dishonest clerk could on the 
 sales books extend debits to customers for less than 
 the actual amount of the sales, and then, if he also 
 had the handling of the cash, could divert to his own 
 use the difference between the amount of payment 
 when the bill was actually paid and the amount 
 standing on the books. If no system of internal 
 check is provided to preclude this, the auditor 
 should see that extensions are properly made. It is 
 not, however, his duty to compare prices entered on 
 bills with ^-he actual selling price; for he has the right 
 
AUDITIIsrG 415 
 
 to assume that at least this much is done by someone 
 in authority within the business itself. 
 
 Sometimes it is necessary for an auditor to follow 
 an item from an auxiliary book into a book of origi- 
 nal entry so as to make sure that part of the property 
 of the business has not disappeared without due debit 
 to some personal account. This should be done for 
 the shipping book, for instance. This is called 
 ** tracing." 
 
 Let us now turn to the specific books. It is cus- 
 tomary to begin an examination with the cash book, 
 for as this is the most general book it soonest gives 
 the auditor a grasp of the business under examina- 
 tion. The first step is to draw off a summary of the 
 cash book by months for the period under review. 
 For each month there should be taken the balance at 
 the beginning, the total debits, the total credits, and 
 the resulting balance at the close. Next, the auditor 
 should do the same for the check book — or the com- 
 bined result for all the check books if more than one 
 is in use, — that is, the balance at the beginning, the 
 deposits, the withdrawals, and the balance at the 
 close. Finally, the same sort of thing should be done 
 for the bank pass book, — that is, the opening balance, 
 the deposits, the checks returned, and the closing 
 balance. 
 
 It is obvious that these three books will not neces- 
 sarily agree, for very often checks will not be drawn 
 for all payments, not all receipts will have been im- 
 mediately deposited, and not all checks drawn will 
 necessarily have been presented at the bank before 
 the pass book is balanced. It is necessary, therefore. 
 
416 ACCOUNTHsTG AND AUDITING 
 
 that these three statements shall be reconciled — that 
 is, that a statement shall be drawn up for each month 
 showing what items appearing in any one of these 
 books have not yet appeared on the others. It might 
 seem at first as if the only thing necessary for the 
 audit is to make a reconciliation for the end of the 
 period under audit; for of course if things are cor- 
 rect at the end of the time they are presumably cor- 
 rect in the intervening months. This would be true 
 if one could be absolutely sure that no fraud had been 
 committed; but since a discrepancy in some months 
 might be made up in later months, and some person 
 having control of cash might have been using funds 
 of the business for his own purposes in the interim, 
 it is desirable to see for each month just what are 
 the differences among these three books. In making 
 this reconciliation it is necessary to examine the 
 checks returned by the bank as paid; and since it is 
 necessary also to use these same checks as vouchers 
 for cash payments, it is well, so far as possible, to 
 perform the two operations at once. It is likely to be 
 worth while, therefore, to compare checks with the 
 cash book entries before undertaking the final recon- 
 ciliation between the check book, the pass book, and 
 the cash book. We will proceed, therefore, to com- 
 pare checks with the cash book credit entries. 
 
 As has already been suggested, it is desirable that 
 all payments of cash which are to be entered on the 
 primary cash book shall be made through the me- 
 dium of checks; if any payments and receipts are 
 made in currency, they may be entered preferably on 
 the petty cash book. If that is done, the checks re- 
 turned by the bank as paid should agree exactly, ex- 
 
AUDITING 417 
 
 cept so far as any checks are outstanding, with the 
 cash book credit items. This makes comparatively 
 simple the task of reconciliation. When currency 
 as well as checks is entered on the cash book, two 
 kinds of cash must be considered in making the 
 reconciliations. It is desirable in that case to tick in 
 the cash book all payments by check when they are 
 found to agree with checks returned by the bank. 
 This is not a laborious task if the auditor takes the 
 returned checks in consecutive order and compares 
 them with the cash book credits, checking the cash 
 book as he goes along. The order is necessarily the 
 same for both checks and entries, of course. It is 
 not enough, however, for the auditor to see that the 
 amounts of checks agree with cash book credits; he 
 must also note whether the payees of the checks and 
 the endorsers are the same as the persons indicated 
 in the cash book entries as the proper recipients of 
 the money; for one method of fraud is to debit a 
 check on the books to the proper account, but to make 
 out the check to the wrong payee — for the benefit of 
 the defaulting employee. Such an operation would 
 not be disclosed by any error in the books except as 
 the balances of the accounts concerned might chance 
 to be investigated. If the cash book is kept so that 
 discounts are entered contra — that is, on the oppo- 
 site side, — the auditor should look to see that the 
 amount of discount is entered on the receipts side of 
 the cash book so as to produce a net credit to cash 
 of only the amount actually paid as shown by the 
 returned check. 
 
 So far om* examination of the cash book has been 
 for the purpose of learning whether the checks re- 
 
 A & A-27 
 
418 ^lCCOUISTTING AND AUDITING 
 
 turned show that the cash book entries faithfully 
 record actual payments. We may postpone until 
 later the examination of the justification for those 
 actual payments. 
 
 When all payments by check have been in this 
 fashion examined, and the checks themselves stand 
 as accepted vouchers, the task of direct reconciliation 
 with the check book and the pass book may begin. 
 One source of difference is the fact that the cash book 
 may contain currency payments which are not, of 
 course, on the check book or the pass book. Again, 
 checks which have not yet been presented at the bank 
 for payment will appear on the cash book and the 
 check book but not on the pass book. Finally, checks 
 drawn in the previous month, but not during that 
 month presented for payment at the bank, but pre- 
 sented during the current month, will be on the pass 
 book but not, of course, among this month's items of 
 the cash book and the check book. The reconcili- 
 ation among these books may be provided by arrang- 
 ing a table with a column for each book and a hori- 
 zontal line for each separate item on any book. Then 
 the first column mav be for the cash book, the second 
 for the check book, and the third for the pass book. 
 If the first line is meant to contain payments, in the 
 cash-book column will be the total credits; in the 
 check-book column, the checks drawn; and, in the 
 pass-book column, the checks charged against the 
 business by the bank. These are likely, for the rea- 
 sons already given, to fail of agreement. If, now, we 
 add in red ink in the column for each book the items 
 omitted from that book but contained in the other 
 books, the totals of the three colmnns should agree. 
 
AUDITING 419 
 
 Thus, currency paid is included in the cash book 
 credits, but since it is not on the. check book and the 
 pass book it is inserted in those columns in red ink. 
 This month's checks not yet paid by the bank are on 
 the cash book and the check book, but are not on the 
 pass book, and, therefore, should be extended in red 
 ink in the pass-book column. Checks entered in the 
 cash book and the check book last month but only 
 this month charged by the bank on the pass book 
 will be entered in the cash-book column and the 
 check-book column, because this amount is necessary 
 to put the other books on a basis with the pass book. 
 An illustration of such a reconciliation is given 
 below. 
 
 Disbursements 
 Currency items 
 Cheeks outstanding 
 Checks of previous months 
 
 Cash Book 
 $27,201.25 
 
 Check Book 
 
 $27,154.37 
 
 46.88 
 
 Pass Book 
 
 $27,004.37 
 
 46.88 
 
 
 1,117.50 
 
 967.50 
 
 967.50 
 
 $28,168.75 $28,168.75 $28,168.75 
 
 As this reconciliation is prepared for each month 
 the auditor should make a list of all differences ap- 
 pearing in that month, — that is, for example, list all 
 checks entered in the check book not in that month 
 returned by the bank. When these items appear 
 later, they may be checked on that list, and thus he 
 will know whether/ all discrepancies are accounted 
 for; any not accounted for by the reconciliations need 
 further examination. It is difficult to exaggerate 
 the value of such lists. It seems to the novice as if 
 time spent in making lists of things which ultimately 
 are to be cancelled is to great extent a waste. This 
 would be true if one could always know that the 
 
420 ACCOUNTING AND AUDITING 
 
 items would be later cancelled; but since the purpose 
 of an audit is to make sure that everything is prop- 
 erly provided for, any time spent in making such lists 
 is nothing less than an ultimate saving. Such lists, 
 moreover, should be given a very clear title; a list of 
 which the purpose is not clear is sometimes worse 
 than no list at all, for sometimes to find out just what 
 it is designed to do takes longer than constructing a 
 new list. Many a bookkeeper has spent fruitless 
 hours in hunting for memoranda which were not 
 properly labeled, or in trying to find the exact use of 
 memoranda at hand. 
 
 When this reconciliation of cash book, check book, 
 and pass book has been completed for disbursements, 
 and a list made of all unexplained discrepancies, the 
 auditor should turn his attention to the receipts side 
 of cash. He should see that all receipts have been 
 accounted for, month by month. A reconciliation is 
 necessary. The differences among the three books 
 are likely to be mainly items on the cash book which 
 have not yet been deposited (particularly receipts of 
 the last day of the month after the customary hour 
 for making deposits), and, if the custom does not 
 prevail in that business of making all payments 
 through the bank, a working balance of cash in the 
 cash drawer. The check book should contain few 
 deposits that are not in the cash book for that month ; 
 but the pass book may contain interest on deposits, 
 if any is allowed by the bank, and this will be in 
 excess of amounts shown in the cash book and the 
 check book for that month. A reconciliation form is 
 shown below. 
 
AUDITING . 421 
 
 Cash Book Check Book Pass Book 
 
 Eeceipts $23,210.27 $23,318.43 $23,328.73 
 
 Receipts not deposited 109.10 109.10 
 
 Deposit of previous month's receipts 217.26 
 
 Interest on bank balances 10.30 10.30 
 
 $23,437.83 $23,437.83 $23,437.83 
 
 The auditor should watch deposits with extreme 
 care. He should recommend that whenever a de- 
 posit is made a duplicate deposit slip shall be re- 
 turned by the bank with some sort of receipt; then 
 one may know not only how much has been deposited 
 each day, but the amount of each separate check. 
 Many defaulters have covered their tracks for long 
 periods of time by borrowing from the future, as has 
 already been indicated; they borrow today's remit- 
 tances, before they have been entered on the books, 
 to cover yesterday's shortage; but though they have 
 provided that the deposits for each day correspond 
 in total with the amounts naturally to be deposited, 
 as shown by the cash book, they are seldom able to 
 borrow checks of just the same detailed amounts, and 
 examination of their detailed deposit slips would 
 have disclosed discrepancies. For this reason it is 
 well to have certified duplicate deposit slips. The 
 auditor ought, moreover, to make sure that the pass 
 book presented to him is genuine, for defaulters have 
 sometimes covered their tracks by presenting for 
 examination a pass book written up by themselves 
 and not corresponding with the pass book provided 
 by the bank. The auditor should demand either that 
 the pass book shall be certified by the bank or that he 
 himself shall receive the book in person from the 
 bank. 
 
422 ACCOUNTING AN1> AUDITING 
 
 Since an audit cannot usually be completed within 
 two or three days, the auditor can often secure, from 
 the bank, checks reported on his reconciliation as 
 outstanding at the time of beginning the audit. 
 These should be audited, for on the books they reduce 
 the required cash balance; and unless the auditor can 
 audit them he has no assurance that cash was actu- 
 ally paid as indicated. It has happened in the past 
 that defalcations have been hidden by a combination 
 of fraudulent entries of which a part were on the 
 stubs of check books, making things look as if checks 
 had been drawn and were outstanding at the time of 
 audit. If an entry is made on the cash book as if a 
 payment were made, and then on the check book the 
 bank balance is reduced (by a fictitious stub), the 
 auditor expects to find the cash balance by the books 
 smaller than the amount shown by the pass book. If 
 then the bank balance is padded by a fictitious pass 
 book, or by deposits borrowed from the future, cash 
 book, check book, and pass book agree. This does not 
 enable the cashier to extract cash, of course ; but it 
 does cover up shortages in cash previously taken ; for 
 it reduces the cash balance, and appears to explain 
 why no vouchers, in the form of checks returned by 
 the bank, are at hand for that reduction. It substi- 
 tutes an imaginary loss of cash for a real one. Only 
 a certification of the pass book, or the later auditing 
 of outstanding checks, or certified duplicate deposit 
 slips, can sufiiciently safeguard a business against 
 this sort of thing. 
 
