BUSINESS ADMINISTRATION "-[ SAMUEL D. HIRSCHL, S.B., J.D. . L Member of the Illinois Bar The texts listed on this page form the basic material for the LaSalle Business Administration Course and Service. They constitute a library of standard practice in all the important divisions of business management. Titles Authors BUSINESS PSYCHOLOGY . HUGO MUNSTERBERG, Ph.D., M.D., LL.D. Harvard University PERSONAL EFFICIENCY, AP- PLIED SALESMANSHIP, AND SALES ADMINISTRA- TION IRVTNC R. ALLEN Sales Counselor BUSINESS LAW I . . BUSINESS LAW II . BUSINESS ENGLISH EDWIN HERBERT LEWIS, Ph.D., LL.D. Lewis Institute, Chicago BUSINESS ECONOMICS . . ERNEST LUDLOW BOGART, Ph.D. University of Illinois INDUSTRIAL ORGANIZA- TION AND MANAGEMENT . HUGO DIEMER, M.E. Pennsylvania State College AMERICAN BANKING . . . HENRY PARKER WILLIS, Ph.D. Secretary, Federal Reserve Board INVESTMENTS AND SPECU- LATION LOUIS GUENTHER Editor, "Financial World" ORGANIZING A BUSINESS . MAURICE H. ROBINSON, Ph.D. University of Illinois FINANCING A BUSINESS . . ELMER H. YOUNGMAN Editor, "Bankers Magazine" ADVERTISING E. H. KASTOR H. W. Kastor & Sons RETAIL MERCHANDISING PAUL NEYSTROM, Ph.D. Van Cleve Co., New York EDWARD M. SKINNER CREDITS AND COLLEC- , Manager, Wilson Bros. TIONS 1 R - s - WHITE American Steel & Wire Co. [ H. E. KRAMER RAILWAY REGULATION . . I. L. SHARFMAN, A.B., LL.B. University of Michigan OCEAN TRAFFIC AND TRADE B. OLNEY HOUGH Editor, "American Exporter" PRINCIPLES OF ACCOUNT- ING STEPHEN GILMAN, B. S. OFFICE ORGANIZATION AND MANAGEMENT C C. PARSONS Manager, Shaw-Walker Co. LASALLE EXTENSION UNIVERSITY PRINCIPLES OF ACCOUNTING STEPHEN OILMAN, B. S. Department of Higher Accountancy, LaSalle Extension University Former Credit Manager, Tennessee Coal, Iron & Railroad Company Extension University Chic a go 1916 Copyright, 1916 LASALLE EXTENSION UNIVERSITY PREFACE Within recent years there has been a noticeable growth of interest in scientific accounting. The day of the tradi- tional bookkeeper whose principal interest was to keep his books in balance is rapidly passing, and his place is being taken by an executive the scientific staff auditor, whose field is as wide as the extent of the business itself. Many have been attracted by the exceptional opportuni- ties afforded by accountancy and have eagerly perused such texts as were available. During the past decade, a number of excellent books have been added to the litera- ture of the accounting profession, but most of such works have been written as reference books for the professional public accountant. Under these conditions, one who has been denied a long training in the school of experience, upon seeking to acquire a comprehensive grasp of accounting science, finds that most treatises on the subject are better suited for reference purposes than for mastering the working principles of accounting in a systematic and organized manner. In the following pages the author has endeavored to develop the fundamental principles of accounting science according to a basic plan. A number of illustrations and problems are given to illuminate the textual discussion. The purpose of the book is not to promulgate the special- ized treatment of any particular phase of the subject, but rather to present the basic principles of the science of accounting in a graphic and comprehendible manner. iii iv Preface While it is not believed that any text on accounting principles would prove inappropriate for the layman, the following pages have been written primarily for those having some training or experience in the art of book- keeping. The author believes that no apology is necessary for "personifying the business, " since experience indicates the desirability of this approach to the subject of account- ing theory. It is nowhere maintained that proprietorship accounts reflect a legal liability ; rather they reflect a theo- retical one, and this, after all, is the crux of the argument. The author desires to express his appreciation and to give due credit to his father, Professor Stephen W. Oilman, A. B., LL. B., C. P. A., of the University of Wisconsin, for his invaluable assistance in reading the manuscript, and to his colleague, Mr. John B. Tanner, C. P. A., for his many helpful suggestions. CONTENTS I. PRELIMINARY SURVEY Symbols 1 Symbolizing the Account 2 Disadvantages of Balance Method 11 The Account 19 II. BASES OF ACCOUNTING The Ledger 21 Account Relations 23 The Trial Balance 24 Analysis of Accounts 26 Proprietor's Account 29 Subsidiary Proprietor's Account 30 Nominal and Real Accounts 33 Development of the Merchandise Account. ... 33 Inventories 34 Mixed Accounts 35 The Accounting Period 36 Balance Sheet and Profit and Loss Statements. 37 The Journal 39 Posting 40 The Controlling Account and Subsidiary Ledger 42 Control Accounts and Double Entry 43 Other Controlling Accounts 43 Incomplete Double Entry 44 Positive and Negative Inventories 46 Liability Inventories 49 Conclusion 50 III. DEVELOPMENT OF THE SPECIAL JOURNALS Function of the Journal 53 Columnar Journal 55 V vi Contents Specialized Journals 60 Cash Discounts 71 Notes and Bills Journals 75 Special Journals and Control Accounts 77 The Ledgers 78 The Private Ledger 79 Other Uses of the Private Ledger 83 The Ledger Account 84 The Columnar Ledger 88 The Columnar Purchase Journal 89 The Voucher Eegister 89 The Status of the Journal 97 Posting Technique 101 Conclusion 104 IV. THE BALANCE SHEET The Trial Balance 106 Profit and Loss Account. 110 Form of Balance Sheet 113 Limitations of the Balance Sheet 115 The Working Balance Sheet 116 Adjusting Entries 118 Explanation of Adjustments , 121 Underlying Principles 126 Summary 134 Form of the Balance Sheet 142 Construction of the Balance Sheet 144 The Seven Steps '145 Nature of Depreciation 147 Incomplete Double Entry 152 Conclusion 153 V, ASSETS AND THEIR VALUATION Primary Classification of Assets 157 Definitions 157 The Economic Cycle 158 Primary Basis of Valuation 16U Contents vii Valuation of Current Assets 160 Debts Eeceivable 162 Notes Receivable 165 Bills Receivable 167 Merchandise or Finished Goods Account 167 Working Assets 167 Fluctuating Values 168 Elements of Book Cost 169 Materials in Process 170 Material and Supply Accounts 171 Accounting for Materials 172 Mixed Assets 178 Land 182 Land Purchased with Stocks or Bonds 184 Buildings 184 Leaseholds 186 Machinery 187 Investments 188 Deferred Assets 191 Intangible Fixed Assets 191 Goodwill 192 Franchises and Patents 195 Organization Expense 196 VI. LIABILITIES Current Liabilities 197 Accrued Liabilities 198 Other Current Liabilities 199 Deferred Liabilities 199 Contingent Liabilities 200 Bonded Indebtedness 203 VII. PROPRIETORSHIP Mixed Elements of Proprietorship 212 Proprietorship Entries 215 Subsidiary Accounts 216 Three Classes of Proprietorship 217 viii Contents Corporation Proprietorship 220 Classification of Nominal Accounts 222 Expense Classification 224 Profit and Loss Statement . 228 Manufacturing Statement 233 Balance Sheet and Profit and Loss Statement. . 237 The Functional Idea 238 Model Form of Statement 239 Trading Account 240 Treatment of Errors 242 Materials and Supplies 243 Prime Cost 246 Manufacturing Expense 246 Factory Profits 246 Depreciation 247 ' Purchase and Sales Discounts 248 Insurance and Taxes 251 Bad Debts 251 Closing the Ledger 252 Statement of Receipts and Disbursements 253 Railroad Income Statements 253 VIII. PROPRIETORSHIP Continued General Ledger Control 263 Apportionment Accounts 265 Treatment of Supplies 266 Summary 266 Clearing Accounts 267 Bases of Distribution 269 IX. PARTNERSHIP Articles of Partnership 276 Junior Partners 277 Formation of a Partnership 278 Interest on Capital 281 Liquidation of Partnership 284 Contents ix X. CORPORATIONS Capital Stock 296 Corporate Books 297 Corporation Proprietorship Accounts 300 Reserves 301 Premium on Stock 302 Discount on Stock 303 Unissued and Treasury Stock 303 Opening Entries 305 Donated Stock 310 Corporate Profits and Dividends 321 Mining Companies 323 Realized Profits 324 Scrip and Stock Dividends 325 XI. RESERVE AND RESERVE FUNDS Valuation Accounts 329 True Reserves . . .. 330 Effect on Balance Sheet Interpretation 332 Reserve Funds 335 Sinking Funds 337 Sinking Fund Installments 339 Secret Reserves 342 Summary 343 XII. DEPRECIATION Depreciation a Cost 347 Fluctuation and Depreciation 348 Appreciation 349 Causes of Depreciation 349 Contingent Depreciation 352 Replacements 353 Plant Ledger 353 The Rate of Depreciation 356 Depreciation Methods 358 Reducing Balance Method 360 Revaluation . . 362 x Contents Working Hours 362 Annuity Method 364 Sinking Fund Method 365 Comparison of Methods 367 ''Dollar Years" Method 367 Other Methods 368 Repairs and Maintenance 369 Renewals 369 Conclusion 370 XIII. SPECIAL FORMS OF STATEMENTS The Statement of Affairs 372 Proprietorship Items 376 Reserves 377 The Deficiency Account 378 Statement of Realization and Liquidation 383 Method of Construction 384 Receiver's Operations 386 Treatment of Cash 387 XIV. THE HOLDING COMPANY AND THE CONSOLIDATED BALANCE SHEET The Accounting Problems 397 True Balance Sheet 399 Consolidated Balance Sheet 399 Elimination of Interrelations 400 Working Form 401 Goodwill 401 Minority Interests 406 Intercompany Sales 407 LIST OF FORMS AND ILLUSTRATIONS Pigs. 1-11 (incl.). Graphical Illustrations of the Funda- mental Accounting Equation 3-18 Pig. 12. Traditional Journal Form 39 Fig. 13. Illustration of Transactions Using Regular Jour- nal Form 57 Pig. 14. Illustration of Transactions Using Columnar Jour- nal 59 Fig. 15. Columnar Journal 61 Fig. 16. Sales Journal 63 Fig. 17. Purchase Journal 64 Fig. 18. Cash Receipts Journal 65 Fig. 19. Columnar Cash Receipts Journal 66 Fig. 20. Cash Disbursements Journal 67 Fig. 21. Cash Journal Which Is Used Purely as a Posting Medium 69 Fig. 22. Cash Journal Which Is Used as a Posting Medium and Which Also Serves as a Cash Account ... 69 Fig. 23. Columnar Journal When Used as a Posting Me- dium for Notes Received and Given 71 Fig. 24. Cash Receipts Journal, Showing Method of Hand- ling Sales Discounts 73 Fig. 25. Cash Disbursements Journal, Showing Method of Handling Purchase Discounts 74 Fig. 26. Posting Medium for Notes and Bills Receivable . . 76 Fig. 27. Accounts Receivable Ledger Page 85 Fig. 28. Accounts Receivable Ledger Page 86 Fig. 29. Accounts Receivable Ledger Page 87 Fig. 30. Columnarized Purchase Journal 88 Fig. 31. Front of Voucher Jacket 92 Fig. 32. Reverse of Voucher Jacket Shown in Fig. 31 92 Fig. 33. Cash Disbursements 94 Pig. 34. Voucher Register 95 Fig. 35. Front of Journal Voucher 98 Fig. 36. Reverse of Journal Voucher Shown in Fig. 35 .... 