 So far our examination of the cash book has been 
 for the purpose of learning whether the actual cash 
 bandied has been accounted for. We may now ex- 
 
AUDITING 423 
 
 amine the methods of learning whether the right 
 amounts of cash have been handled. Cash disburse- 
 ments on notes, bonds, mortgages, interest, etc., 
 should be compared with the original records so that 
 one can be sure that the amounts entered are proper, 
 and the vouchers should be examined. Payments for 
 the purchase of stocks and bonds should be compared 
 carefully with the broker's memorandum of pur- 
 chase, for since the price of securities is fluctuating 
 hour by hour the possibility of fraud in that connec- 
 tion is very great, and only when the amount has 
 been vouched by some responsible person can it be 
 passed by the auditor. Payments for the purchase 
 of real estate should be compared with the deeds; the 
 memorandum of record by the proper recording 
 official should be examined, — especially to see that 
 the date is as it should be; and the auditor should see 
 that the title to the deed stands in the name of the 
 business or of some person authorized to hold for the 
 .business. For all payments which require the vote 
 of the directors of a corporation, the auditor should 
 examine the minutes of the directors' meetings to see 
 that proper authorization was given. Among such 
 payments are those of dividends, and the auditor 
 should see that the amount of dividends is the proper 
 percentage on the capital stock. He should examine 
 the dividend books and dividend checks to see that 
 the proper amounts were paid to each stockholder; 
 for otherwise it might be possible for a dishonest em- 
 ployee to reduce the dividend check of some person 
 not likely to keep informed as to the amount of divi- 
 dends and deflect the deficiency to someone who 
 would share the gain with him. Payments of salaries 
 
424 ACCOUNTING AND AUDITING 
 
 determined by vote of directors should be compared 
 with the minutes of such vote. Payments of wages 
 should be compared with the pay roll, and the auditor 
 should see that the pay roll has been properly ap- 
 proved by an officer in authority; and he should for 
 test purposes compare two or three pay rolls in each 
 year's work with the time books and thus ascertain 
 that there has been no padding or carelessness in 
 determining the amount for each employee. Of 
 course all entries of payments for merchandise, sup- 
 plies, etc., should be compared with the original re- 
 ceipted bills or other vouchers. It has already been 
 suggested that one method of deflecting cash to 
 wrong usage is to debit a creditor for the full face of 
 a bill even though a sum smaller (because of discount 
 or returned goods) should have been paid. It is the 
 auditor's business, therefore, whenever payments 
 have been made on items which may have been sub- 
 ject to discount, to learn whether discounts were 
 available on those payments, and to see whether, if 
 the full charge, was made, the creditor has been deb- 
 ited too much and someone has appropriated the 
 excess. When the auditor cannot find vouchers he 
 should ask someone in authority to give him a signed 
 statement as to the legitimacy of payments. This 
 would apply, of com'se, to petty cash items, as well as 
 to general items. The auditor should make a List of 
 all items which he cannot properly vouch, and on that 
 list he should indicate what sort of voucher, if any, 
 is available, and in what sense it is not adequate. 
 This list he should submit to his clients. 
 
 It is seldom possible to get adequate vouchers for 
 cash receipts. Usually the only thing that can be 
 
AUDITING 425 
 
 done is to compare the receiptB entered on the cash 
 book with entries in the other books and judge in 
 that way whether the amount is proper. Since much 
 information of this sort is got usually from the 
 ledger, and since all postings ought sooner or later to 
 be checked, it is well to combine the two processes 
 and check into the ledger as one goes along. For 
 pa^onents by customers, for example, it is well for 
 the auditor to look up the customers' accounts in the 
 ledger and see whether the amount is correct; and 
 while he is engaged in that task he may well check 
 the posting of the receipt. This saves the turning of 
 pages when finally the checking of all postings is to 
 be completed. In this work of checking receipts 
 from customers, the auditor should note carefully 
 whether discounts entered on the cash book, as 
 allowed on bills collected, agree with the terms of 
 sale ; for it is comparatively easy for a cashier having 
 access to the books to give a customer credit for a 
 discount when none was allowed and deflect to his 
 own pocket the extra amount of cash actually paid 
 by the customer over the net amount of the bill. 
 When the full amount of bills is entered on one side 
 of the cash book, and discount on the other, the audi- 
 tor should note whether deposits cover the fuU 
 amount reported as actually paid. If he finds de- 
 ductions from bills because of returned sales, he 
 should confirm such returns by the receiving book. 
 He should also verify all receipts from interest, rents, 
 mortgage payments, etc., and see that Cash was deb- 
 ited for the full amount called for by the debt. He 
 should see also that receipts from cash sales, as en- 
 tered on the cash book, agree with the amount shown 
 
426 ACCOUNTING AND AUDITING 
 
 on the sales book. Wlien notes have been sold and 
 have not been entered on the cash book, the bill book 
 should disclose their existence. If such notes have 
 been omitted from that book also, but have been dis- 
 counted with the bank where deposits are kept, the 
 proceeds will show on the pass book, and the dis- 
 crepancy in the reconciliation will disclose the issue. 
 Otherwise no way can be found of surely detecting 
 such omissions from the books. When any notes 
 have been discounted, the auditor should see that the 
 net amount of cash reported is the full actual pro- 
 ceeds and not a smaller sum which leaves a margin 
 for embezzlement. 
 
 The auditor should examine the extension of all 
 cash items into special columns and make sure that 
 none are included in wrong totals. When all items 
 on the cash book have been passed, the footings of 
 the book should be figured, the balance determined, 
 and the posting checked into the general ledger (or, 
 if cash is not posted, the cash item on the trial bal- 
 ance checked). 
 
 When counting cash it is desirable to make a 
 memorandum of the specific items counted — so that 
 none may be presented a second time. This list 
 should include the amount of each denomination of 
 cash, any so-called ^^cash items" (with full memoran- 
 dum for later identification), and all checks awaiting 
 deposit. **Cash items," which are mere memoranda 
 of temporary loan, cash in transit, etc., should not be 
 passed unless they have been vouched by some person 
 in authority. 
 
 The auditor naturally proceeds next to the jour- 
 nal. Since journal items are likely to be few in 
 
AUDITING 437 
 
 number and scattered through the general ledger, a 
 considerable waste of labor in turning pages is likely 
 to be avoided if the postings are checked in a some- 
 what peculiar order. It is usually wise after the first 
 journal entry is checked in the ledger to note, while 
 the ledger is open at that account, what other journal 
 entries are posted to that account, and then check 
 these in the journal before checking the second jour- 
 nal entry. The method, therefore, is to check the 
 first journal entry from the journal to the ledger; to 
 check all other postings of that account in the ledger 
 back into the journal; to check the second journal 
 posting into the ledger; to check back into the jour- 
 nal all other postings from the journal to that ledger 
 account; and so on until all ledger items have been 
 checked. The finding of journal entries for ledger 
 accounts is usually much less work than the finding 
 of ledger accounts from journal entries; for, whereas 
 the ledger may cover many hundred pages, and 
 checking to it may involve much turning of leaves, 
 the journal is likely to cover a comparatively small 
 number and so items can be easily found. In audit- 
 ing journal items the same precautions should be fol- 
 lowed as in auditing items appearing on the cash 
 book. In addition, however, certain items are likely 
 to require certification by officers in authority. 
 Charges to Bad Debts, for instance, should be au- 
 thorized; else, as we have seen, they may be substi- 
 tuted for Cash. Many journal items are likely to be 
 transfers and to involve adjustments. For these no 
 adequate vouchers can usually be found; and, there- 
 fore, it is wise for the auditor to request that all jour- 
 nal entries be signed by the person having the proper 
 
428 ACCOUNTING AND AUDITING 
 
 authority, or that such person give him a certificate 
 that the signer accepts responsibility for the correct- 
 ness of the entry. If the person who should authorize 
 the entry is not sure that it is correct, he should ask 
 the auditor's judgment on the matter, and then he 
 may, if he desires, indicate on his certificate that the 
 entry was made on the advice of the auditor; but in 
 any case the auditor should demand that some person 
 in authority be responsible for truthful representa- 
 tion of the circumstances which gave rise to the 
 entry. The auditor will do well to make a copy of all 
 items relating to bonds, stocks, capital, and closing 
 entries for the determination and disposition of 
 profits; for as these are matters which should enter 
 into the report made to his client, he may well have 
 copies in his working papers and not be forced to 
 rely on the original books. The auditor should ob- 
 serve' that the total debits, as shown by the journal, 
 equal the total credits. If there are special columns 
 in the journal, he should go over all the footings; and 
 he must by checking, of course, see that all items are 
 properly posted. 
 
 The order to be followed in auditing the other 
 books is not of much consequence. We may well 
 take them here chronologically. 
 
 The first is the order book to indicate what orders 
 have been issued for the purchase of supplies and 
 merchandise. If this book is properly kept, no pur- 
 chases are authorized unless they first appear here. 
 The auditor will use it, therefore, for confirming 
 purchases. 
 
 If a receiving book is kept, the auditor should 
 compare the record of goods received with the pur- 
 
AUDITING 429 
 
 chase book and make sure that all receipts have been 
 properly debited to Supplies or Merchandise and 
 credited to the shippers. 
 
 The purchase book should be examined to see 
 whether any items appear there which have not 
 already been checked as confirmed by the order book 
 and the receiving book, whether items have been 
 properly distributed to various departments (if pur- 
 chases are debited to more than one account), 
 whether the footings have been properly taken, 
 whether (if there are several purchase accounts) the 
 cross-footing of totals agrees with the total of all 
 purchases, and whether postings have been properly 
 made to the general ledger. It is not always neces- 
 sary for the auditor to check purchases into the pur- 
 chase ledger; for if all purchases have been properly 
 credited to Creditors, and the balance of creditors' 
 accounts in the purchase ledger agrees with Credit- 
 ors in the general ledger, it is presumable that these 
 accounts are correct in detail. The chief possibility 
 of error is that some item will get upon a wrong ac- 
 count. This may be provided against by communi- 
 cation with creditors, as will be shown later. 
 
 If a separate book is kept for returned purchases, 
 this should be examined very much as the purchase 
 book is examined, by the method above described. 
 Such returned purchases should be entered in a ship- 
 ments book. This will furnish the confirmation for 
 the debits to creditors' accounts; and the total of 
 such returned purchases should be, of course, debited 
 to Creditors in the general ledger. These may well 
 be checked into the creditors' ledger as a protection 
 against overstatement of cash payments — unless this 
 
430 ACCOUNTING AND AUDITING 
 
 has already been provided against by the method 
 suggested for auditing cash disbursements (page 
 424). 
 
 A thorough examination of the stock book, if any 
 such is kept, is likely to be a considerable task, but 
 it should not be shirked if a complete audit is de- 
 sired. It is impossible, of course, for the auditor 
 to go behind the inventory for the beginning of the 
 period under audit, but he should require that this 
 inventory be presented to him and that it bear the 
 signature of someone in authority who accepts it as 
 of the beginning of the period. If the receiving book 
 shows, as it should, all receipts since that inventory, 
 and the shipping book shows all shipments since 
 that inventory, the auditor has in his own hands the 
 means of determining the present inventory. If, on 
 the other hand, the books cannot be kept on this care- 
 ful plan — ^because, for instance, goods come in and 
 out without passage through the receiving and ship- 
 ping rooms, — the auditor cannot learn the gradual 
 changes in the stock on ,hand and must fall back on 
 an inventory at the end of the period. For this, 
 however, he should demand the signature of some- 
 one in authority. He should test the prices by recent 
 invoices. In many lines of business in which it 
 is customary to fix prices at a certain percentage of 
 cost, one can from the sales alone approximate the 
 cost of the goods sold. By combining the inventory 
 at the start, the purchases, and the presumable cost 
 of the goods sold, one can get the present inventory. 
 This, of course, can be nothing more than an ap- 
 proximation ; but it may serve as a check on radically 
 erroneous statements of present stock. 
 
AUDITING • 431 
 
 Where possible, the sales book should be com- 
 pared with the shipping book so as to show whether 
 all the goods shipped were charged to customers. 
 The auditor should verify the extensions of price 
 and thus make sure that no error was made in charg- 
 ing a customer less than the proper amount; he 
 should verify the footings of the sales book, and 
 should check the postings to the general ledger — 
 both for the debit to Customers and for the credit to 
 Merchandise. It is not always necessary to check 
 the postings to the sales ledger, for the examination 
 of customers' accounts, to be considered later, may 
 obviate this. 
 
 If a book is kept for goods shipped on approval, 
 this should be examined carefully to see whether it 
 contains all items marked on the shipments book as 
 for this purpose, and whether all items show^n by it 
 to have been retained have been properly debited on 
 the sales book. Goods returned, as shown by this 
 approvals book, should be traced ii^to the receiving 
 book. If any items of long standing on this book 
 have been neither returned, as shown by the receiv- 
 ing book, nor debited on the sales book, an investiga- 
 tion should be made. All such items should be listed. 
 
 If a separate book is kept for C. O. D. items, the 
 amounts should be traced into the sales book to see 
 that all items have been accounted for. 
 
 Let us now turn to the ledgers. For the general 
 ledger it is necessary to go over all postings to make 
 sure that all items have been checked as agreeing 
 with some book of original entry. If any remain 
 imchecked, they should be listed for future refer- 
 ence. Memorandum should be made of any ap- 
 
482 ACCOUNTING AND AUDITING 
 
 parent irregularities. The balance of each account 
 should be figured, and the result should be checked 
 to the trial balance. 
 
 If controlling accounts have been accurately kept 
 to represent dealings with creditors and customers, 
 the balance of each particular account of a creditor 
 or a customer is not of primary importance for an 
 auditor; for any discrepancies must lie in an over- 
 statement of one account offset by an understate- 
 ment of another. Since, however, there is oppor- 
 tunity for embezzlement through omission of receipts 
 from both the controlling account and the subordi- 
 nate ledger accounts, it is the auditor's business to 
 get confirmation for the books through the subordi- 
 nate-ledger balances. It is desirable to have from 
 all persons with whom the business has relations an 
 occasional confirmation of their accounts. It is well, 
 therefore, for the auditor to send to all creditors and 
 to all customers at the time of beginning an audit a 
 statement showing the balance on their accounts as 
 the books then stand, and to ask for a return of the 
 statement endorsed as correct. Though usually not 
 all such statements will be return^ed, if this work is 
 done at annual audits each account is likely to be 
 confirmed at least once in two or three years, and 
 the possibility of this is a good check on clerks with 
 dishonest tendencies. It should be understood, of 
 course, that an auditor has no right to send out re- 
 quests for confirmation without the consent of his 
 client. The task of making statements for confirma- 
 tion is not so great as might at first sight appear, for 
 the regular monthly statements may be utilized for 
 this purpose. If the auditor accepts the statements 
 
AUDITING 433 
 
 f 
 
 prepared by the bookkeeper, compares them with the 
 books, puts upon them a private mark which cannot 
 be duplicated by the bookkeepers, and then requests 
 that this particular statement — and not another 
 which may be substituted for it — be returned to the 
 auditor's own address, the check is complete. For 
 the auditor's private mark he may provide a rubber 
 stamp with some characteristic that is not easily ob- 
 served by the uninitiated — such, for instance, as 
 slight flaws or irregularities (cut in the letters) 
 which could hardly be detected by anyone not in the 
 secret. 
 
 If this test by calling for confirmation is not 
 feasible to apply, the auditor should check all post- 
 ings of the purchase ledger and sales ledger from the 
 books of original entry. A bookkeeper knowing 
 that this will be done is little likely to substitute a 
 debit to a customer for a debit to cash. 
 
 We now assume that the books have been care- 
 fully examined to learn that all expenditures 
 have been properly vouched for, that all receipts 
 have been properly credited, that all postings have 
 been made to the ledger, and that all balances have 
 been properly figured. If during the process of the 
 audit all items have been checked when verified, ex- 
 amined, or posted, no item should remain either in a 
 book of original entry or in the ledger without the 
 auditor's private check mark or a memorandum call- 
 ing attention to its irregularity. When this work is 
 supposed to be complete, all the books should be ex- 
 amined finally for assurance that each item does actu- 
 ally bear its proper check marks. Several kinds of 
 check marks should be used, for otherwise a check 
 
 A & A-28 
 
434 ACCOUNTING AND AUDITING 
 
 given for one purpose may be interpreted as for an- 
 other. Cash book items, for instance, are likely to 
 need three kinds of marks — one for bank verification, 
 one for vouching, and one for posting. 
 
 If the auditor finds in the coin-se of his work that 
 some errors of accounting have been made, he should 
 merely make memoranda of the necessary adjust- 
 ments and postpone the correcting entries until his 
 examination is complete; for he may later find coun- 
 tervailing facts which alter his first conclusions. 
 Mere bookkeeping errors he should correct as he goes 
 along, however, — ^though not without authority. 
 
 If when the examination of the books is supposed 
 to be complete a new trial balance is taken directly 
 from the books and the totals of all books posted in 
 lump sum are copied into the working papers, the 
 present figures should agree with the figures origi- 
 nally taken off at the beginning of the audit (allow- 
 ing for the adjustments made during the course of 
 the audit or at its close). If a discrepancy persists 
 between the original figures and the final working 
 figures (after allowing for the adjustments), ob- 
 viously someone has been tampering with the books 
 during the course of the audit, and the figures which 
 show a discrepancy should be examined so that the 
 auditor may learn who has been making unauthor- 
 ized changes. 
 
 We are now supposing the audit to have pro- 
 gressed so far as to vouch for the correctness of the 
 bookkeeping. The auditor's next task is to pass 
 judgment upon matters of accounting which have 
 not already arisen in connection with the examina- 
 tion of the bookkeeping. Let us take first the con- 
 
AUDITING ^ 435 
 
 siderations involved in passing upon a balance sheet. 
 We may as well take these in alphabetical order. 
 
 The auditor should see that accounts payable re- 
 ported are for legitimate debts, and that no invoices 
 which have been once paid are included; invoices 
 should bear dates that are properly related to the 
 present time. 
 
 He should see that accounts receivable reported 
 are in conformity with the original charges, and that 
 included among them are not debts so long overdue 
 that presumably no collection can be made on them. 
 Allowance must be made for discounts offered and 
 for probable bad debts. 
 
 If bonds are outstanding and any trustee has been 
 appointed as a registrar, the auditor should secure 
 from the trustee a certificate to the effect that only 
 as many bonds are outstanding as are reported on 
 the balance sheet. If any bonds owned are reported 
 as deposited for collateral, the auditor should pro- 
 cure from the holders a certificate showing just what 
 is so held. 
 
 The auditor should make sure that all bills receiv- 
 able presented to him as good assets are genuine, and 
 that the}^ are presumably good. In order to make 
 his work complete he should seek from the makers 
 and endorsers of such notes confirmation as to their 
 amount and genuineness. Unsecured notes long 
 overdue should not be considered as good assets, but 
 should be charged back to those from whom the 
 business took them — and possibly the resulting book 
 accounts should be closed out to Bad Debts. If any 
 notes have been discounted or turned over to banks 
 for collection, and are , therefore not in the posses- 
 
436 ACCOUNTING AND AUDITING 
 
 sion of the business, the auditor should get from the 
 banks holding such notes certification of their 
 amount, makers, and dates. 
 
 Since the auditor cannot ordinarily know how 
 good are the book debts and the notes of any busi- 
 ness, he ma}^ well demand from someone in authority 
 a written statement as to their probable value. If 
 any reserve has been set aside for doubtful debts, he 
 may base on that statement his judgment concerning 
 the adequacy of that reserve. 
 
 If any trust company or other outside agency is 
 registrar for capital stock issued, the auditor should 
 require from such agent a certificate as to the amount 
 of stock outstanding, and should see that it is re- 
 ported on the balance sheet at that figure. 
 
 If any claims are reported among the assets, he 
 should see that allow^ance has been made for any 
 which are disputed, and that only those presumably 
 collectible are counted. 
 
 If any securities are shown to him as collateral 
 for debts held by the business, the auditor should by 
 communication with the owners of the securities 
 learn whether they are correctly reported as pledged 
 for the debt concerned. 
 
 If the business maintains branches, the auditor 
 must watch caref uUj^ to see that the accounts are not 
 so mixed as to count assets twice and liabilities not at 
 aU. If, for instance, the branch buys goods of the 
 main house and gives its notes in payment, fraudu- 
 lent accounting might report the merchandise as an 
 asset for each house, the Bills Receivable as an asset 
 of the main house, but .the Bills Payable not at all. 
 For each of these, good ground can be found ; but no 
 
AUDITING 437 
 
 ground can be found for all of tliem at once. The 
 merchandise is an asset for either house, but not for 
 both; the Bills Receivable is an asset for the main 
 house, but then the Bills Payable is a liability of the 
 branch ; the Bills Payable may be neglected as a lia- 
 bility, for it is purely internal, but then the Bills 
 Receivable must not be counted as an asset. In other 
 words, the two sets of books must be absolutely dis- 
 tinct or absolutely consolidated. 
 
 The auditor should examine the minutes of a cor- 
 poration to learn whether any liabilities incurred 
 have been omitted from the balance sheet. If the 
 corporation is new, moreover, he should inspect all 
 prospectuses and other promises made to persons in- 
 vited to subscribe to stock, and should observe 
 whether any promises have failed of fulfillment. 
 
 The auditor should make sure that all dividends 
 declared and matured have been paid, or that the 
 amount unpaid remains as a liability shown on the 
 balance sheet. If, as is commonly done, a corpora- 
 tion makes a special bank deposit to cover the pay- 
 ment of dividends, the unexpended balance of that 
 account represents the unpaid dividends; and, there- 
 fore, the dividends do not need to appear as liabili- 
 ties if that bank balance is not included among the 
 assets; but if the bank balance is so included in cash, 
 the dividends must appear as a liability. The same 
 thing is true for unpaid interest on bonds outstand- 
 ing. For coupon bonds, the unredeemed matured 
 coupons measure the liability. 
 
 The auditor should demand of a person in au- 
 thority a certificate that the assets shown on the 
 books as plant, machinery, and other things not sus- 
 
458 ACCOUNTING AND AUDITING 
 
 ceptible of adequate valuations at sight by tlie audi- 
 tor, are actually in possession of the company and 
 unimpaired — or that the amount of depreciation 
 allowed, either in a fund or as a liability, is adequate 
 to cover shrinkage. 
 
 He will do well to learn from the records of deeds 
 whether any mortgages have been issued. 
 
 In case a corporation has issued income bonds of 
 a cumulative sort (that is, bonds which, though they 
 3deld interest only if the interest is earned in the 
 years covered, yet demand the payment of interest in 
 later years to offset the failure of interest in the lean 
 years) or cumulative preferred stock (which requires 
 that dividends not paid in one year shall be made up 
 out of later earnings before common stock shall pay 
 dividends), the report of the corporation should 
 show any such arrears. These arrears are not direct 
 liabilities, however, for they are not claims against 
 the company until earnings have been made; in other 
 words, they are not claims against the company in 
 any way to affect its solvency; and since the purpose 
 of a balance sheet is primarily to show solvency, they 
 do not need to appear among the liabilities. They 
 may well be given in a footnote or in an appended 
 statement, however, for they do affect the investment 
 value of the stocks and bonds. 
 
 The auditor should examine the income sheet and 
 see that the charges bear correct relation to the parts 
 of the business which cause them. Depreciation 
 charged on the income sheet should agree in amount 
 with the depreciation deducted from assets. Inter- 
 est on the income sheet should bear the correct rela- 
 tion to investments and to interest-bearing debts 
 
AUDITING 439 
 
 outstanding. Allowance for bad debts deducted from 
 gross earnings should agree with the changes shown 
 on the balance sheet. Accrued items on the balance 
 sheet should be included in the totals of income-sheet 
 earnings and expenses. The income sheet final bal- 
 ances should be included in balance-sheet balances. 
 The income sheet and the balance sheet must be con- 
 sistent, for they are different statements for the same 
 final result — as we saw on a sixycolumn statement. 
 
 Let us now turn to the auditor's report. He 
 should state in the first place what work he has actu- 
 ally done, that is, what sort of audit he has con- 
 ducted, and if he has been requested by anyone in 
 authority to omit any work ordinarily done, or has 
 been excused from such work, he should note in his 
 report that omission. He should never in his conclu- 
 sions state what are to him mere opinions. His task 
 is to learn the facts about the books and about the 
 business, and to state whether the books show the 
 facts as they appear to him to be. He may state his 
 opinion with regard to allowances for depreciation, 
 bad debts, etc., but those are opinions only in the 
 sense that they are matters of judgment; but he 
 should not state an opinion as to the management of 
 the business or the honesty of those conducting it 
 until that opinion has become practically a certainty 
 based upon proof which he can present. If he re- 
 ports all material facts, including a statement of all 
 irregularities, as has been suggested, his clients are 
 likely to be in a better position than he to form mere 
 opinions. Clients usually welcome suggestions for 
 improved methods, however. In other words, the 
 
440 ACCOUNTING AND AUDITING 
 
 auditor's work should be constructive rather than 
 destructive. 
 