99 Fig. 37. Journal Voucher Which Is to Be Bound and Used as a Posting Medium 100 Fig. 38. Journal Page 102 Fig. 39. Voucher Register and Journal Combined 103 xi xii List of Forms and Illustrations Fig. 40. Six-Column Statement 117 Fig. 41. Working Balance Sheet 119 Fig. 42. Working Balance Sheet 122 Fig. 43. Balance Sheet of J. J. Williams 126 Fig. 44. Working Balance Sheet 136 Fig. 45. Balance Sheet in Account Form 142 Fig. 46. Balance Sheet in Account Form 144 Fig. 47. Balance Sheet in Report Form 146 Fig. 48. Machinery Account 150 Fig. 49. Common Forms of Stock Ledger Accounts 173 Fig. 50. Recapitulation of Requisitions 174 Fig. 51. Chart Showing Primary Subdivision of Proprie- torship 214 Fig. 52. Chart Showing Classification of Expense Accounts According to Objects of Expenditure 225 Fig. 53. Chart Showing Common Classification of Expense Accounts 227 Fig. 54. Model Statement Form 228 Fig. 55. Statement for a Merchandising Organization .... 231 Fig. 56. Statement for a Manufacturing Organization .... 232 Fig. 57. Manufacturing Statement 233 Fig. 58. Complete Statement for Manufacturing Organiza- tion 234 Fig. 59. Statement for Manufacturing Organization in Ac- count Form 235 Fig. 60. Statement for Manufacturing Organization in Somewhat Different Form 236 Fig. 61. Illustration of the Profit and Loss Statement for the Problem Discussed in Chapter IV, pages 134 to 141 241 Fig. 62. Raw Materials Control Account 244 Fig. 63. Supplies Control Account 245 Fig. 64. Closing Journal Entries 254 Fig. 65. Ledger Accounts after Closing 255 Fig. 66. Railroad Income Statement 256 Fig. 67. Organization Chart 260 Fig. 68. Chart Illustrating Functional Classification of Ac- counts 264 Fig. 69. General Ledger Clearing Accounts 273 Fig. 70. Stock Ledger Page Ruling 299 Fig. 71. Plant Ledger Page' 355 Fig. 72. Chart Illustrating Depreciation Methods 359 Fig. 73. Suggested Form for Statement of Affairs 374 Fig. 74. Charts Illustrating Lines of Stock Control of a Holding Company 404 PRINCIPLES OF ACCOUNTING CHAPTER I PRELIMINARY SURVEY An individual engaged in business might conduct that business successfully without keeping records. He could do so only if the business was small and the transactions such as to be remembered easily. As a matter of fact, no business, however simple in its nature, does entirely without records of some sort, primitive though they may be. As business becomes complex, adequate records are essential. The reason for this is the inability of any human being to remember complicated transactions accurately. Man, therefore, symbolizes. SYMBOLS Symbols of one sort or another have been in use by the human race since the beginning of recorded time. A "symbol" is that which stands for or represents some- thing lse ; a visible sign or representation of an idea or quality or of another object. 1 Thus the heathen 's idol is a symbol. Maps, drawings, and paintings are symbols. A baseball Scoreboard is a symbol. Models of all sorts are symbols. The printed or written word is a symbol. In the chief engineer's office in Panama there is a small-scale working model of the canal. Every detail is complete. By means of electrical control every opera- i Webster's New International Dictionary, 1 2 Principles of Accounting tion taking place anywhere on the canal is reproduced in miniature. Ships move from one ocean to another; locks open and close. All normal functions are symbol- ized. The chief executive may watch this working model and exercise adequate control over the activities of his entire organization. He has the same comprehensive viewpoint as that which an aviator would have when flying over the canal zone. The importance of the word " comprehensive" is very great because it illustrates the chief function of a symbol. The highly complex business must utilize this principle if it is to be managed adequately. Managers work with the aid of symbols almost entirely in order that they may obtain a comprehensive view of their business, which is possible in no other way. SYMBOLIZING THE ACCOUNT Every reader is familiar with the usual bookkeeping symbol the account. For the sake of bringing out cer- tain important principles, another symbol may be tem- porarily adopted. This symbol is the ordinary pair of scales or balances. For illustration let us assume a very simple case and then apply this symbol to it. An individual named Brown is employed as business manager by Ames. Ames is entitled to all profits and is respon- sible for all losses, Brown being paid a salary. Inasmuch as Brown is responsible for results to Ames, he must keep a record of all business transactions as an aid to administrative data. He may do so by visualizing or symbolizing the different business transactions which take place, with the aid of balances or scales and some small metal cubes, each representing one dollar. 2 2 This and following illustrations are for the purpose of developing the fundamental theory of double entry accounts and should not be taken seri- Preliminary Survey 3 At the beginning of business Ames may, for the purpose of this illustration of primitive transactions, be considered to have invested $15.00 in cash. This is recorded (Figure 1) and may be illustrated by depositing fifteen metal cubes in the scalepan marked and assumed to represent "assets" and another fifteen in the one marked "liabilities." By this means is recorded the fact that the business has come into the possession of certain assets ($15.00 in cash) and owes, or must account for, an equivalent amount ($15.00 to Ames). ASSETS LIABILITIES $15.00 TilbOTotd Totolfl5.00 FIG. 1. Registering the Investment Suppose Brown took $10.00 and bought 10 bushels of grain. How would he record this by the symbols 1 The difficulty is obvious, since he has simply exchanged one asset for another. If, however, we replace the scalepan on the left side, previously described, with two scalepans and label one "cash" and the other "merchandise" this transaction can be illustrated. (See Figure 2.) Suppose Brown sells 5 bushels of the grain for $6.00. What adjustment of the balance must he make? Since one-half of the grain ($5.00 worth) has been dispensed, he must take five of the weights out of the "merchandise" scalepan, and since the business received $6.00, he must ously with regard to the transactions themselves, the amounts involved, or other matters not pertinent to the development of principles. Principles of Accounting put six weights in the "cash" scalepan. When he does this, the several scales no longer balance in the aggregate, since there are sixteen weights in the pans on one side ASSETS LIABILITIES $15.00 fclS.OO $15.00 Total Total* 1 5.00 FIG. 2 (a). Condition before Buying the Grain ASSETS LIABILITIES sio.oo $15.00 Total I 5.00 / I I I I I | $15.00 Total 115.00 FIG. 2 (b). Condition after Buying the Grain and only fifteen on the other. This discrepancy is caused by the fact that $5.00 worth of grain was sold for $6.00, resulting in a one-dollar profit. To whom does this profit belong? To the proprietor, Ames. It is to be accounted Preliminary Survey 5 for by the business to the proprietor. Being in the nature of a liability it must be recorded, and this is done by putting one weight in the liability scalepan. (See Figure 3.) Brown buys 10 more bushels of grain at $1.00 per bushel, but instead of paying for it he buys on account. He, therefore, must register an asset and a liability of the same amount, viz., $10.00. He can put ten weights in ' ' merchandise ' ' and ten weights in ' ' liabilities. ' r One ASSETS LIABILITIES $11.00 SI 6.00 FIG. 3. Condition after Selling Five Bushels of Grain (Cost $5.00) for $6.00 objection to this is that he is not properly distinguishing between liabilities to an outsider (for $10.00) and to the proprietor, Ames (for $16.00). Brown will want to keep them separate because Ames is entitled to all profits and is responsible for all losses, while the outsider is entitled to only $10.00 in any event. This distinction can be easily made by hanging two scalepans instead of one on the liability side. (See Figure 4.) The business, let us assume, does not have to pay for the grain for thirty days, but Brown offers to pay $9.00 immediately in settlement of the entire account. This is 6 Principles of Accounting accepted. An analysis of the transaction shows that $9.00 in cash is parted with by the business; therefore nine of the weights come out of "cash." The entire liability of $10.00 has been wiped out, which means that ten weights must be taken from the scalepan, "liabilities to others." When this has been done, the scales are again out of balance, there being one more weight in the pans on the left-hand or asset side than on the right- ASSETS LIABILITIES $15.00 $26.00 Total $10.00 $16.00 Total $26.00 FiG. 4. Condition after Buying Ten Bushels of Grain on Account (Cost $10.00) hand or liability side. This is because a profit amounting to $1.00 has been made, which must be accounted for to Ames, the proprietor. When one weight is put in his scalepan representing this obligation, a balance is struck, showing that equilibrium has been re-established. (See Figure 5.) Ten bushels of grain are now sold for $12.00, but instead of giving cash the purchaser gives his verbal promise to pay $12.00 in thirty days. Another scalepan (which may be labeled "accounts receivable") must be hung on the left-hand or asset side to register this class Preliminary Survey 7 ASSETS LIABILITIES $2.00 R $15.00 $17.00 Total _ $17.00 Total $17.00 FIG. 5. Condition after Discounting Bill of $10.00 for $9.00 and thus Gaining $1.00 $ 100* $ 5.00 ASSETS 1 $12.00 $19.00 Total LIABILITIES ,$19.00 Total $19.00 FIG. 6. Condition after SeUing Ten Bushels of Grain for $12.00 on Account and thus Making a Profit of $2.00 8 Principles of Accounting of asset ("promise to pay"). Twelve weights are put in "accounts receivable, " and ten are taken out of " merchandise " as the grain is dispensed. To obtain the balance and to register properly the obligation of the business to account to Ames for the $2.00 profit on the sale, two weights are put in the appropriate scalepan. (See Figure 6.) ASSETS LIABILITIES $13.00 $ 5.00 $18.00 $18.00 Total FIG. 7. Condition after Allowing Discount of Eeceivable Total $18.00 L.OO on Accounts Brown gives permission to discount the bill of $12.00 for $11.00 in cash. This will be registered by deducting twelve weights from "accounts receivable" (because that account is settled in full) and adding eleven weights to "cash" (because that is the exact amount received). The difference is due to the loss of $1.00 suffered in the transaction and is registered by deducting one weight from "Ames." (See Figure 7.) Preliminary Survey Kent of $1.00 is now due and payable, and Brown therefore pays it in cash. This is handled by deducting one weight from "cash" and also one from "Ames," since he is responsible for all expenditures. (See Figure 8.) ASSETS LIABILITIES $12.00 MERCHAND1SE > f 5.00 / I I '! I ' $17.00 117.00 Total Total $17.00 FIG. 8. Condition after Paying Bent of $1.00 Certain fixtures amounting to $8.00 are needed and are bought on account. (See Figure 9.) The transactions pictured in Figures 1 to 9 having been followed through, it becomes apparent that this method of "symbolizing" the business is satisfactory in a primitive way, but that it has certain grave defects. It shows, at all times, the current state of affairs as to property and debts, but it tells no history. It is an indicator of present conditions and not a recorder. This is because both additions and deductions of weights are made in each 10 Principles of Accounting of the various scalepans. This could be remedied by having two scalepans for each class of item whether it is an asset or a liability. Such an arrangement is shown in Figure 10. With this arrangement no subtractions ASSETS LIABILITIES $12.00 $ 6.00 $ 5.00 SI 7.00 18.00 $25.00 Total ' Tool $25.00 PiG. 9. Condition after Buying Fixtures on Account for $8.00 are ever made, but the same result is obtained by making additions on the other side. This is a considerable im- provement, since by labeling the weights with the date they were put on the balance, an examination would give a graphic picture of the history of the various trans- actions on any given date; of property on hand at any Preliminary Survey 11 given date; of the condition of Ames' (the proprietor's) account on any given date. Having only one place to register all gains (items due to Ames) and all losses (items due from Ames) makes it difficult to analyze the sources and character of these various typified transactions of losses and gains, and it can readily be seen that if any considerable volume of business were done, it would be important to know and to analyze, in detail, the various loss and gain facts. DISADVANTAGES OF BALANCE METHOD This system of illustration by using a pair of scales is very good in one way; i. e., when an incomplete record is made when all facts are not recorded the scales get out of balance and thus automatically indicate an error; but there are certain obvious disadvantages about such a primitive arrangement which will be apparent. These may be remedied by doing away with the actual physical machinery and substituting therefor the picture or rep- resentation of such a pair of scales. We thus forego the advantage of an automatic loss of balance whenever an incomplete record is made but make up for it many times over by increased convenience and effectiveness, and if figures are substituted for the weights, we can check the correctness of our balance by footing the sides and noting whether or not they are equal. The date of the trans- actions can also be more conveniently recorded. Figure 11 shows such an arrangement using figures which rep- resent the same results attained in Figure 10. By using the pair of scales originally suggested, it is clear that various sets or pairs of scalepans with the numerous weights on them need not be kept hanging on the scale beam all the time. They might be kept in separate places and all brought together at periodic 12 Principles of Accounting 1 1 3.00 I 5.00 ACCOUNTS RECEIVABLE AMES IISiOOTotal $18.00 Total jmoo FIG. 10 (a). Same Condition as Shown in Fig. 7, but with Different Arrangement of Scalepans Preliminary Survey 13 $13.00 $ 5.00 1.00 ACCOUNTS RECEIVABLE n \~$ 1.00 $19.00 Total $18.00 Totil $19.00 FIG. 10 (b). Condition after Paying Kent of $1.00 Principles of Accounting &I3.00 ASSETS CASH $ 1.00 15.00 MERCHANDISE $2.00 ACCOUNTS RECEIVABLE LIABILITIES TO OTHERS TIG. 10 (c). Condition after Losing Two Bushels of Grain by Fire This loss reduces Ames' credit balance by $2.00, bis net worth now being $15.00 ($18.00 $3.00) offset by assets as follows: Cash ($13.00 SI. 00) =$12.00 Merchandise ($5.00 - $2.00) = 3.00 Total $15.00 Preliminary Survey 15 13.00 ASSETS CASH $15.00 $4.00 I I I I I I \ j MERCHANDISE ACCOUNTS RECEIVABLE 8.00 Fiiiii \ $ 5 00 UABIL1TIES TO OTHERS AMES $ 5.00 $19.00 $37.00 Total Toul $37.00 Fig. 10 (d). Condition after Buying Five Bushels of Grain for Cash and Five Bushels on Account, Selling Three Bushels on Account for $4.00, and Paying $2.00 License Fee in Cash 16 Principles of Accounting FIG. 11 (a). Same Condition as Shown in Fig. 10 (d) (assumed date, June 1, 1916) Preliminary Survey 17 ACCOUNTS RECDVABLE AMES Fig. 11 (b), Condition of June 2, 1916, after (1) Paying the Amount Owing to Others, (2) Collecting One-Half of the Accounts Keceivable, (3) Selling $10.00 Worth of Grain for $12.00 in Cash, and (4) Buying $5.00 Worth of Merchandise on Account 18 Principles of Accounting ASSETSI \ ZLJS2 12. c \ Qun rs. 7"V z^ A A JTIES / V f Fig. 11 (c). By the Addition of Certain Kulings We Convert the Balancing Arrangement into a Practical Working Form without at All Losing Sight of the Fundamental Balancing Principle Preliminary Survey 19 intervals to be balanced in the aggregate. It would be necessary to have them all brought together at one time, since it would be seldom that the individual pairs would balance alone. The combination balance, representing all recorded facts, is the test that is needed. In a similar way this pictorial balance (Figure 11) need not be all on one sheet of paper. A separate sheet may be headed ' ' Cash, ' ' another one ' l Merchandise, ' ' another ' ' Accounts Keceivable," a fourth "Liabilities to Others/' and a fifth "Liabilities to Ames," and so on. Totals of each side of each sheet may be taken, and these total figures for all the sheets may be incorporated in the balance even though the sheet headed "Cash" might be separately located from the one headed "Merchandise." This is a very important point since it allows for the greatest possible elasticity, convenience, and efficiency in the keeping of records. By bringing the figures together in one place at a moment of time at the end of regular periods for balancing, the test for completeness of record may be applied. THE ACCOUNT Each one of these information units may be called an "account" Thus we speak of the "Cash Account," the "Merchandise Account," etc. The word "account" is for convenience frequently omitted in written work, in which case it is usual to indicate the meaning as follows : cash referring to money but Cash (capitalized) referring to "Cash Account." 20 Principles of Accounting TEST QUESTIONS 1. What functions are served by symbols? 2. What is the fundamental characteristic of the symbol employed in this chapter? 3. How would Figure 10 (a) appear after buying 10 of grain on account for $1.00 per bushel and selling 13 ^" account for $2.00 per bushel and paying $5.00 f ' 4. What is an account? CHAPTER II BASES OF ACCOUNTING The left-hand side of an account is for convenience called the " debit " side, and the right is known as the "credit" side. The law of balances is that the total figures on the left or debit side representing the aggregate of all the accounts must be exactly equal to the total figures representing the aggregate of all the accounts with amounts on the right or credit side. The working- out of this law has been illustrated in the preceding elementary examples. This fundamental conception is called the "Law of Double Entry," since the introduction of the several figures on the debit or credit side of an account is called "making entries." The book which contains the various accounts is known as the "Ledger." THE LEDGER In this Ledger we have a device or mechanism by the aid of which the manager of a business may obtain a comprehensive view of the situation of business as a whole, in which the activities of the business are reflected, and by which the history of the business is recorded. It is a "symbol" a representation a graphic picture of the business. The mechanics of operating this device is known as the "art of bookkeeping"; the act of adapting and regulating it and of interpreting its results is called the "science of accountancy." Upon the ledger page is the "account"; the collection of ledger pages is the 21 22 Principles of Accounting Ledger. In this Ledger is an account for every class of item owned by the business (assets), such as: Cash Account. Accounts Eeceivable Account. Notes Eeceivable Account. Merchandise Account. Eeal Estate Account. Buildings Account. Machinery Account. Etc. These accounts may themselves be, and often are, sub- divided or carved up into smaller units. Thus Machinery Account might be eliminated under this general designa- tion, and in its place we might have Lathes. Milling Machines. Planers. Etc. Or, if that classification were not desirable, the division might be made departmentally into Machinery, Department A. " " B. " " C. Etc. Thus we see that the assets may be recorded either in large classes or in smaller ones, but the finer the sub- division, the greater the number of accounts in the Ledger, since each classification of assets will have an account in the Ledger to represent it. In the Ledger we also have an account for every class of item owed by the business (liabilities), such as: Bases of Accounting 23 Accounts Payable Account. Notes Payable Account. Mortgages Payable Account. The obligation of the business represented by the Proprietor's Account. Etc. These, like the assets, may be analyzed into their constit- uents. We have stated that this Ledger, this collection of accounts, has for its object the representation of the present state of the business assets ancHi abilities ; hence it follows that when the status of any of these assets or liabilities changes, a corresponding change must be made in the proper ledger accounts. If this is not done, the accounts will no longer represent or reflect the truth as to the business and will, therefore, not be performing their proper functions. When the business parts with $10.00 in money for $10.00 worth of merchandise, we must record this in our ledger account by entering $10.00 to the credit of Cash and $10.00 to the debit of Merchandise. When the busi- ness sells $10.00 worth of merchandise for $12.00 worth of verbal promises to pay, we must debit Accounts Receivable $12.00, credit Merchandise $10.00, and directly or indirectly credit the Proprietor $2.00, since the busi- ness owes him the profit. When a fire burns up the store, we will credit Buildings and debit directly or indirectly the Proprietor's Account, since the Proprie- tor's Account is chargeable with all losses. ACCOUNT RELATIONS The following changes are the only ones that can take place in a business and, therefore, the only ones that can be reflected by the ledger accounts. 