 The auditor's report is supposed, usually, to show 
 the condition of the business both at the beginning 
 and at the end of the period under examination. He 
 should therefore show a balance gheet for the two 
 periods, or a combined balance sheet showing the fig- 
 ures for the beginning and the end, with the increases 
 or decreases. He should show also a summary of 
 important balance-sheet changes arranged somewhat 
 after the fashion of the table given on page 341. 
 He should show not only the income sheet, but a clear 
 statement of the disposition of the income — to divi- 
 dends, surplus, and other reserves. Matters which 
 are largely determined by judgment should be pre- 
 sented in the report in such form that others having 
 slightly different bases of judgment may be enabled 
 to draw their own conclusions. The auditor should 
 therefore append to his report a list of bad debts 
 charged off, of bills receivable, of accounts receiv- 
 able, and a statement of the amount of inventory and 
 the basis on which it was verified. He should add a 
 statement of bills payable and, if it is likely to prove 
 of any value to readers of the report, of the accounts 
 payable. He may well add a list of securities owned, 
 of delinquent debtors, and, if his audit is primarily 
 for the purpose of detecting dishonesty, a list of out- 
 standing checks. He should in all cases append a 
 list of missing checks and of missing vouchers. 
 
 Let us turn now to the matter of examinations 
 for creditors or possible investors. If a client who 
 requests an examination is willing to pay for a com- 
 plete audit, and the persons whose business is under 
 
.AUDITIN'G 441 
 
 examination do not object, this is usually desirable. 
 If, however, this is not feasible, much work neces- 
 sary for a complete audit may be omitted in this ex- 
 amination. The purpose of an examination is to 
 learn whether the assets are real and whether the 
 profits are as represented. The examination need 
 ordinarily go no farther than to ascertain these facts. 
 The auditor is not expected to vouch for the honesty 
 of employees or officers. 
 
 The auditor will naturally begin by making a 
 copy of the trial balance for the beginning and for 
 the end of the period under examination. A com- 
 parison of these will furnish a summary of the busi- 
 ness. It may be worth while to make a complete copy 
 of each property account, for then he will know what 
 expenditures have been made on its behalf, and what 
 receipts have accrued from it. The next step is for 
 the auditor to make sure that the trial balance faith- 
 fully represents the ledger. He should go through 
 the ledger carefully, take footings and balances, and 
 see that the trial balance figures correspond. 
 
 The next task is for the auditor to examine the 
 reality of the assets, and this should be done in the 
 main as it is done for a complete audit. He should 
 note, moreover, that the future has not been antici- 
 pated — for instance, by the premature cutting of 
 coupons on bonds. Some assets, however, do not 
 need in this case examination quite so cai'eful as is 
 required where the piu*pose of the audit is to learn 
 whether fraud has been committed by employees. If 
 the proprietor is willing to certify to a list of ac- 
 counts receivable as legitimate debts due to the busi- 
 ness, it is hardly necessary for the auditor to conduct 
 
442 ACCOUNTING AND AUDITING 
 
 an audit of the customers' ledger — unless, indeed, he 
 thinks that the proprietor may be committing an 
 innocent error due to the fraud of his own employees. 
 In that case, the auditor will do well to investigate 
 the accounts as suggested for a complete audit. It 
 must be understood, however, that a man certifying 
 to assets of his business, though he is liable both 
 civilly and criminally for any intentional fraud, is 
 not liable for errors due to lack of judgment. The 
 auditor must therefore use such means as he has at 
 his disposal for learning how much the book accounts 
 are actually worth for collection purposes. He 
 should go through them and report how many are 
 overdue, how many are collectible from customers 
 who in the past have proved not thoroughly reliable, 
 and how many ought to be written off as bad debts. 
 
 The auditor should make a list of all assets after 
 he has examined them as indicated for a complete 
 audit, and should furnish a copy of that list to his 
 cUent; for if the client is going to purchase an in- 
 terest in the business, he should have in his posses- 
 sion information showing exactly what he has pur- 
 chased. If this is not done, the auditor has not fore- 
 stalled the possibility of a substitution of assets 
 which (though it may be innocent and the proprietor 
 may consider the assets substituted quite as good as 
 those originally examined) may cause heavy loss to 
 the client. This list should include security or col- 
 lateral for all debts due to the business, insurance 
 premiums prepaid, accrued interest and declared 
 dividends, and certified inventories of merchandise. 
 
 The auditor should make a detailed list of Liabili- 
 ties; for otherwise liabilities may be foisted upon the 
 
AUDITING 443 
 
 purchaser. These liabilities should be learned by 
 the methods previously indicated. 
 
 The auditor should read through the cash book 
 and the journal, even when he does not need to vouch 
 them or check them with the ledger; for they may 
 throw valuable light on the valuation of assets, the 
 sources of profit, the causes of loss, and the methods 
 previously in vogue for determining profit and loss. 
 He should make note of all entries which cast doubt 
 on the correctness of trial-balance figures. 
 
 He should be on the watch for the ^^ salting" of 
 assets and sales. He should realize that the purpose 
 of the seller of a business, however honest he may be 
 in intent, is to get as much for his business as he 
 thinks it is worth and that an optimistic tempera- 
 ment is likely to see more value and profit than does 
 a skeptical purchaser. The auditor must make sure, 
 then, that the sales reported are actually sales. He 
 should add the columns of the sales books and see 
 that the proper amounts have gone to the ledger. 
 He should add the columns of the purchase books 
 and see that those are properly posted. He should 
 do the same for returned sales and returned pur- 
 chases. He may then wisely make tables showing 
 the monthly totals of sales, purchases, returned sales, 
 and returned purchases, for recent years, and thus 
 learn whether any suspicious fluctuations have oc- 
 curred, — Shaving regard, of course, to the di:fferent 
 activity of di]fferent seasons. A sudden and recent 
 increase of sales suggests sales to persons of doubt- 
 ful credit, or even fictitious sales — that is, sales to 
 confederates v> ith an understanding that goods may 
 be returned later. A sudden and recent decline in 
 
444 ACCOUNTING AND AUDITING 
 
 purchases suggests an exhaustion of stock or a post- 
 ponement of entry for debts actually incurred. Spe- 
 cial care should be taken to see that all goods inven- 
 toried have been entered as purchases. Sudden and 
 recent increases in cash balances deserve investiga- 
 tion — ^lest they have arisen from liabilities not 
 recorded. 
 
 The auditor should note any outside relations 
 that the business has with members of the firm, with 
 directors, and with their relatives and friends; for 
 sometimes such relations are unprofitable, and some- 
 times, if profitable, they may cease when the business 
 changes ownership. 
 
 Sometimes certain statistical information is of 
 great value to a client in enabling him to judge 
 whether a business is doing what it should. A table 
 showing for a series of years the percentage of sales 
 to capital (commonly called the ^* turnover"), of ex- 
 penses to sales, of working capital to sales, of losses 
 by bad debts to sales, will give an indication not only 
 of the absolute standing of the business, but of its 
 tendency. 
 
 The auditor should note whether all expenses 
 have been actually charged — ^not only depreciation, 
 but proprietors' salaries and interest on proprietors' 
 capital. 
 
 The work of an auditor, in other words, comprises 
 the practical application of all the principles which 
 have been discussed in various connections in this 
 book. An auditor must see not only that the book- 
 keeping is correct, but that sound accounting prin- 
 ciples are applied in all matters of judgment. No 
 attempt has been made in this chapter to repeat the 
 
AUDITING 445 
 
 principles of the preceding chapters. It is to be un- 
 derstood that wherever a principle is enunciated as 
 covering original entries, it is equally applicable to 
 the interpretation of those entries, and to an audi- 
 tor's acceptance or rejection of them. 
 
 Many problems arising in an auditor's work are 
 peculiar to the kind of business or the particular cir- 
 cumstances on which he happens to be at any time 
 engaged. It is impossible in a book of this sort to 
 cover all kinds of businesses and all circumstances. 
 Problems are arising in auditing railroad accounts, 
 for instance, gas company accounts, mining ac- 
 counts, accounts of charitable institutions, which are 
 unlike any here indicated; but except for the peculi- 
 arities of the transactions themselves or the forms 
 of books in use, they will not be found to require the 
 application of principles different from those given 
 here. No man can expect to audit satisfactorily the 
 books of any business unless he knows the nature of 
 the work performed in the usual course of that busi- 
 ness. The first step of an auditor should always be 
 to familiarize himself with the business itself and 
 with the books customarily used. 
 
 It must be realized by every bookkeeper, account- 
 ant, and auditor, that he stands in a relation to his 
 client such that the information which comes to him 
 through the books does not belong to him. He has 
 no more right to use it for his own benefit, for the 
 benefit of his friends, or even to tell it to another as 
 a mere matter of interest, than he has to use for his 
 own benefit or give or lend to another the merchan- 
 dise, the cash, or the other property of his client. It 
 is not enough for him to realize merely that he must 
 
446 ACCOUNTING AND AUDITING 
 
 not make use of his information or turn it over to 
 friends who may make use of it: he must realize that 
 after information has once passed his lips he has no 
 knowledge as to what may become of it. Though he 
 tells business secrets only to acquaintances who he 
 knows have absolutely no use for that information, 
 he cannot know that those friends will not allow it 
 also to escape them and become the property of an- 
 other who may use less discretion in its spread. In- 
 formation merely interesting sometimes spreads 
 until it reaches someone who finds it profitable, or 
 until its spread is harmful for the person originally 
 concerned — especially if it be perverted in the spread. 
 The only rule for a person concerned in the accounts 
 of another is to say absolutely nothing about the 
 information which he receives — even to members of 
 his own immediate family. ' ^ 
 
 If a bookkeeper, accountant, or auditor, learns 
 from accounts that something is going on which has 
 his hearty disapproval, so hearty that he cannot con- 
 scientiously have part in it even to the extent of 
 being a silent witness, he must at once sever his con- 
 nection with the firm concerned. Even then, how- 
 ever, he has no business to go out and tell his dis- 
 covery unless he is sure that the facts which have 
 come to his knowledge show criminality and require 
 him to make disclosures to the officers of justice — 
 disclosures which he is ready to repeat in open court 
 and are conclusive evidence of legal offense, — and 
 these disclosures should be made only to the oflScers 
 of justice. A statement of suspicion is one of the 
 most harmful statements that can possibly be made. 
 He must say absolutely nothing or else come boldly 
 
AUDITING 44? 
 
 forward and help the authorities to punish the guilty; 
 but he must be sure of his ground before he makes 
 any attempt to bring to justice those whom he con- 
 siders to be guilty. Indeed, it is the duty of an ac- 
 countant, before going to any prosecuting offi- 
 cer, to state to his superiors what are his conclusions 
 from the facts and give them opportunity to explain 
 any possible misunderstandings. If, then, he is sure 
 that legal or moral wrong has been committed, 
 he should at once sever his connection with the 
 firm. Whether he shall make disclosures is a mat- 
 ter for his private conscience. He must avoid, more- 
 over, the possibility of being misunderstood, — must 
 avoid not only blackmail, but the appearance of 
 blackmail. He must not allow even the thought that 
 he can be bought off. In no case should he give any 
 slightest hint of criminality unless he has made up 
 his mind that if his employers fail to explain things 
 satisfactorily he will leave them. Then he must 
 leave. To suggest susi)icion to employers and then 
 to keep still because of fear of losing his position, or 
 because his salary is raised, or because his position 
 is made more attractive, is the height of dishonor. 
 In other words, no half-way is to be considered for a 
 moment. The relations between employer and ac- 
 countant are so confidential, moreover, that the com- 
 munity and even the courts look somewhat askance 
 at anyone who violates such confidence. The in- 
 former should be sure before taking any steps toward 
 prosecution that the community's need for his infor- 
 mation more than offsets the other requirement of 
 loyalty to private obligation. 
 
 It is obvious from what has been said that the 
 
448 ACCOUNTING AND AUDITING 
 
 work of an accountant and auditor is not only mathe- 
 matical but moral. Throughout his work he must 
 realize that he is drawing lines of division, and that 
 what lies on one side of a line may belong to one per- 
 son while that lying on the other side belongs to 
 another. Unless he has a judicial temper, the in- 
 fluence of those with whom he comes in contact is 
 likely to overtop his sense of responsibility to those 
 who are distant; and this he must not allow. Unless 
 he has a philosophical mind, he will be unable to 
 make important distinctions between things which 
 on their faces are similar. Unless he has mathe- 
 matical ability, he will be unable to perform necessary 
 calculations. His integrity, moreover, must be abso- 
 lute. It is for these reasons that accounting is com- 
 ing to be recognized as a profession. The account- 
 ant's relation to his client is exactly the same as that 
 of the physician and the lawyer. The accountant 
 is taken into the client's confidence, and it must be 
 known that he will keep his information to himself; 
 he must have education and abilitv, or he will not 
 be able to pass judgment in difficult problems; he 
 must have the keen moral sense to realize that the 
 purpose of accounting is to tell the truth, and that 
 the truth is no respecter of persons, of interests, or 
 of consequences. Of late years a strong movement 
 has developed for the control of corporations, and 
 the means of control most commonly recommended 
 is such publicity that the community can know for 
 each corporation whether it is good or evil. Such 
 publicity requires the services of a large army not 
 only of skilled accountants, but of accountants of 
 integrity; and therefore the promise for the growth 
 
AUDITING 449 
 
 of this profession is large. Anyone contemplating 
 entrance into it, on the other hand, must realize not 
 only the mental and moral attainment essential for 
 it, but the great responsibility involved in the work. 
 
 A & A-29 
 
APPENDIX 
 
 TEST QUESTIONS 
 
 [These questions are not intended to cover all the ground of th© text, 
 nor are all the questions answered directly in the text. The purpose of 
 these questions is to enable the student to see whether he has done his 
 studying with sufficient thoughtful care, and to suggest to him the sort of 
 problems he should make up for himself. A few questions given here can 
 be answered by reference to the proper paragraphs in the chapters to 
 which they apply; but most of them require a putting- together of separate 
 ideas expressed in the text — involving a comparison, or a correlation, or a 
 new application.] 
 
 Chapter I. Introduction. (Pages 13-17.) 
 
 1. What is the difference between bookkeeping 
 and accounting? 
 
 2. Can rules of thumb be given for the solution 
 of accounting problems ? 
 
 3. Are accounting principles to be used before 
 the bookkeeping entries are made, after such entries, 
 or both before and after ? 
 
 4. What are the three fundamental principles 
 of bookkeeping ? 
 
 Chapter II. Debit and Ceedit. (Pages 19-32.) 
 
 1. Shall we debit or credit John Doe when he 
 gives us his note for the payment of a debt due us ? 
 
 453 
 
46« ACCOUNTING AND AUDITING 
 
 2. Shall we debit or credit Cash when we pay 
 for merchandise? 
 
 3. Shall we debit or credit Rent for sums paid 
 to the business by tenants of property that it owns ? 
 
 4. What is the function of property accounts in 
 bookkeeping? 
 
 5. What is the function of nominal accounts in 
 bookkeeping? , 
 
 6. Why, in any system of logical bookkeeping, 
 must there be a debit for every credit ? 
 
 Chapter III. The Method of Entry. 
 (Pages 33-48.) 
 
 1. What is the function of a ledger ? 
 
 2. How do items get into a ledger ? 
 
 3. Are any books absolutely necessary besides a 
 journal and a ledger? 
 
 4. Is the modern journal usually voluminous ? 
 
 5. What relation does the cash book bear to the 
 journal? 
 
 6. Does double-entry bookkeeping require at 
 least two postings for each transaction? 
 
 7. How far is the form of the double-entry cash 
 book different from that of the parallel-column 
 journal? 
 
 8. Why may not items go directly to the ledger 
 without previous entry in another book? 
 
 9. If an entry has been made debiting Roe 
 instead of Doe, how may it be corrected without 
 erasure ? 
 
QUESTIONS 4S3 
 
 Chaptek IV. The Common Ledger Accounts. 
 (Pages 49-107.) 
 
 1. Show, in the form of a simple journalization, 
 what should be debited and what credited in each of 
 the following cases : 
 
 Payment, by you, of wages in the form of mer- 
 chandise. 
 
 Receipt, by you, of a bond which you have agreed 
 to take in payment of an accepted draft. 
 
 Writing off a bad debt owed you by a customer. 
 
 Interest allowed you on your bank deposit. 
 
 A discovery that in an invoice of goods pur- 
 chased to be sold as merchandise, and charged as mer- 
 chandise, is included $100 worth of office supplies, and 
 $100 worth of goods shipped to the proprietor's resi- 
 dence, and broken goods to the value of $100. 
 
 Receipt of a promissory note for an account 
 already written off as uncollectible. 
 
 2. What should be debited and what credited 
 after each of the following transactions? 
 
 (a) Buying on credit, at the first of the year, 
 stationery expected to last eight months. 
 
 (6) Paying for that stationery by issuing a note, 
 (e) Paying that note. 
 
 (d) Exchanging that stationery at cost (none 
 being used) for merchandise. 
 
 (e) Selling that merchandise at cost and receiv- 
 ing a note in payment. 
 
 (f) Collecting cash for the note. 
 
 Now what is the net result, upon ledger balances, 
 of all these transactions? 
 
454 ACCOUNTING AND AUDITING 
 
 3. What transactions are most likely to have 
 given rise to the following journalizations: ' 
 
 Interest 
 
 $50 
 
 
 To Cash 
 
 
 $50 
 
 Adam Bede 
 
 1000 
 
 
 laterest 
 
 50 
 
 
 To Bills Payable 
 
 
 1050 
 
 Loss and Gain 
 
 450 
 
 
 To Charles Darnaj 
 
 
 450 
 
 4. (a) Jan. 1, X invests in a partnership a note 
 of his wife, for $5,000, due in one month. (6) Jan. 14, 
 X exchanges the note for one of his own payable at 
 the same time, (c) Jan. 25, X takes up his own note, 
 leaving in exchange an accepted draft, due Feb. 1, on 
 B, who is a creditor of the partnership, (d) Feb. 1, 
 . the debt of the firm to B becomes due, and B 's accept- 
 ance is sent to him in payment. 
 
 Journalize the entries. 
 
 (e) In the meantime, B, not knowing that X is a 
 member of the firm and that his acceptance will be 
 used to cancel a debt to him, sends his check to X 
 for payment of the acceptance. The two letters cross, 
 and X, not knowing that the acceptance has been sent 
 to B, turns in the check to the cashier, who misunder- 
 stands X and thinks the check is invested by X. 
 
 What entry will the cashier make? 
 
 (/) X discovers that the cashier has misunder- 
 stood him, and explains. The correct situation is dis- 
 covered, is confirmed by a letter from B, and a check 
 is sent to B, his check being already deposited. 
 
 What entry shall now be made to correct the 
 books? 
 
QUESTIONS 456 
 
 5. The transactions indicated below were jour- 
 nalized as in the entries below. Is the journalization 
 correct in each case? If not, make a journalization 
 to correct the error, assuming that the original jour- 
 nalization cannot be erased or displaced. 
 
 (a) Sold gcods, on 5% commission, for Henry Esmond, to Arthur 
 Pendennis, $1000. 
 
 Arthur Pendennis * $1000 
 
 To Henry Esmond $950 
 
 Commission 50 
 
 (&) Stationery bought and paid for m returned, and the mon»y paid 
 is refunded. 
 
 Cash 25 
 
 To Expense 25 
 
 (c) We discount at 'a bank our own note for $500. The discount is $7. 
 Bills Keceivable 500 
 
 Interest 7 
 
 To Cash 507 
 
 (d) It is desired to split up the expense account into two accounts, 
 with stationery items kept by themselves in a new account. The amount 
 of the old items for the new account has been found, and the transfer is 
 made on the journal. 
 
 Expense 56 
 
 To Stationery 50 
 
 (e) While a new building is going up, the contractors receive advances 
 of money on account of the final payment on the contract. The interest 
 lost on these advances is a part of the cost to the owners. They wish t« 
 enter it so. 
 
 Interest 760 
 
 To Real Estate 750 
 
 6. On which side of the ledger is the balance of 
 the following accounts likely to be? What, in each 
 case, does the amount of such a balance indicate ? 
 
 Bills Receivable. Merchandise. 
 
 Plant. Rents. 
 
 Profit and Loss. Commission. 
 
 Wages. Surplus. 
 
456 ACCOUNTING AND AUDITING 
 
 Chapter V. The Practical Operations of Book- 
 keeping. (Pages 109-138.) 
 
 1. How is it possible to divide an entry between 
 two books so that some part is common to both books, 
 and yet to avoid the danger of double posting of the 
 common part? 
 
 2. In posting, how much of each entry should be 
 written in the ledger ? 
 
 3. How are balances shown on the cash book? 
 
 4. How are ledger balances shown ? 
 
 5. What is the principle on which a special book, 
 for example, the cash book, may have several special 
 columns on each side? 
 
 6. What are the limitations on the use of special 
 principal books and special columns? 
 
 Chapter VI. Drawing Conclusions from the 
 Books. (Pages 139-173.) 
 
 1. How far does a trial balance that shows equal 
 debits and credits prove that the books are correct? 
 
 2. (a) Show a six-column statement of the fol- 
 lowing facts: 
 
 Merchandise sold, $43,000; merchandise bought, 
 $42,000; merchandise on hand, $13,000; debts due by 
 customers, $15,000; debts due to creditors, $12,000; 
 proprietor's investment, $45,000; expenses paid, $11,- 
 000; expenses incurred but not yet paid, $250; real 
 estate valuation (unchanged during the year), $40,- 
 000; bills payable, $9,000; cash, $1,000. 
 
 (b) Show the balance sheet for the new year. 
 
QUESTIONS 457 
 
 3. Pill out the following incomplete six-column 
 statement, using no figures not given or implied. 
 
 
 Dr. 
 
 Cr. Resources. Liabilities. Loss. 
 
 Gain. 
 
 Cash 
 
 
 20,000 
 
 
 Office Furniture 
 
 3,000 
 
 500 
 
 
 Expense 
 
 13,000 
 
 13,000 
 
 
 Interest 
 
 500 
 
 
 50 
 
 Bills Receivable 
 
 
 5,000 
 
 
 Bills Payable 
 
 
 2,000 
 
 
 Accounts Eeceivable 
 
 3,000 
 
 
 
 Accounts Payable 
 
 
 1,000 
 
 
 Merchandise 
 
 20,000 
 
 
 21,000 
 
 Capital Stock 
 
 
 
 
 Show the balance sheet for the new year, sup- 
 posing no dividends to be declared. 
 
 4. The trial balance for the ledger shown below 
 fails to prove. Find the trouble. 
 
 
 PEOPEIETOR 
 
 Sundries 
 
 $16,000.00 
 
 Cash 
 
 Bills Payable 
 
 MERCHANDISE 
 
 $10,549.00 Aaron Burr 
 1,648.00 
 
 1,527.10 
 
 Proprietor 
 
 BILLS EECEIVABLE 
 
 2,000.00 Aaron Burr 
 
 1^27.10 
 
 
 BILLS PAYABLE 
 
 Merchandise 
 
 1,684.00 
 
 Proprietor 
 
 CASH 
 
 14,000.00 Merchandise 
 
 10,549.00 
 
 Merchandise 
 
 AAEON BUER 
 
 1,527.10 Bills Eeceivable 
 
 1,527.10 
 
458 
 
 ACCOUNTING AND AUDITING 
 
 5. The figures below are what a bookkeeper finds 
 on his books at the close of the year : 
 
 Capital Stock 
 
 
 $i69,oao 
 
 EeaJ Estate 
 
 $70,000 
 
 
 Mortgages Payable 
 
 
 55,000 
 
 Bills Payable 
 
 
 25,000 
 
 Bills Eeceivable 
 
 15,000 
 
 
 Accounts Eeceivable 
 
 17,000 
 
 
 Purchases 
 
 150,000 
 
 
 Cash 
 
 7,000 
 
 
 Expenses 
 
 15,000 
 
 
 Interest 
 
 3,000 
 
 
 Taxes 
 
 2,500 
 
 
 Sales 
 
 
 30,500 
 
 
 $279,500 
 
 $279,500 
 
 He reports to the directors a balance sheet as 
 follows : 
 
 Eeal Estate 
 
 $63,000 
 
 Capital Stock 
 
 $109,000 
 
 Bills Eeceivable 
 
 15,000 
 
 Mortgages Payable 
 
 55,000 
 
 Accounts Eeceivable 
 
 17,000 
 
 Bills Payable 
 
 25,000 
 
 Merchandise 
 
 130,000 
 
 Eeserve for Bad Debts 
 
 4,250 
 
 Cash 
 
 7,000 
 
 
 
 Profit and Loss 
 
 21,250 
 
 
 
 $253,250 
 
 $253,250 
 
 Explain all apparent discrepancies between the 
 two sets of figutes. 
 
 6. Why, in a six-column statement, must the dif- 
 ference between resources and liabilities equal the 
 difference between gains and losses ? 
 