1. An increase in an asset, which will always be 24 Principles of Accounting balanced by a decrease in another asset or an increase in some liability or both. 2. A decrease in an asset, which will always be balanced by an increase in another asset or a decrease in some liability or both. 3. An increase in a liability, which will always be balanced by a decrease in another liability or an increase in an asset or both. 4. A decrease in a liability, which will always be balanced by an increase in another liability or a decrease in an asset or both. The reader, by referring to the graphic charts on pre- ceding pages and making various practical experiments, may test the accuracy of this statement. THE TRIAL BALANCE The periodic testing of the accounts to see if they are in balance is called ' ' taking a trial balance. ' ' A trial balance may be in two forms : a balance of totals or a balance of balances. For the ledger accounts shown on the next page the trial balance of totals would be as follows : Debits Credits Cash $14,700.00 $12,350.00 Merchandise 19,850.00 12,200.00 Proprietor 2,500.00 12,500.00 Totals $37,050.00 $37,050.00 A trial balance of balances for the same accounts would appear thus : Debits Credits Cash $ 2,350.00 Merchandise 7,650.00 Proprietor $10,000.00 Totals $10,000.00 $10,000.00 Bases of Accounting 25 CASH Jan. 1 . .(a) $1,000.00 3,000.00 4,300.00 3,500.00 2,900.00 MERCH Jan. 2 ..(g) $ 850.00 2,000.00 3,800.00 3,200.00 2,500.00 5 (b) 6 (h) 15 ..(c) 16 ..(i) 20 ... . .(d) 21 . .. . .(k) 30 Ce) 31 (T\ ANDISE Jan. 1 . (f ) $10,000.00 850.00 2,000.00 3,800.00 3.200.00 Jan. 5 ..(b) $2,500.00 4,000.00 3,000.00 2,700.00 2 . (g) 15 ... . .(c) 6 (h} 20 (d} 16 . . (i) 30 ... . .(e) 21.. ..m PROPRIETOR Jan. 31 (1) $2,500.00 Jan. 1 (a) $ 1,000.00 1 (f) 10,000.00 5 (b) 15 (c) 20.. 30. (d) (e) 500.00 300.00 500.00 200.00 In the second form of trial balance, shown on the opposite page, the difference between the two sides of each account is drawn off to determine whether or not they are in balance, while in the former the totals of both sides are used. Either method is correct, but the latter is perhaps preferable. The fact is that a trial balance is not an absolute proof of correctness, but simply a proof of double entry that for every debit there exists an equal credit or credits. The accounts might be greatly in error and yet balance perfectly. If Cash were credited and Merchandise debited for $10.00 when the Proprietor should have been debited, the trial balance will not necessarily reveal the mistake. The trial balance may be said to demand equal debits and credits and to have no concern with the distri- bution or location of those debits and credits. 26 Principles of Accounting ANALYSIS OF ACCOUNTS There is nothing rigid or inelastic about accounts. They may be created, consolidated, analyzed, or anni- hilated, according to the needs of the business. If any one account is not illuminating, it may be analyzed into its logical parts and its contents transferred to several other accounts. The old account then may be balanced and indicated as inactive and as receiving no more entries. Suppose, for example, that a concern owns the fol- lowing : Land and Factory at Chicago , $10,000.00 Land and Factory at New York 20,000.00 Land and Factory at Boston 5,000.00 Total $35,000.00 In its Ledger it has one account as follows : KEAL ESTATE Jan. 1 $35,000.00 On July 15 it desires to distinguish between the property in the various cities. It can close out the old account and substitute for it three new accounts as follows : EEAL ESTATE Jan. 1 $35,000.00 $35,000.00 July 15 E.E. Chicago (a) $10,000.00 15B.E. N. Y. (b) 20,000.00 15R.E. Boston (c) 5,000.00 $35,000.00 Bases of Accounting EEAL ESTATE CHICAGO 27 July 15 (a) $10,000.00 EEAL ESTATE NEW YORK July 15 (b) $20,000.00 EEAL ESTATE BOSTON July 15 (c) $5,000.00 As another illustration let the following represent a company's Merchandise Account: GENERAL MERCHANDISE Jan. 1 , 5, 7, 10 $ 600.00 65.00 110.00 155.00 15 211.00 20 540.00 25 308.00 30 10.00 $1,999.00 Feb. 1 Balance $ 709.00 Jan. 3 $ 500.00 11 400.00 21 22.00 25 301.00 27 67.00 31 Balance.. 709.00 $1,999.00 Suppose that on February 2 it is decided to split this account into its several components: Hay, $200.00; Grain, $400.00; Ground Feed, $109.00. When this is done, the following will appear : 28 Principles of Accounting GENERAL MERCHANDISE Jan 1 $ 600.00 Jan. 3 $ 500.00 5 . . . . 65.00 11 400.00 7 110.00 21 22.00 10 155.00 25 301.00 15 211.00 27 67.00 20 540.00 31 Balance* 709.00 25 308.00 30 10.00 $1,999.00 $1,999.00 Feb 1 Balance 1 . . .. ..$ 709.00 Feb. 2 Hay . (a) $200.00 2 Grain . (b) 40000 Ground Feed. .(c) 109.00 $ 709.00 $709.00 H AY Feb. 2.. ..(a) $200.00 GRAIN Feb. 2 (b) $400.00 GROUND FEED Feb. 2 (c) $109.00 1 The operation of consolidating a number of debit and credit items in an account into one item is known as "transferring" or "forwarding the balance." It is an operation with which all those who have studied bookkeeping are fa- miliar and, therefore, needs no description in this volume. Suffice it to say that it consists in making an entry on the smaller of the two sides of the account sufficient to equal the opposite total and thus balance it and in then ruling a single line under each column, which is followed by the total of each column. Under the total is ruled a double line. The balancing figure is then forwarded to, or brought down on, the opposite side. It requires but little thought to see that the status of the account is not changed in the least by this procedure. Base* f Accounting 29 's ACCOUNT ^ich this principle of subdivision . oeen most thoroughly applied is the ;j,r'S. i'he Proprietor's Account is the one showing the accountability of the business to the one who furnishes the funds with which to conduct the business and who is entitled to all profits and is responsible for all losses. Whenever a profit is made, it must in the end be credited to the account representing the proprietor's investment, as in a sense it is in the nature of a special liability of the business to him. Whenever a loss occurs, it is debited to the Proprietor's Account, since he is responsible for all losses. A valid claim against the proprietor is in a similar sense in the nature of an asset of the business as any other valid claim is an asset. This conception of the business as a separate entity or individuality is particularly appropriate in a consideration of the theory of accounts. It is sometimes a little difficult to keep this separate individuality in mind, especially where the proprietor is also the manager, in which case he is one individual exercising dual functions. These two func- tions should be kept separate and distinct as an aid to any analysis of accounting principles to be made. Inasmuch as the business has an existence apart from that of its proprietor, it is evident that the relation between the two is a matter of the highest importance. A business is instituted and carried on with one end, and only one, in view. This ultimate goal is profit. That business which disregards profit cannot long endure, and since the Proprietor's Account is the one that ultimately records changes resulting in profits or losses, it is the most important of all accounts. Proper analysis of the 30 Principles of Accounting Proprietor's Account is of the greatest importance. And we find it to be true that in modern accounting practice scientific analysis and classification have been carried to a finer point here than in any other account or set of accounts. SUBSIDIARY PROPRIETOR'S ACCOUNT Very few, if any, concerns are so simple in their nature and operation as to find a single Proprietor's Account sufficient for their needs. Practically every business is complex. It may trade in, not one staple article, but numerous articles. It has not half a dozen items of expense, but possibly hundreds or thousands. It may be composed not of one department, but of several. To manage such a business properly requires accurately classified knowledge for administrative guidance. It is not sufficient to know that the business as a whole is profitable. The manager must know just how profitable each department or other subdivision is. If he does not know this, how can he feel sure that his organization is not composed of several highly profitable departments and one or two very unprofitable ones whose elimination would result in a distinct increase in total profits? If several lines of merchandise are being sold, some may be contributing large profits, and some actually costing more than they produce. The manager must know these things, and he can get them in but one way from the accounts in general and from the Proprietor's Account in particular. In order that this vital information may be yielded by the Proprietor's Account, a number of carefully selected subsidiary Proprietor's Accounts must be brought into existence. For example, consider a small department store with Bases of Accounting 31 three selling departments. It would be proper to open ten accounts in the Ledger as follows : 1. Proprietor for Profits, Dept. 1 2 " " " ** 2 3 " " " "3 4. " " Expenses/ * 1 5. " " " " 2 6. " " " " 3 7. Merchandise, Dept. 1 8. " " 2 9. " " 3 10. Proprietor's Main Account The first two sets of accounts are pure proprietorship accounts, which will receive the entries that otherwise would go to the single proprietorship account heretofore discussed. The nature of the Proprietor's Account remains the same, but its structure is changed. It has been separated into appropriate parts. There still remains a single so-called "Proprietor's Account" (10 in above list), but it receives its entries as summaries of the data contained in the new proprietorship accounts (1 to 6 inclusive). The profit for a given period for a given department is determined by combining the two accounts Proprietor for Profits, Dept. 1, and Proprietor for Expenses, Dept. 1. This final figure representing net profit is then transferred to the main Proprietor's Account, and the other two proprietorship accounts are closed. This is done with each set of accounts for each department. At the end of any accounting period it is possible to determine the profits not only of the store as a whole but of each department or subdivision. This principle, outlined only crudely so far, is capable of the 32 Principles of Accounting widest application and is the very foundation of modern accounting. There will ordinarily be a separate Proprietor's Account for each distinct class of expenses or losses, such as : 1. Proprietor for Wages. 2. " " Bent. 3. " " Light. 4. " " Heat. 5. " " Interest. In modern practice it is customary to drop the two words "proprietor for" and simply speak of these accounts as 1. Wages. 2. Rent. 3. Light. 