 7. In a proprietor's absence the books of a busi- 
 ness are opened and kept by a bookkeeper who keeps 
 accurate record of transactions reported to him but 
 cannot be trusted to figure valuations or profits. At 
 
QUESTIONS 45& 
 
 the end of a year, the records show, before the books 
 are closed and simply as the result of regular transac- 
 tions, the following figures : 
 
 Proprietor's investment, $100,000; Bills Payable, 
 $17,000; Bills Receivable, $26,000; Real Estate, 
 $20,000 ; Accounts Payable, $15,000 ; Accounts Receiv- 
 able, $20,000 ; Cash, $5,000 ; Merchandise on hand, val- 
 ued at cost, $75,000; Merchandise Dr. on ledger, 
 $49,500 ; Expense, $12,000 ; Interest balance received, 
 $500. 
 
 Now the proprietor returns and Wishes to close 
 his books for the year. If he needs any information 
 not given above, what questions will he ask in obtain- 
 ing it ? Assimie any fairly reasonable answers to such 
 questions, if any, and then show what is the propri- 
 etor's present investment in the business. 
 
 Chapter VII. Some Highly Developed Types of 
 Bookkeeping. (Pages 175-212.) 
 
 1. "What is a controlling account ? 
 
 2. What are the advantages and the disadvan- 
 tages of keeping a separate sales ledger? 
 
 3. Are postings made to controlling accoimts 
 from the books of original entry, or from the subordi- 
 nate ledgers? 
 
 4. Why is not error introduced when discounts 
 given are entered on the receipts side of the cash 
 book? 
 
 / 
 
460 ACCOUNTING AND AUDITING 
 
 5. What is the objection to ' ' contra items ' ' in the 
 cash book? 
 
 6. Can books be kept without a journal? 
 
 7. Under the so-called * impressed" system of 
 handling petty cash, what is represented by the bal- 
 ance of Petty Cash in the general ledger? 
 
 8. Under the voucher system, what is repre- 
 sented by the credit balance of Vouchers Payable? 
 
 Chapter VIII. The Peculiarities of Corporation 
 Accounts. (Pages 213-237.) 
 
 1. What is the difference between Subscription 
 and Stock Subscribed? 
 
 2. Is it advantageous to distinguish betw^een 
 Stock Subscribed and Capital Stock? 
 
 3. What is the proper entry for premium on the 
 sale of stock? 
 
 4. Does it make any difference whether corpo- 
 rators donate shares to a corporation, or take fewer 
 shares at a corresponding premium? 
 
 5. Should each of the following accounts show a 
 debit or a credit balance : Good Will, Subscriptions 
 to Stock, Dividends, Surplus? Why? 
 
 6. In combining proprietorships into a corpora- 
 tion, how is it customary to allow, on the books, for 
 earning capacity, and to close proprietors' accounts? 
 
 7. Subscriptions at 75 are received for treasury 
 stock having a par value of $100. After the payment 
 of one installment of the subscription, to the amount 
 of $25 a share, the subscriber defaults. What entry 
 should be made on the books of the corporation at the 
 time of forfeiture? 
 
QUEiiTlOKS 461 
 
 Chapter IX. Property or Expense? 
 (Pages 239-261.) 
 
 1. Are nominal accounts likely to be worth face 
 value ? 
 
 2. Can all the accounts of a business be nominal? 
 
 3. Can all the accounts of a business be real ? 
 
 4. '^Real Estate is a capital account, and Rent is 
 a revenue account. ' ' How far is this statement true ? 
 If it is correct, what does it mean ? 
 
 5. Which of the following should be charged to 
 capital account and which to revenue account: the 
 purchase of a patent right ; legal fees for organizing 
 a corporation; the purchase of a lease; repairs of 
 machinery ; replacement of machinery ; the purchase 
 of additional machinery ; the loss by fire of uninsured 
 property ? 
 
 6. In a manufacturing business what accounts 
 should you open and charge for the following expen- 
 ditures ? Should each of such accounts be treated at 
 the end of the year as a capital account or as a rev- 
 enue account? 
 
 Taxes on a piece of real estate held for possible 
 extension of plant. 
 
 Wages of a chemist carrying on experiments for 
 improvement of processes. 
 
 Contributions to an agency for gathering infor- 
 mation about foreign markets. 
 
 Expense of maintaining an exhibit at an interna- 
 tional exposition. 
 
 Compensation to the owner of a piece of land 
 when a lease on that land is by mutual agreement 
 canceled. 
 
i62 ACCOUNTING AND AUDITING 
 
 7. What is the test for determining the things 
 that should be charged (1) to capital? (2) to 
 revenue ? 
 
 Is there any middle ground in which a charge 
 may be made def ensibly to either capital or revenue ? 
 If so, what defence is commonly offered for charging 
 to each? 
 
 8. A new machine costing $5,000 is bought to 
 replace one that originally cost $5,000, but is now 
 worn out. The expense of operating the new machine 
 will be only three-fourths that for the old. How 
 much shall be charged to Maintenance at the time of 
 replacement? 
 
 9. The new machine mentioned in question 8, 
 above, is now supposed to cost $7,000. The expense 
 of operation will be the same as for the machine 
 now worn out. How much shall be charged to 
 Maintenance ? 
 
 Chapter X. Depreciation. (Pages 263-280.) 
 
 1. What is the argument for figuring deprecia- 
 tion of machinery at a decreasing rate ? 
 
 2. Suppose a piece of property has depreciated 
 in value to the amount of $1,000. Then $3,000 is spent 
 on it, making it so much better than it was originally 
 that its earnings will be $200 more than originally. 
 How shall that $3,000 be charged? 
 
 3. What is usually credited when Maintenance 
 is charged'? 
 
 4. What is usually credited when Depreciation is 
 charged? 
 
QUESTIONS 463 
 
 5. Should Maintenance go upon the income sheet 
 or upon the balance sheet? 
 
 6. Should Depreciation go upon the income sheet 
 or upon the balance sheet ? 
 
 7. Which sheet is affected by the credit madq 
 when Depreciation is debited? 
 
 8. On Dec. 28, 1910, you buy a patent right under 
 which you can manufacture and sell annually for 
 five years in one state 1,000 desk attachments at a 
 profit of one dollar each over the profit on the only 
 unpatented marketable Article. 
 
 (a) From the table below, determine as accurately 
 as you can the theoretical value of that patent right 
 when money is worth 5%. 
 
 Present worth of $1 due in 6 years, at 5% $0,746215 
 
 Present worth of $1 due in 5 years, at 5% 0.783526 
 
 Present worth of $1 due in 4 years at 5% 0.822702 
 
 Present worth of $1 due in 3 years at 5% 0.863838 
 
 Present worth of $1 due in 2 years at 5% 0.907029 
 
 Present worth of $1 due in 1 year, at 5% 0.952381 
 
 (6) Is your figure absolutely accurate for the the- 
 oretical value, or is it based on a calculable error ? If 
 the latter, how should you calculate the error ? 
 
 (c) Shall that patent right appear on a balance 
 sheet for Dec. 31, 1911, on an income sheet for 1911, 
 on both, or on neither ? If so, for what approximate 
 amount ? 
 
 Chaptek XI. Profits. (Pages 281-304.) 
 
 1. What ought books to show with regard to dis- 
 counts (on merchandise) for prompt payments f 
 
464 ACCOUNTING AND AUDITING 
 
 2. You are charged with ^^ taking account oi 
 stock" in a store. The clerks give you the numbers 
 and descriptions of articles, and the invoice book- 
 keeper fills in prices as they appear on incoming bills. 
 How far is this material adequate for an inventory? 
 
 3. In what sense is discount on bonds issued an 
 asset ? 
 
 4. Is it true that premium on bonds bought is 
 an asset? 
 
 5. Is it true that premium on stock sold is profit ? 
 
 6. How should you treat interest received on a 
 bond bought above par ? 
 
 7. Except for the items mentioned below, a cor- 
 poration's balance sheets for 1909 and 1910 show the 
 same figures. How much do these items tell about the 
 history of the corporation for the year 1909-1910 ? 
 
 
 1 
 
 1909 
 
 
 
 
 Surplus 
 
 $70,000 
 
 
 
 1910 
 
 
 liation Fund 
 
 $20,000 
 
 General Reserve 
 
 60,000 
 
 
 
 Depreciation Reserve 
 
 20,000 
 
 
 
 Surplus 
 
 10,000 
 
 8. If in the case indicated in question 9 for Chap- 
 ter 9 the whole $7,000 was charged to Maintenance, 
 would you call the $2,000 excess cost of the new ma- 
 chine over the old a secret reserve ? 
 
 Chapter XII. The Income Sheet. 
 (Pages 305-314.) 
 
 1. What is the relation between an income sheet 
 and a balance sheet? Can an item appear upon both 
 at the same time ? 
 
QUESTIONS 465 
 
 2. The following is a condensed trial balance 
 of a partnership. The only inventory is for sup- 
 plies, which amounts to $25,000. No accrued or pre- 
 paid items are outstanding. Allow 10% depreciation 
 on all accounts (except cash and supplies) represent- 
 ing property, 5% on all sums due the business from 
 outside, credit the partners 5% interest on their 
 investments, credit salaries to the partners at $3,000 
 for A and $2,000 for B, and then divide profit or 
 loss equally between the partners. Show the income 
 sheet. 
 
 A 
 
 
 $40,000 
 
 B 
 
 
 20,000 
 
 Plant and Machinery 
 
 $45,000 
 
 
 Supplies 
 
 43,000 
 
 
 Sales 
 
 
 95,000 
 
 Labor 
 
 30,000 
 
 
 Expense 
 
 7,500 
 
 
 Interest 
 
 600 
 
 
 Discounts 
 
 1,250 
 
 
 Fuel 
 
 3,000 
 
 
 Insurance 
 
 1,150 
 
 
 Freight 
 
 1,500 
 
 
 Accounts Payable 
 
 
 9,000 
 
 Accounts Receivable 
 
 32,000 
 
 
 Steam Earnings 
 
 
 1,500 
 
 Cash 
 
 500 
 
 
 
 $165,500 
 
 $165,500 
 
 3. A profit and loss account at the end of a year, 
 after the books have been closed is as shown below. 
 
 A & A-30 
 
466 
 
 AccouNTma AitTt) AtrmTma 
 
 Present in the most intelligible form the information 
 that it gives about the business for the year. 
 
 
 Peofit 
 
 AND Loss 
 
 Fife. l,BiU8 Rm. 
 
 $200 
 
 Jan. : 
 
 Dfc. 81, Bad Debt! 
 
 700 
 
 Dec. 3: 
 
 Neglected Discounts 50 
 
 
 Expense 
 
 400 
 
 
 Wagee 
 
 28,000 
 
 
 Deprcclatioa 
 
 T,009 
 
 
 Diridend, No. 07 
 
 8,500 
 
 
 Dividend, No. 68 
 
 3,500 
 
 
 Bmlano6 
 
 16^00 
 
 
 
 $50,859 
 
 
 1, Balance $15,000 
 
 1, Interest 400 
 
 Rent 1,200 
 
 Collected Discount 300 
 
 Trading Account 42,950 
 
 $59,850 
 
 Chapter XIII. The Balance Sheet. 
 (Pages 315-330.) 
 
 1. If payments are received on account of goods 
 in process of manufacture, should such payments 
 appear on the balance sheet ? If so, where ? 
 
 2. Is it worth while to open a Bills Discounted 
 account in the ledger ? When would such an account 
 be debited and when credited? 
 
 3. Why is it desirable to divide balance-sheet 
 items into groups? 
 
 4. Certain items on the liabilities side of a cor- 
 poration balance sheet appeared on December 31 in 
 different vears as follows : 
 
 
 1907 
 
 1908 
 
 1909 
 
 Allowance for bad debts 
 
 
 $50,000 
 
 $100,000 
 
 Reserve for depreciation 
 
 $50,000 
 
 100,000 
 
 200,000 
 
 Reserve for betterments 
 
 
 150,000 
 
 200,000 
 
 Surplus 
 
 450,000 
 
 400,000 
 
 500,000 
 
.QUESTIONS 
 
 467 
 
 The income sheet for 1908 showed surplus for the 
 year $150,000; and that for 1909 showed $250,000. 
 
 Are the income-sheet figures consistent with the 
 balance-sheet figures? If not, why? If so, what 
 journal entries for each year produced the changes in 
 the balance sheets above? 
 
 Chapter XIV. The Interpretation of Balance 
 Sheets. (Pages 331-346.) 
 
 1. The balance sheet of a corporation on Decem- 
 ber 31, 1908, stood as follows: 
 
 Real Estate 
 
 $50,000 
 
 Capital Stock 
 
 $200,000 
 
 Plant 
 
 95,000 
 
 Accounts Payable 
 
 20,000 
 
 Horses, etc. 
 
 15,000 
 
 Bills Payable 
 
 25,000 
 
 Patents 
 
 20,000 
 
 Profit and Loss 
 
 15,000 
 
 Merchandise 
 
 30,000 
 
 
 
 Accounts Receivable 
 
 30,000 
 
 
 
 Cash 
 
 20,000 
 
 
 
 260,0©0 
 
 260,000 
 
 On December 31, 1909, the books appeared as 
 below: 
 
 Real Estate 
 
 $55,000 
 
 Capital Stock 
 
 $200,000 
 
 Plant 
 
 88,000 
 
 Accounts Payable 
 
 12,000 
 
 Horses, etc. 
 
 12,000 
 
 Bills Payable 
 
 17,000 
 
 Patents 
 
 19,000 
 
 Profit and Loss 
 
 * 33,000 
 
 Merchandise 
 
 42,000 
 
 
 
 Accounts Receivable 
 
 28,00!) 
 
 
 
 Cash 
 
 18,000 
 
 ^ 
 
 
 262,000 
 
 262,0«0. 
 
 What were the profits for the year ? 
 Where are they? 
 
468 ACCOUNTING AND AUDITING 
 
 2. You organize a corporation, and on January 
 1, 1908, the following facts are shown by the books : 
 
 The corporation has taken over from an indi- 
 vidual owner a business of which the assets, deter- 
 mined by conservative valuation of the property, are 
 $100,000 (Bills Receivable and Accounts ReceivaWe, 
 $20,000; Supplies, $5,000; Real Estate and Plant, 
 $75,000). Capital stock to the amount of $500,000 
 has been issued, of which $200,000 has been given the 
 original owner for his title, and $300,000 has been 
 sold for cash at par. The corporation has bought a 
 neighboring plant for $100,000, paying for it by BiUs 
 Payable to that amount. 
 
 Show a brief balance sheet under these conditions. 
 
 Now, you are absent from the corporation's affairs 
 for two years. On your return you are told that 
 6 per cent, dividend has been paid in each year, and 
 you are shown the balance sheets below. 
 
 Give a brief history of the business for each of 
 the two years of your absence. 
 
 
 Jan. ] 
 
 L, 1909. 
 
 
 Eeal Estate and Plant 
 
 $420,000 
 
 Capital Stock 
 
 $500,000 
 
 Bills Rec. and Accts. Eec. 
 
 70,000 
 
 Funded Debt 
 
 100,000 
 
 Supplies 
 
 5,000 
 
 Profit and Loss 
 
 20,000 
 
 Merchandise 
 
 105,000 
 
 
 
 Cash 
 
 20,000 
 
 
 
 
 $620,000 
 
 $620,000 
 
 ' 
 
 Jan. 1 
 
 ., 1910. 
 
 
 Eeal Estate and Plant 
 
 $400,000 
 
 Capital Stock 
 
 $600,000 
 
 Depreciation Fund Bonds 
 
 20,000 
 
 Eeserve Fund 
 
 20,000 
 
 Eeserve Fund Bonds 
 
 20,000 
 
 Profit and Loss 
 
 20,000 
 
 Bills Eec. and Accts. Eec. 
 
 70,000 
 
 
 
 Supplies 
 
 5,000 
 
 
 
 Mixchandis© 
 
 105,000 
 
 
 
 Cash 
 
 20,000 
 
 
 
 $640,000 $640,000 
 
QUESTIONS 469 
 
 3. The balance sheet of a corporation on Jan. 1, 
 1909, was as follows: 
 
 Merchandise 
 
 $65,000 
 
 Capital Stock 
 
 $75,000 
 
 Bills Eeceivable 
 
 15,000 
 
 Bills Payable 
 
 10,000 
 
 Accounts Eeceivable 
 
 8,000 
 
 Accounts Payable 
 
 5,000 
 
 Fixtures 
 
 3,000 
 
 Surplus 
 
 5,000 
 
 Cash 
 
 4,000 
 
 
 
 $95,000 $95,000 
 
 During the year 1909, the net income was $10,000 ; 
 purchases, $200,000; sales, at 20% above cost price, 
 $240,000; cash decrease, $3,000; bills receivable 
 accepted, $5,000 in excess of such notes collected; 
 accounts receivable charged, $1,000 in excess of 
 accounts receivable collected; bills payable extin- 
 guished, $1,000 in excess of those issued; accounts 
 payable incurred, $2,000 in excess of those paid ; divi- 
 dends paid, $8,000. 
 
 Show the balance sheet for January 1, 1910. 
 
 4. You contemplate purchasing an interest in a 
 business that has run five years, and agree to pay one- 
 third the valuation of its net assets. The following 
 statement is given you by the partners : 
 
 Dr. 
 
 
 Buildings, machinery, etc., at Cost 
 
 $50,000 
 
 Expended for repairs and renewals 
 
 8,000 
 
 Patent rights purchased 
 
 14,000 
 
 Balance of sales ledger 
 
 26,000 
 
 Inventory, as per stores and .^tock books 
 
 19,000 
 
 
 $117,000 
 
 Cb. 
 
 
 Bilk payable 
 
 $48,000 
 
 Baliinec of purchase ledger 
 
 47fiOQ 
 
 PavtaifiPB' capital 
 
 22,000 
 
 $117,000 
 
470 ACCOUNTING AND AUDITING 
 
 (a) Assuming that this statement gives all that 
 you need to know, how much must you pay for your 
 interest in the business ? 
 
 (6) Does this statement give all necessary infor- 
 mation about the assets? If not, what is lacking? 
 
 5. Comment upon the condition of a corporation 
 which shows the following amounts for 1910 com- 
 pared with 1909 : 
 
 Accounts Eeceivable 
 
 Bills Receivable 
 
 Accounts Payable 
 
 Bills Payable 
 
 Merchandise inventory 
 
 Gash 
 
 Sales 
 
 Purchases 
 
 Surplus 
 
 Chapter XV. The Determination ^of Costs. 
 (Pages 347-373.) 
 
 1. What is the common mechanism for showing 
 the prime cost of labor? 
 
 2. What is shown by the stores ledger? 
 
 3. What are the ultimate purposes to be served 
 by cost accounting? 
 
 4. What are the chief elements in a machine 
 rate? 
 
 5. Why is idle machine time of consequence? 
 
 6. Should burden, or overhead cost, be an impor- 
 tant factor in the accounting of retail department 
 stores ; of wholesale department stores ; of charitable 
 institutions; of railroads? 
 
 1909 
 
 1910 
 
 $55,000 
 
 $66,000 
 
 20,000 
 
 25,000 
 
 20,000 
 
 23,000 
 
 15,000 
 
 16,500 
 
 30,000 
 
 37,500 
 
 8,000 
 
 8,500 
 
 300,000 
 
 310,000 
 
 225,000 
 
 238,000 
 
 10,000 
 
 29,500 
 
' QUESTIONS 471 
 
 7. On what basis should you distribute general or 
 overhead expenses to manufacturing orders under 
 the following conditions: 
 
 (a) In a shop making hand product only and 
 employing workmen of low grade only? 
 
 (6) In a shop making hand product only, employ- 
 ing some low-grade and some high-grade labor, and 
 seasoning one-fourth of its product through the vari- 
 ous steps of manufacture so that one year is required 
 for completion of the various processes for that part, 
 but the other three-fourths of the product is com- 
 pleted in one month ? 
 
 (c) In a shop making part of its product by hand, 
 part by low-cost machines, part by high-cost 
 machines, employing both high-grade and low-grade 
 labor, and turning out all product rapidly? 
 
 Chapter XVI. Settlements Based on Accounts. 
 (Pages 375-395.) 
 
 1. Under what conditions is goodwill creditable 
 to partners? Why not otherwise? 
 
 2. How does a statement of affairs for an insol- 
 vent business differ in form and arrangement from a 
 balance sheet? Construct an imaginary balance 
 sheet that will do for illustration, and then make out 
 a possible statement of affairs to correspond. 
 
 3. What is a Realization and Liquidation 
 account? 
 
 4. Is Deficiency the same as a debit balance to 
 Profit and Loss? 
 
 5. In a corporation, is Deficiency the same as 
 Deficit? 
 
472 ACCOUNTING AND AUDITING 
 
 6. Below is a summary of single-entry partner- 
 ship books, with the inventories. 
 
 Set aside five per cent on the value of all assets 
 (except cash) as a reserve fund for depreciation 
 and for accrued items not on the books, and divide 
 profits equally between the partners. Show the bal- 
 ance sheet after the books are closed. 
 
 James Otis, Inveetment $43,750 
 
 Henrj Vane, Investment 50,000 
 
 Withdrawals by Partners ($2,000 each) 4,000 
 
 Inventory, Goods 65,925 
 
 Inventory, Bills Receivable 38,400 
 
 Inventory, Furniture and Fixtures 4,750 
 
 Cash on Hand 14,065 
 
 Caah Paid for Wages 22,500 
 
 Cash Paid for General Expenses 14,170 
 
 Cash Paid for Raw Material ' 16,250 
 
 Sums Owed for Raw Material 6,250 
 
 Bills Payable 37,500 
 
 Debits to Customers 81,ft90 
 
 Credits to Customers 59,190 
 
 7. Construct a Deficiency Account to fit the situ- 
 ation disclosed by the following condensed trial bal- 
 ance and the subsequent entries shown. 
 
 Capital Stock 
 
 
 $65,000 
 
 Real Estate 
 
 $210,000 
 
 
 Merchandise 
 
 80,000 
 
 
 Bills Receivable and Accounts Receivable 43,500 
 
 
 Bills Payable and Accounts Payable 
 
 
 304,500 
 
 Expense 
 
 30,670 
 
 
 Bills Receivable' Discounted 
 
 
 25,000 
 
 Cash 
 
 30,330 
 
 
 
 $394,500 
 
 $394,500 
 
 Bills Discounted 
 
 $25,000 
 
 
 To Cash 
 
 
 $25,000 
 
 Protested endorsed notes taken up^ 
 
 
 
QUESTIONS 473 
 
 Bad Debts 17,000 
 
 To Accounts Receivable 17,000 
 
 Bad accounts closed 
 
 Profit and Loss 24,000 
 
 To Merchandise 24,000 
 
 Depreciation on old stock, 30% 
 
 Maintenance of Real Estate 5,000 
 
 To Cash 5,000 
 
 Repairs on property 
 
 8. A partnership agreement provides for equal 
 division of profits. The following trial balance is 
 normal for the business concerned. What light does 
 it cast upon the adequacy of the partnership 
 agreement ? 
 
 A 
 B 
 C 
 
 $1,000 
 
 7,000 
 15,000 
 
 $50,627 
 27,510 
 42,568 
 
 Bills Payable 
 Accounts Payable 
 Real Estate 
 
 62,000 
 
 30,000 
 23,000 
 
 Merchandise 
 
 60,705 
 
 
 Bills Receivable 
 
 15,000 
 
 
 Accounts Receivable 
 
 17,000 
 
 
 Sales 
 
 Purchases 
 
 175,000 
 
 210,000 
 
 Expense i 
 Interest 
 
 27,000 
 1,500 
 
 
 Neglected Discount 
 
 2,500 
 
 
 
 $a88,705 
 
 $383,705 
 
 Chapter XVII. Auditing. (Pages 397-449.) 
 
 1. If an auditor knows that no dishonesty has 
 been practiced, may he confine his work to checking 
 the bookkeeping, begimikig with the books of original 
 entry *? 
 
474 ACCOUNTING AND AUDITING^ 
 
 2. Is a signed acknowledgment from an officer 
 of a corporation sufficient voucher for items which 
 otherwise an auditor would personally examine? 
 
 3. What is the function of an auditor's note 
 book? 
 
 4. "What are the more common methods of hiding 
 the extraction of cash from customers' remittances, 
 and how does an auditor detect resort to them ? 
 
 5. Why is not the controlling account a sufficient 
 check on sales accounts ? 
 
 6. What are the more common methods of over- 
 stating cash payments, and how does an auditor detect 
 resort to them? 
 
 7. How should you audit payments of interest ; 
 of taxes ; of notes payable ; of discounted notes pro- 
 tested; of officers' salaries; of dividends? 
 
 8. Why does an audit usually begin with cash? 
 
 9. Why do journal items require special care? 
 
 10. What precautions should be taken against 
 padded inventories? 
 
 11. In examinations, how far may certificates 
 take the place of auditing? 
 
 12. What is the function of an auditor's report? 
 
INDEX 
 
 Account, defined, 34 
 
 Account sales, 193 
 
 Accounts Payable, 119, 345 
 
 Accounts Receivable, 119, 344 
 
 Accounting compared with book- 
 keeping, 13 
 
 Accrued items, 157, 282, 319 
 
 Additional rate, 365, 371 
 
 Allowance for Bad Debts, 326 
 
 Assets, classes of, 316 
 
 Auditing, 397-449 
 
 (To avoid confusion with the gen- 
 eral index, a special index for 
 the chapter on auditing is 
 given at the end.) 
 