4. Heat. 5. Interest. Many have difficulty in seeing that these really repre- sent assets of the business in the sense that they are accounts due from the proprietor. True, the proprietor seldom pays them, because the business usually owes him more than he owes the business, and consequently, the settlement when made is on a net basis. Hereafter, in this book, when we speak of those accounts that represent obligations to or amounts due from the proprietor, we will use the names which they habitually bear in account- ancy, such as Bent, Wages, etc., and not the more cumber- some but more accurate titles of Proprietor for Bent, Proprietor for Wages, etc. Bases of Accounting 33 NOMINAL AND EEAL ACCOUNTS All these accounts due from or due to the proprietor are technically known as "nominal accounts" to dis- tinguish them from all other asset and liability accounts which are called "real accounts." Every nominal account may be said to have been " split off" from the original Proprietor's Account with which we started, and the results shown by each must eventually find their way back to the main Proprietor's Account. DEVELOPMENT OF THE MERCHANDISE ACCOUNT We have seen that when a business buys merchandise, Merchandise Account is debited and Cash Account credited and that when merchandise is sold at an advanced price, Merchandise Account may be credited for the cost price, the Proprietor credited for the profit, and Cash (or Accounts Eeceivable) debited for the total. This is a theoretically correct proceeding, but there are many practical objections which make it inadvisable. With a large stock of rapidly moving merchandise acquired under varying conditions of market, it is diffi- cult, if not impossible, to obtain the true cost price of each sale, nor is there any practical advantage gained by doing so. A far more convenient, simple, and economical scheme is to debit Merchandise and credit Cash (or Accounts Payable) for the cost price of goods purchased and to debit Cash (or Accounts Receivable) and credit Mer- chandise for the selling price of goods sold. Here it is obvious that an inaccurate record has necessarily been made. Goods are debited to Merchandise on one basis cost, and credited to Merchandise on another basis sell- ing price. What does the difference between the debit 34 Principles of Accounting and the credit side of Merchandise represent? It represents nothing. There is an element of profit or loss mixed in with merchandise, and this profit or loss properly belongs in the Proprietor 's Account. INVENTORIES We can, however, determine the facts as to profit or loss at any given time by an inventory. An inventory consists simply of a physical count or determination of the weight of articles and the assignment of a cost value to these articles. For example, suppose that 100 bushels of wheat are purchased at 90 cents a bushel, or $90.00, that sales amount to $120.00, and that, after having made those sales, the inventory shows 10 bushels of wheat still on hand which cost 90 cents a bushel, or $9.00. How would the profit be determined? In the first place, it is necessary to know how many bushels of wheat were sold and what the cost value was. If 100 bushels are pur- chased and 10 bushels are left, 90 bushels must have been sold. Each bushel cost 90 cents ; therefore the total cost of the goods sold is 90 X 90 cents, or $81.00. Therefore $120.00 worth of goods were sold that cost but $81.00. $120.00 $81.00 = $39.00 profit. This profit can then be placed to the credit of the Proprietor's Account and represents the profits on all wheat transactions for the period. This is more efficient, economical, and satis- factory than laboriously figuring the profit on each separate sale, and yet it arrives at the same final result. It is simply a short cut to the facts existing at the end of the accounting period. Bases of Accounting MERCHANDISE 35 Jan. 1 Purchases $ 90.00 Jan. 2 Sales $ 30.00 Gross Profit Trans- 17 " .... . . . 50.00 ferred to Proprie- 23 " 19 00 tor 's Account . . . 39.00 24 " 7.00 27 " 14 00 31 Inventory 9 00 $129.00 $129.00 Feb. 1 Inventory . $ 9.00 Note. The reader will observe that adding inventory on the credit side is equivalent to subtracting it from the debit side. Bookkeeping technique forbids making deductions in accounts but prescribes the equivalent of additions on the opposite side. MIXED ACCOUNTS The Merchandise Account, as above shown, is what is known as a " mixed account. " A mixed account is one which is partly real and partly nominal. Mixed accounts are not looked upon with favor by the best accountants, and for that reason they are being used less and less. There is no necessity for any mixed accounts, since they may be easily analyzed into their component parts, or accounts, which are either wholly real or nominal. Thus, the Merchandise Account above shown can be discon- tinued and three other accounts created to take its place. These three accounts are : 1. Sales Account. 2. Purchase Account. 3. Inventory Account. The Sales Account is credited with all sales at selling price, the Purchase Account is debited with all purchases at cost, and the Inventory Account registers the result of the periodic inventory. The profit at any time is deter- mined by adding the inventory of goods on hand at the 36 Principles of Accounting beginning of the period to the total purchases made and from that sum deducting the final inventory. The balance equals the cost of goods sold, and the difference between it and the balance of the Sales Account represents gross profit. For example, on June 1, 1916, there were goods on hand (determined by inventory) of $8,332.18. Purchases dur- ing June amounted to $27,121.90. Goods on hand, June 30, 1916 (determined by inventory), amounted to $10,- 883.38. Total sales during June equaled $27,115.99. To determine the profit for June the following calculation is made: Total Sales in June $27,115.99 Inventory, June 1 $ 8,332.18 Add Purchases during June 27,121.90 $35,454.08 Deduct Inventory, June 30 10,883.38 Cost of Goods Sold 24,570.70 Gross Profit $ 2,545.29 THE ACCOUNTING PERIOD With the simple mechanical contrivance suggested in the early part of Chapter I it is possible to determine the condition of the business from moment to moment. The various changes since made, together with others not yet mentioned, render this impractical, if not impossible. We must be satisfied, therefore, with a periodic revelation of the business condition. This, however, is not a serious drawback. It is not necessary to know the exact facts hour by hour or day by day. It is sufficient to obtain them at certain regular intervals. The regular interval for any business, be it a month or a year, is called the "ac- counting period." Bases of Accounting 37 The accounting period starts with all the nominal or sub-proprietorship accounts in balance, with the excep- tion of the main Proprietor's Account. During the ac- counting period certain changes in the business take place, which are registered in the accounts. At the end of the period the balances of the proprietorship or nomi- nal accounts are transferred to the main Proprietor's Account, and the Ledger is then ready to receive entries for the next accounting period. BALANCE SHEET AND PROFIT AND Loss STATEMENTS The end of every complete accounting period is signal- ized by two operations : the preparation of a statement of profit and loss and the preparation of a balance sheet. The statement of profit and loss is simply a conventional recital of the various debits and credits which are entered in the nominal accounts representing losses or gains. This statement is constructed according to a definite plan and is a classified exhibit, not a mere list or schedule. The balance sheet is a trial balance of the Ledger after the nominal or proprietorship accounts have been closed out into the main Proprietor's Account. It is a trial balance of balances and not of totals, and it is taken after, and not before, the nominal accounts have been consoli- dated. It is thus a list of the balances of all real accounts in the Ledger, or a list of the assets and the liabilities as shown by the records (including, of course, the Pro- prietor 's Account, which is for the purpose of the balance a liability and which itself includes the balances of all the nominal accounts). The functions of these two statements are now plain. The balance sheet shows the condition of the business at the end of the accounting period. It is like a photo- graphic snapshot, since it gives a permanent picture of 38 Principles of Accounting a rapidly changing business as of a definite moment of time. The statement of profit and loss fills in the gap between two successive balance sheets, explaining the differences existing between them and telling the story of results accomplished by the transactions. It has been said that accounting has only two principal objects to determine : (a) at a definite period the financial position of the business and (b) the causes for such in- creases and decreases. The first function is that of the balance sheet and the second, that of the statement of profit and loss. The technical preparation of these statements may well be left for treatment in a later chapter, but their importance must be fully appreciated now. Without them the book records of a business would be almost valueless. The length of the accounting period is not essential. The important thing is that these periods should be of a uniform length. The chief use of any kind of record is for comparison and, in order that comparison of two statements of profit and loss may be valuable, they must cover the same standard period. The most commonly employed unit is the year, although many concerns now use the month. The objection to the month as a unit is that all months are not equal in time ; some months con- tain four and some five Sundays, some months have thirty-one days and others less. A somewhat better small unit is the four weeks' period and, where it can con- veniently be employed, it is coming into favor. Likewise, for comparative purposes, the two periodical statements, the statement of profit and loss and the balance sheet, should be uniform in structure with the similar state- ments of other periods. Bases of Accounting 39 THE JOUKNAL, So far, the Ledger is the only book we have considered, and as a matter of fact, it is the one significant record in any business. It can be seen, however, that FIG. 12. The Traditional Journal Form even in a simple business appalling inaccuracy would re- sult if all entries were made directly in the Ledger. Through carelessness errors would result that would disturb the balance the most important characteristic of the Ledger. Through the inability of the average human 40 Principles of Accounting mind to grasp and hold a complex situation compre- hensively, it becomes necessary to draw up a memo- randum of the entries before actually making them in the Ledger. The figures on this memorandum may be tested for " balance" and the amounts then transferred to the Ledger with a feeling of confidence that they are correct. This memorandum classifies the debits and cred- its and furnishes a guide and authority to make the ledger entries. It is really an order to the ledger clerk to make certain entries. If permanently kept, it affords ready means of locating errors in the Ledger should that book be out of balance, since the two can be compared for dis- crepancies. Such a memorandum, in whatever technical forms it may be kept, is a Journal. The traditional Journal 2 is a blank book ruled as shown in Figure 12. The extreme right-hand column receives all figures which are to be credits in the Ledger, and the column to the left of it receives figures which are to be debits in the Ledger. Since debits and credits in the Ledger must be equal, debits and credits in the Journal must also be equal. Therefore, a test is obtained by adding up these two journal columns and comparing the totals, which should agree. POSTING The operation of transferring figures from the Journal to the Ledger is known as "posting." It is one of the rigid rules of modern bookkeeping that all ledger entries must be "posted" and never made direct. When this rule is in force, the authority for any entry can be de- termined by checking it back against the Journal (or 2 The Journal, as described in this chapter, is pedagogically very im- portant, but in its traditional form it has practically disappeared from modern practice. The journal function still remains, however. The modern substitutes for the Journal will be described at length in Chapter III. Bases of Accounting 41 one of its modern substitutes). This rule, of course, does not apply to the forwarding of balances, which in- volves no new entry. The journal entries for the transactions in Figure 11 might appear as follows : 1916 June 2 Accounts Payable $ 5.00 Cash $ 5.00 2 Cash 2.00 Accounts ^Receivable 2.00 2 Cash 12.00 Merchandise 10.00 Ames 2.00 2 Merchandise 5.00 Accounts Payable 5.00 For convenience in tracing items between the Journal and the Ledger, it is customary to indicate in each journal entry the page of the Ledger to which the posting was made and in the Ledger Account the journal page from which it came. Modern business conditions have brought about a sub- division of the Journal into special journals which record only particular classes of facts. Most of them are not called journals for fear of confusing them with the General Journal, which still is used to handle certain special or unusual transactions or adjustment entries which cannot be conveniently cared for otherwise. The usual journals employed in nearly every business are : The Cash Journals. The Purchase Journal. The Sales Journal. The General Journal. In addition to these four there are other journals in common use. These will be discussed at length in Chap- ter m. 42 Principles of Accounting THE CONTROLLING ACCOUNT AND SUBSIDIARY LEDGER So far in our discussion we have only hinted at the method of handling two of the most important accounts in the Ledger Accounts Eeceivable and Accounts Pay- able. Accounts Receivable is the group name which is applied to the aggregate of amounts which others owe to us, while Accounts Payable is the group name for the total of all items which we owe to others. Practically all modern business is done on a credit rather than a cash basis. Nearly all the customers who come into a store purchase goods "on account. " The basis of credit is trust. Those trusted customers are permitted to purchase goods based merely on their promise to pay at some future date. Such "promises to pay" are assets. Each regular customer may have an account in the General Ledger headed with his name and, when sales are made to him, his account is charged with the amount of the sale. When he makes payments, his account is credited. His account at all times shows the actual amount which he owes. Since a storekeeper is in business for the purpose of merchandising, and the better storekeeper he is, the more merchandising he can do, it follows that a good merchant may have a large number of such customers' accounts in his General Ledger. The more accounts there are in the General Ledger, the more chance for error exists and the more difficult it becomes to keep the Ledger in balance. The remedy for this situation is to take all the customers ' accounts out of the General Ledger, substituting for them a single account entitled "Accounts Eeceivable. ' ' The in- dividual customers ' accounts may be bound in a separate loose-leaf ledger. The trial balance of such a customers' ledger should show a net figure exactly equal to the Bases of Accounting 43 ance of the Accounts Eeceivable Account in the General Ledger. Such an Accounts Receivable Account is known as a "controlling account." A controlling account is a sum- mary account, which receives in totals the debits and credits which its subsidiary ledger accounts receive in detail. If the total debits to various customers ' accounts in the subsidiary ledger should be $10,000.00 during a given month, then the Accounts Eeceivable Account should be charged with $10,000.00 in one lump sum at the end of the month. If the sum of credits to individual customers ' accounts is $7,000.00 during that same period, then the controlling account must be credited with $7,- 000.00 in a lump at the end of that month. The manner of handling such postings is discussed in a later chapter. CONTROL ACCOUNTS AND DOUBLE ENTRY The important point to note is that the General Ledger is complete in itself. As many entries as desired may be made in the subsidiary records without affecting the General Ledger in the least. The double entry system revolves around the General Ledger as its unit and, in a certain sense, has no concern with any other book. As long as the General Ledger balances, we have double entry regardless of any supporting schedules, analytical records, or subsidiary ledgers. OTHER CONTROLLING ACCOUNTS In addition to the Accounts Receivable Account there are several other controlling accounts commonly em- ployed. The various creditors' accounts are usually kept in a subsidiary ledger and controlled by an Accounts Payable Account in the General Ledger. The Notes Receivable Account and the Notes Payable Account are 44 Principles of Accounting often controlling accounts. The former controls the notes themselves, and its balance must agree with the unpaid notes on file or on hand in the depository. The Notes Payable Account controls a memorandum record known as a " Notes Register. " 3 In conclusion, a controlling account is one which is supported by subsidiary detailed records. The informa- tion appears in totals, showing in one aggregate amount the net balance of its subsidiary accounts. Controlling accounts are almost universally employed in modern business and, as a matter of fact, the General Ledger of a large corporation may consist almost entirely of control accounts. INCOMPLETE DOUBLE ENTRY Were it not for the fact that the C. P. A. examina- tions of the various states sometimes ask questions re- garding "incomplete double entry " or " single entry, " as it is often called, it would hardly be necessary to do more than mention the subject in this book. Very few large business houses use anything but double entry in these modern days. The distinguishing feature of single entry is its per- sonal character. It generally keeps accounts with per- sons and not with forces or things. It is the double entry system with property accounts and the various non-per- sonal liability accounts eliminated. It is clear that this incompleteness renders it incapable of proof by balance. This reason alone is sufficient argu- ment against its use. Furthermore, no profit and loss statement can be prepared from the books, since nominal accounts are not kept. No balance sheet can be prepared 3 Discussion of other controlling accounts will appear in following chap- ters in connection with the several subjects as they are reached. Bases of Accounting 45 since a balance sheet is fundamentally a post-closing trial balance of the General Ledger; but a substitute for the balance sheet may be prepared by taking a physical in- ventory of all property owned and of all liabilities and by listing the amounts so determined in balance sheet form, the difference between the assets and liabilities representing the proprietor's interest in the business. This exhibit is called a "statement of resources and lia- bilities/' A comparison of two successive statements of re- sources and liabilities will afford some information as to the events that took place between the two dates. A comparison of the figures on such statements will indicate the net gain or loss of the period, if all withdrawals or additional investments have been taken into considera- tion. These, at best, are clumsy expedients, and single entry has no place in modern accounting, although it is still found in use with some smaller business houses, particu- larly in the rural districts. The accountant should know how to change a set of books from incomplete double entry (or single entry) to complete double entry. The solution, in theory, is com- paratively simple to make complete what is incomplete something must be supplied, that which is missing must be furnished. Therefore, the various non-personal ac- counts must be added to the single entry system to obtain the double entry. The method of doing this is to prepare a statement of resources and liabilities and to use this statement as the basis of a journal entry. Since the per- sonal accounts are already in the Ledger, it is not neces- sary to post them, but all the other items are posted, and the Ledger is then on a double entry basis. 