 Auxiliary books, 118 
 
 B 
 
 Bad debts, 103, 324, 330 
 Balance sheets, described, 173, 260, 
 315 
 
 illustrated, 261, 330 
 
 comparison of, 330, 331 
 
 interpretation of, 343 
 Balancing, method of, 115 
 Bill book, 118 
 
 Bills Discounted account, 320, 330 
 Bills Payable account, use of, 58, 
 
 78, 93 
 Bills Receivable account, 52, 92, 344 
 Bonds, discoumt on, reason for, 27«, 
 294 
 
 premium on, 250, 274, 2»3 
 Book account, 79 
 
 Bookkeeping compared with account- 
 ing, 13 
 Burden, see Cost, overhead 
 
 Capital stock, aceount, 213 
 
 sold at a premium, 223, 233, 294 
 
 sold at a discount, 224, 229, 235, 
 295 
 Cash account, use of, 51, 92 
 Cash book, use of, 36 
 
 form of, 41, 122, 123 
 
 special-column, 131, 178, 180, 192 
 Cash-sales book, 111 
 Charging against revenue, 259 
 Charging to capital, 259 
 Checking, in posting, 110 
 
 blank. 111, 116, 132 
 Collected Discounts account, 286, 346 
 Contingent items, 319 
 Commercial discounts, see Merchan- 
 dise Discount account 
 Commission cash book, irregular, 192 
 Consignments account, 193 
 Contra entries, 114, 178 
 Contracts, profit on, 290 
 Controlling account, defined, 176 
 Corpus of estate, 385 
 Cost, prime, 348, 351 
 
 overhead, 348, 352 
 
 joint, 349 
 
 apace, 355, 370 
 
 selling, 368 
 Cost accounting, purposes of, 348, 
 350 
 
 475 
 
 \ 
 
476 
 
 INDEX 
 
 Cost book, 352 
 
 Credit, meaning of, 21, 32 
 
 Creditors account, see Accounts 
 Payable 
 
 Customers account, see Accounts Re- 
 ceivable 
 
 Customers ledger, see Sales Ledger 
 
 Day book, 35 
 Debit, meaning of, 21, 32 
 Deficiency account, 393, 394, 395 
 Deficit, 304, 307, 323, 330 
 Depreciation, on six-column state- 
 ment, 157 
 prevented by maintenance, 267 
 methods of calculating, 268 
 methods of entering, 279 
 nature of, 295 
 Depreciation fund, ,279, 298 
 Details, fullness of, 44 
 Discount, entered contra, 114, 179 
 (see also Interest, Interest ac- 
 count. Merchandise Discount 
 account, Neglected Discount 
 account. Collected Discount 
 account. Bonds, Capital Stock) 
 Dividends, on income sheets, 305 
 Dividends account, 213 
 Donated stock, 228 
 Double entry, origin of, 31 
 
 in showing profits, 151 
 Drafts as bills receivable, 53 
 
 as bills payable, 59 
 
 E 
 
 Earnings, gross, 310 
 
 net, 310 
 Earnings account, 302 
 Erasures, 45 
 Errors, correction of, 45 
 
 detection of, 142 
 Expense aoeount, 60 
 Explanation accounts, 28 
 
 (see also Nominal aceoimts) 
 
 F 
 
 Fashion affecting values, 264, 265 
 Fixed charges, 312 
 Force accounts, 26 
 
 (see also Nominal accounts) 
 Foreign currencies, bookkeeping for, 
 
 211 
 Furniture and Fixtures account, 59 
 
 Good will, 221, 381 
 Gross earnings, 310 
 
 Idle time, 362, 370 
 
 Impressed system of petty cash, 202 
 
 Income, " other, *' 812 
 
 net, 312 
 Income account, use of, 173, 302, 
 
 306 
 Income sheet, use of, 173, 260, 305 
 
 illustrated, 261, 308, 309, 313 
 Insolvency, 386 
 Installment Subscription account, 
 
 215 
 Interest, as affecting the value of 
 
 notes, 55 
 on income sheets, 312 
 Interest aecount, use of, 61, 66, 81, 
 
 82 
 Inventories in figuring profits, 95, 
 
 258, 263, 372 
 Inventory account, 97 
 Invoice book, see Purchase bo«k 
 
 Journal, use of, 35 
 
 forms of entry, 36, 38, 121 
 
 footing of, lis 
 
 special forms of, 185, IflT, IW 
 
 elimination of, 191 
 JournaJteatioB, parpos« of, 35 
 
INDEX 
 
 m 
 
 Labor-eaviug, principle of, 37 
 Ledger, use of, 33 
 
 legal status of, 48 
 
 manner of posting to, 110, 126 
 
 closing accounts in, 163, 167 
 
 subordinate, 175, 192 
 
 sales, 176 
 
 cuitomers, 176 
 
 purchase, 177 
 
 tabular, 204 
 
 stock, 214, 220 
 
 stockholders, 214, 220 
 
 installment, 217 
 
 stores, 351 
 
 machine, 367 
 Ledger folio column, use of, 110 
 Leases, 277 
 
 Liabilities, classes of, 316 
 Loss, extraordinary, 302, 307 
 (see also Profit and loss) 
 
 M 
 
 Machine rate, 358 
 
 Machinery and plant account, 59 
 
 Maintenance account, 242, 266, 279 
 
 excessive charges to, 299 
 Manufacturing and Selling Account, 
 
 306 
 Manufacturing account, 370 
 Manufacturing accounts, 347 
 Merchandise, valuation of, 259, 263, 
 
 284, 289, 344 
 Merchandise account, use of, 64, 94 
 Merchandise Discount account, use 
 
 of, 102, 286, 346 
 entry of, 113, 183 
 Minimum rate, 365, 370 
 
 Net income, see Income 
 
 Nominal accounts, 28, 30, 61, 94, 240, 
 
 249, 259 
 closing, -164 
 Notes, see Bills Receivable, Bills 
 
 Payable, Bills Discounted 
 
 Obsolescence, 253, 266 
 Occupied time, 365 
 Operating Account, 306 
 Operating expense, 310 
 Operating ratio, 310 
 Original entry, books of, 47 
 
 Partnership, 375 
 Personal accounts, 30 
 Petty Accounts, 204 
 Petty Cash, use of, 202 
 Posting, defined, 35 
 
 method of, 110, 117 
 Posting checks, 110 
 Premium, see Bonds, and Capital 
 
 Stock 
 Prepaid items, 278 
 Principal books, 117 
 Private ledger, 208 
 Profit, determining, 150, 281, 325, 
 326 
 
 as between years, 283, 307 
 
 extraordinary, 301, 302, 307 
 Profit and Loss account, use of, lOt, 
 
 306, 307 
 Property accounts, 24, 93 
 Purchases account, 97 
 Purchase book, use of, 36 
 
 form of, 42, 124 
 
 N 
 
 B 
 
 Neglected Discounts account, 
 
 346 
 Net earnings, 310 
 
 286, Rates, machine, 358 
 minimum, 365, 370 
 additional, 365, 371 
 
An 
 
 INDEX 
 
 Eeal accouats, 80, 240, 249, 259 
 
 Be«l estate account, 59 
 
 Eealizatioa and Liquidation account, 
 
 390, 393 
 Red ink item*, 115, 156, 163 
 Beplacements, 246, 266, 299 
 Beserye accounts, use of, 106, 268, 
 
 325, 326 
 Beierve secret, 299 
 Responsibilitj, basis of aecounting, 
 
 21 
 Seturned purchases, 9S 
 Returned sales, 98 
 Royalty contracts, 277 
 
 Bales account, 98 
 Sales book, use of, 36 
 
 form of, 43, 125 
 Sales ledger, described, 176 
 Secret reserve, 299 
 Selling cost, 368 
 Shipments account, 193 
 Short extension, 182 
 Single entry, 31, 382 
 Sinking fund as surplus, 300 
 Sinking fund method, 268 
 Six-column statement, described, 152 
 
 illustrated, 154 
 Space cost, 355 
 
 Solvency, method of showing, 315 
 Special column, principle of, 128, 
 
 182 
 Special-column cash book, 131, 178, 
 
 180, 192 
 Special-column journal, 135, 137, 138 
 Statement of affairs, 386 
 Statement of resources and liabili- 
 ties, 324, 327 
 Stock account, 372 
 Stock Subscribed account, 215 
 Stores account, 351 
 Stores ledger, 351 
 Subordinate ledgers, 175, 192 
 
 Subtractions, how performed in 
 
 bookkeeping, 115 
 Supplies, on a balance sheet, 318 
 Surplus, account, use of, 106, 223, 
 297, 307, 314, 317, 322 
 
 capital, 224, 230, 294 
 
 donated, 228 
 
 premium, 294 
 
 sinking fund as, 300 
 
 for year, 313 
 Suspense account, 104, 105 
 
 T 
 
 Tabular ledger, 204 
 Taxes, on income sheets, 309, 311 
 Trading Account, 306, 372 
 Treasury stock, 228, 231 
 Treasury Stock Subscribed, 236 
 Trial balance, defined, 139 
 
 illustrated, 141 
 
 errors disclosed by, 142 
 
 importance of, 145 
 
 inadequacy of, 146 
 
 getting a stubborn, 147 
 Trusteeships, 384 
 Truth, as the aim of accounting, 
 
 283, 300 
 Turnover, 444 
 
 Valuation, bases for, 240 
 
 on cost of duplication, 243, 244 
 
 on earning capacity, 244 
 
 on cost, 245 
 
 for inventories, 258, 263 
 
 of claims, 324, 345 
 
 of reserves, 327 
 Vouchers Payable, 206 
 Voucher register, 206 
 Voucher system, 205 
 
 W 
 
 Wasting assets, 254 
 
INDSX 
 
 479 
 
 AUDITING 
 
 Auditing, soop* of, 400 
 
 firfit steps in, 402 
 Auditor, private mark of, 438 
 
 responsibilitieB of, 445 
 
 qualifications of, 448 
 Assets, checking, 404 
 Bad debts, 406, 427, 435 
 Balance sheet, 434, 440 
 Bills Discounted, 409, 426^ 435 
 BUls Payable, 408, 423, 426 
 Bills Eeceivable, 409, 435 
 Bonds, 423, 435, 438, 441 
 Branch accounts, 436 
 Capital stock, 436, 437, 438 
 Cash account, fraud in, 405, 467, 
 422 
 
 checking, 415 
 Cash items, 426 
 Check book, 415, 418, 430, 422 
 Cheeking, 409, 412, 413, 416, 423, 
 
 425, 426, 429, 431 
 Checks, outstanding, 422 
 Confirming, 411, 428, 429 
 Controlling accounts, 412, 414, 
 
 432 
 Corrections, 484 
 
 Creditors' accounts confirmed, 432 
 Cross footing, 412, 429 
 Customers ' accounts, confirmed, 
 
 432 
 examined, 442 
 Deposits, 421, 425 
 Discounts, 406, 407, 417, 424, 425, 
 
 426, 435 
 Distribution, 412, 429 
 Dividends, 423, 437 
 
 Examinations, distinguished from 
 audits, 397 
 
 conduct of, 440-444 
 
 Inactive accounts, 408 
 
 Income sheet, 438, 440 
 
 Insurance, 407 
 
 Interest, 407, 423, 425, 437 
 
 Inventories, 409, 430 
 
 Journal, 426 
 
 Ledgers, checking, 412, 413, 414 
 
 Minutes of directors, 423, 437 
 
 Mortgages, 423, 425, 438 
 
 Note book, auditor \ 402, 403, 
 404, 413, 419, 424, 426, 428 
 
 Pass book, 415, 418, 420, 421, 422 
 
 Petty cash, 424 
 
 Real Estate, 423 
 
 Reconcilement, 416, 418, 420 
 
 Rents, 423, 425 
 
 Report, 400, 413, 424, 428, 439, 
 441-444 
 
 Returns, 406, 407, 425, 429, 431 
 
 Salaries, 423 
 
 Salting, 443 
 
 Securities, 423, 436 
 
 Statements substituted for audit- 
 ing, 400, 414, 428, 430, 436, 
 437 
 
 Stocks, 423 
 
 Taxes, 407 
 
 Tracing, 415, 428, 431 
 
 Trial balances, 403, 414, 432 
 
 Verifying, 411, 425 
 
 Vouching, 411 
 
 Wages, 424 
 
re 2520< 
 
 
 
 ^^j# * '^^ V