46 Principles of Accounting POSITIVE AND NEGATIVE INVENTORIES We have discussed very briefly the use of a physical inventory in connection with the old-fashioned Merchan- dise Account. An inventory consists of a physical count (or measurement of volume or weight) of articles (or materials) together with their valuation. It is employed to correct a mixed account containing both real and nomi- nal elements, its use being by no means confined to the Merchandise Account. For instance, assume a business having an accounting period of one year extending from the first day of January to the last day of December. The management insures the buildings and pays a pre- mium of $100.00, the protection to cover a period of two years. Insurance may be considered as an expense, in which case the following entry 4 will be made : 1915 Jan. 1 Insurance (a nominal account) $100.00 Cash $100.00 On December 31 the books are closed, and the balances of all nominal accounts, among which is the Insurance Account, are transferred into the Proprietor's Account. This $100.00 spent for insurance is a loss an expense and serves to reduce the amount of profits. On December 31 of the next year there will be no insurance item to take into consideration before determining profits. Because the insurance was paid for in advance, the first year must bear the entire burden and the second year none, although the benefit applies equally to both years. We see, there- fore, that the profits of the first year have been "robbed" * This entry would ordinarily be made through the Cash Journal (or the Cash Book, as it is usually designated), but in this case as in others hereafter, we shall indicate the entry as though it were a general journal entry. This is customary among accountancy writers, and we shall conform to the estab- lished practice. Bases of Accounting 47 for the benefit of the second by the amount of one-half the premium, or $50.00. The results for each year are untrue, and no fair comparison can be made between them. This can be plainly seen, since it is apparent that the business might possibly have entered into an agree- ment with the Insurance Company to make yearly pay- ments. In this case $50.00 would have been debited to Insurance and absorbed by the Proprietor's Account the first year and another $50.00 the second year, thus mak- ing a fair and equitable division between the two periods. It is obvious, however, that cash payments cannot always be arranged in this convenient way. The device which is used in such cases is the inventory. If the business dis- burses $100.00 for insurance the first year, we have seen that the following entry is made : 1915 Jan. 1 Insurance (a nominal account) $100.00 Cash $100.00 At the end of the year an inventory is taken of the insurance, and when it is found that half of the protection has been used up and that half of it is still available for another year, the following journal entry is made : 1915 Dec. 31 Unexpired Insurance (a real account) $50.00 Insurance (a nominal account) $50.00 After this entry the balance of the Insurance Account is only $50.00, which is transferred to the Proprietor's Account. At the end of the next year an inventory of unexpired insurance develops that no more protection is due on the policy. The asset of unexpired insurance is non-existent and must be written off. Posting of the following journal entry accomplishes this purpose : 48 Principles of Accounting 1916 Dec. 31 Insurance (nominal account) $50.00 Unexpired Insurance (real account) $50.00 The balance of Insurance may then be transferred to the Proprietor's Account. There are two ways of handling accounts which are partly asset and partly expense. One way is to remove the asset elements, leaving a true expense account. The other is to remove the expense element, leaving a true asset account. Either method is absolutely proper. Thus, in the example just mentioned, either of the two following entries would have been made at the end of the first year: (a) 1915 Dec. 31 Unexpired Insurance (asset) $50.00 Insurance (mixed) $50.00 (The Insurance Account being left wholly "expense") (b) 1915 Dec. 31 Expired Insurance (expense) $50.00 Insurance (mixed) $50.00 (The Insurance Account being left wholly "asset") The principle involved in this discussion is that an expenditure should be justly distributed over the ac- counting periods benefited. Thus, if the insurance pro- tection lasts two years, the expense incurred should bear equally upon those of two years. This involves treating the expense as an asset which will expire as time passes. It appears on the balance sheet as an asset, i. e., Unex- pired Insurance, but it is not a permanent asset and with the passage of time finds its way into the nominal ac- counts. Such assets are known as "Deferred Assets," "Deferred Debits," or "Deferred Charges." Bases of Accounting 49 LIABILITY INVENTORIES In addition to the asset inventories discussed in the foregoing section, there are also liability inventories. The purpose of such inventories is also to equalize charges over two or more accounting periods. For ex- ample, at the end of a given accounting period it may be noted that a certain portion of the year's taxes have accrued but have not yet been paid. Suppose experience shows that the year 's taxes will be $120.00, payable at the end of the tax year. The period for which the tax will be assessed may not coincide with the concern's account- ing period ; wherefore, part of the $120.00 is chargeable to one accounting period and the balance to the next. If two months ' taxes were chargeable to the first period, an entry would be made : Taxes (expense) $20.00 Taxes Payable Accrued (liability) $20.00 The item of taxes would then be absorbed in the Proprie- tor's Account for the current accounting period, while the item of taxes payable accrued would appear as a liability on the balance sheet and would be cared for in the subsequent accounting period when the taxes are actually paid. As another illustration, suppose wages have accrued at the end of the period. If wages are payable every Saturday and the end of the accounting period falls on Wednesday, the wages for Monday, Tuesday, and Wednesday will not have been paid. For these three days they might amount to $800.00. To set this item up as an accrued liability and to insure that the proper period bears the burden, the following entry is made : Wages (expense) $800.00 Accrued Wages Payable (liability) , ? $800.00 50 Principles of Accounting The item of wages $800.00, together with the balance of the Wages Account, is absorbed by the Proprietor's Account, and the item of accrued wages payable appears as a liability on the balance sheet. If such asset and liability inventory adjustments are not made at the end of an accounting period, it is clear that the accidental circumstances of payment or non- payment of cash will affect the profits of the period either favorably or unfavorably. Either is undesirable, since a distorted and untrue picture of affairs of the business is thus given. CONCLTJSION A discussion of technique is not desirable in a work on accounting principles, since these things pertain princi- pally to the art of bookkeeping. We have, therefore, not made an attempt to go into these matters. The actual methods of consolidating the balances of nominal accounts with the Proprietor's Account should be understood by the reader before studying this text. Suffice it to say that journal entries are made which debit all nominal accounts which have credit balances and credit all nomi- nal accounts which have debit balances, the contra entries going to an intermediate proprietorship account usually called the "Profit and Loss Account." The balance of this Profit and Loss Account, representing a profit or a loss, is then by a journal entry transferred to the Pro- prietor's Account. We have now seen that, because of the structure of the human mind, man requires symbols or representations of complex things in order that they may be thereby brought within his comprehension. The symbol of the balance is the one used to represent the business. Its funda- mental characteristic is its balancing feature, and from Bases of Accounting 51 this comes the double entry rule the law of debits and credits. The business is represented or symbolized by a collection of accounts, which are combined into the Gener- al Ledger. Changes in the business are reflected in that ledger by appropriate debit and credit entries, which theoretically may be made directly to the accounts af- fected, but which for various practical reasons are "posted" from the Journal (or one of its modern substi- tutes). The balance of this Ledger is tested by a device called "the trial balance." The Ledger represents as debits the assets of the business and as credits the liabili- ties of the business. The liabilities for practical purposes are divided into liabilities to the proprietor and liabilities to others, the Proprietor's Account normally showing a credit balance but receiving debit entries for all ex- penses and losses. The proprietor is responsible for all losses; hence they are in a technical sense assets of the business an account receivable from the proprietor. The proprietor is entitled to all profits; hence they are technically liabilities of the business to the proprietor an account payable to the proprietor. For purposes of analysis a great many separate pro- prietor's accounts are usually used, each one receiving only certain kinds of entries, but the balances of these proprietorship, or nominal, accounts are periodically transferred to some intermediate proprietor's account where the net result, whether a gain or a loss, is deter- mined. These periods are known as "accounting periods" and should be uniform for comparative pur- poses. Because the results of successive accounting periods are compared with each other, it is essential that one period be not unfairly favored at the expense of another, that expenses and gains be recorded in the periods during which incurred or earned. This has 52 Principles of Accounting given rise to expense and liability inventories Deferred Debit Items and Deferred Credit Items as they are some- times technically called. At the end of every accounting period two main exhib- its are prepared the statement of profit and loss and the balance sheet. The latter shows the balances of the ledger accounts at a definite moment of time; the former presents in a systematic way a summary of the debits and credits made to the various nominal or pro- prietorship accounts during the accounting period. TEST QUESTIONS 1. What is the Ledger? 2. What is the relation of the proprietor to the business? 3. Why is a trial balance of balances as good as a trial bal- ance of totals in testing for completeness of record? 4. What is the fundamental distinction between real and nominal accounts? 5. What are the elements of the mixed merchandise account? CHAPTER DEVELOPMENT OF THE SPECIAL JOURNALS In the preceding chapter we found that a business is symbolized or represented by a collection of accounts in a record which is called "the Ledger " and that current changes in the business are reflected by changes in the general ledger accounts. The method of showing such changes in the Ledger is called "making ledger en- tries. " In an ideally simple business requiring only a few simple accounts, these entries might be made directly in the Ledger, but the complexity of modern business renders such procedure absolutely impossible, and it is now universally the custom to make a formal preliminary memorandum of each ledger entry. This memorandum acts as an order on the ledger clerk to make certain en- tries and should be permanently retained, since it may be desirable at any time to investigate the authority for the entries. Such a collection of memoranda is called ' ' a Journal. ' ' FUNCTION OF THE JOTJKNAL The modern, inflexible rule of bookkeeping is that no ledger entry shall be made, unless it is posted from a record performing the function of a journal. The Journal classifies all business transactions into debits and credits, and from it the debit and credit figures are posted to the appropriate debit or credit sides of the specified ledger accounts. The number of the ledger page 53 54 Principles of Accounting is then shown on the Journal in the space provided, called "the folio column/' and the number of the journal page is also shown on the Ledger, thus facilitating cross references. Example: June 1, 1916, John Smith bought merchan- dise on account from Arthur Eamsey amounting to $20(XOO. June 1, John Smith gave his note for $150,00 @ 6% to Arthur Eamsey in part payment of the account. June 30, John Smith paid the note, the interest, and the balance of the open account in cash, less discount of \% on the open account. 1916 June June 1 June 30 JOURNAL JOHN SMITH Merchandise Purchases (a) $200.00 Accounts Payable (a) $200.00 (Arthur Eamsey $200.00) 1 Accounts Payable (b) 150.00 (Arthur Ramsey $150.00) 1 Notes Payable (b) 150.00 Accounts Payable (c) 50.00 (Arthur Eamsey $50.00)1 Notes Payable (c) 150.00 Interest Paid (a) .75 Cash (c) 200.25 Purchase Discounts (c) .50 The transactions shown above in journal entry form are now ready for posting to the General Ledger. (The postings to the subsidiary Purchase, or Creditors', Ledger need not be illustrated at this time.) The ledger ac- 1 The items in parentheses are posted only to the subsidiary Purchase Ledger. This Purchase Ledger has Accounts Payable as its general ledger controlling account. The method of handling controlling accounts illustrated in the above journal entry is not in ordinary use, since certain labor-saving devices, to be explained hereafter, are usually employed. Development of Special Journals 55 counts, after postings from the above journal entries have been made, appear as follows : MERCHANDISE PURCHASES 1916 June .1 (a) $200.00 ACCOUNTS PAYABLE 1916 (b) $150.00 1916 (a) $200.00 30.. . . (c} 50.00 NOTES PAYABLE 1916 June 30. (c) $150.00 1916 June 1, (b) $150.00 INTEREST PAID 1916 June 30 (c) $ .75 PURCHASE DISCOUNTS 1916 June 30. (c) $ .50 CASH 1916 June 30 (c) $200.25 COLUMNAR JOURNAL The combination of a single Journal and a General Ledger (with two subsidiary ledgers for recording de- 56 Principles of Accounting tails of Accounts Eeceivable and Accounts Payable) is sufficient to handle any kind of business transaction, no matter how complex it may be. A little thought, how- ever, will show that there will be a great many transac- tions to be recorded which are similar in nature, although not in amount. Even in a small business there will be a great many debits and credits to the Cash Account during any one accounting period ; there will be many entries to Merchandise Purchases, to Merchandise Sales, to Ac- counts Receivable, and to Accounts Payable Accounts. It would be perfectly proper in the case of cash transac- tions to post day by day from the Journal to the Ledger all debits and credits except those to the Cash Account ; at the end of the month the bookkeeper could pick out of the Journal all debits to Cash, total them on an adding machine, and post that total in one lump sum to the debit of the Cash Account. In a similar way he could pick out all journal credits to Cash and post the total to the credit of the Cash Account. If there were fifty debits and credits to Cash scattered through the Journal, the book- keeper would save forty-eight general ledger entries by the above plan. The one danger to be feared is that he will overlook one or more items in arriving at his total. This, of course, would throw the General Ledger out of balance. To avoid this possibility of error, two extra columns may be put in the Journal, one headed ' ' Cash- Dr." and the other, "Cash-Cr." All cash items will appear in these special columns instead of in the regular debit and credit columns. At the end of the month the "Cash-Dr." column is footed and the total posted to the debit of the Cash Account in one lump sum. The ' ' Cash- Cr." column is also footed and the total posted to the credit of the Cash Account. A journal page in simplest form is shown in Figure 13, Development of Special Journals 57 S",ooo 00 (I) 3,000 3,000 06 fc) I.OOO U) 5~00 OC /,ooo 00 3.S-0 Ztro (F /oo /oo 00 23 00 4 IS-o 00 FIG. 13. Illustration of Transactions Using Regular Journal Form Compare with Fig. 14 for a better method of handling same transactions. 58 Principles of, Accounting and one exactly the same, except that all cash items are segregated as explained, in Figure 14. John Smith's cash account after posting the journal entries shown in Figure 13 appears as follows : CASH JOHN SMITH 1916 June 1 . . (a) $5,000.00 1916 June 2 (b) $3,000.00 9 (f) 250.00 7 (e) 980.00 15 . . (g) 900.00 30 Balance 3,397.00 18 . . (h) 100.00 30 . . (k) 1,127.00 $7,377.00 $7,377.00 July 31 Balance... ..$3.397.00 John Smith's cash account after posting journal entries shown in Figure 14 appears as follows: CASH JOHN SMITH 1916 June 30. ,$7,377.00 1916 June 30 $3,980.00 30 Balance 3,397.00 $7,377.00 $7,377.00 July 1 Balance $3,397.00 It can easily he seen that this is a great labor-saver where a number of cash items appear in the Journal. It is, of course, equally labor-saving when used with other classes of items. If a great many credit sales are made, two more columns may be added to the four already in the Journal. One of these may be headed "Accounts Eeceivable-Dr. ' ' and the other, ' l Merchandise Sales-Cr. ' ' The first column collects all amounts debitable to Ac- Development of Special Journals 59 JOURNAL DATE EXPLANATION LF. CASH Dr. Cr. SUNDRY Dr. a. /,ooo ',000 f/P / 7,377 FIG. 14. Dluatration of Transactions Using Columnar Journal Compare with Fig. 13. 60 Principles of Accounting counts Eeceivable Account and holds them until the end of the month, at which time the total only is posted. In the same way "Merchandise Sales-Cr. ' ' collects and holds all credits for the Merchandise Sales Account until the end of the month, total only being posted. A similar pair of columns can be used for Merchandise Purchases and Accounts Payable. Any number of such special columns may be employed, limited only by the size of the Journal Book, which should not be too large for comfortable handling. A Journal containing special columns for (1) Cash, (2) Accounts Eeceivable, (3) Accounts Payable, (4) Mer- chandise Purchases, and (5) Merchandise Sales, together with " general' ' columns for all items that cannot be " lumped " into any of the above five classes, will be ruled as shown in Figure 15. You will note that the method of posting the columnar totals is to bring them into the ' * general ' ' column. There are two reasons for this: (1) A test of balance is ob- tained by footing the two "general" columns, which should be equal after the special column footings have been transferred to them, and (2) it is in accord with a good rule which says that nothing shall be posted from a columnar journal save items in the "general" columns. Adherence to this rule prevents errors. SPECIALIZED JOUKNALS As the Journal continues to expand and new columns are added, the book becomes unwieldy and difficult to handle. Furthermore, as the business grows, the transac- tions increase to a number greater than one bookkeeper can handle and yet the Journal, so far as we have now developed it, can be used by only one bookkeeper at a time. What is more natural, under these circumstances, Development of Special Journals 61 62 Principles of Accounting than to split this journal into two separate journals, so that two men can work at one time? You should notice that even though it is split into two books it is still the same journal with which we started. There is a physical difference, but not a difference in function. It is clear that little or nothing will be accomplished by making the two new journals exact duplicates of the original journal, since each would still have too many special columns. The better way is to limit one of the journals to recording one class of facts. In other words, take two of the special columns away from the original journal and make a new journal out of them. In a busi- ness where the number of sales on credit is very large, the new journal might be called the " Sales Journal/' and its use would be confined to recording sales to customers. (See Figure 16.) During the month the individual items should be posted to the Customers' Ledger (a subsidiary ledger controlled by the Accounts Eeceivable Account in the General Ledger), thus, $383.75 would be debited to Myron Van Gorder's account and $30.30 would be debited to C. F. Denison's account. At the end of the month the total sales $414.05 would be debited to Accounts Eeceivable and credited to Sales in the General Ledger. You will now begin to perceive how the controlling account and the subsidiary ledger are handled in actual practice. The subsidiary ledger is posted from day to day, and the general ledger accounts are posted at the end of the month in totals. The regular Journal has now been shorn of some of its importance, since all sales are handled through a special journal reserved for the purpose. In much the same way we may use a Purchase Journal for all pur- chases from others on credit. This journal resembles Development of Special Journals 63 the Sales Journal in appearance, although it has an en- tirely different function. The individual purchases are credited to the individual accounts in the Creditors' SALES JOURNAL DATE ACCOUNTS DEBITED TERMS 'EXTEN- TOTAL 1$ /.IS" IS 2$ 30 30 11, S'o .0 f 00 to (), .'32- 12. ?o -31 05 4/4 of FIG. 16. Sales Journal Ledger (a subsidiary ledger controlled by Accounts Pay- able in the General Ledger), and at the end of the month the total is debited to Purchases and credited to Ac- 64 Principles of Accounting counts Payable in the General Ledger in one lump sum. (See Figure 17.) If the reader can once grasp the idea that the Ledger is complete in itself and independent of all detailed sub- sidiary records, he will have but little difficulty in under- standing even the most complex types of journals. Each PURCHASE JOURNAL DATE ACCOUNT CREDITED /, 2,5-0 oo I/ 3,7 & FIG. 17. Purchase Journal journal must act as the basis for at least two general ledger entries as in the Sales Journal shown, where Ac- counts Receivable was debited $414.05 and Sales Account was credited $414.05. Two other entries were made (to the subsidiary ledger) from the Sales Journal, but these in no way affected the General Ledger, although they aggregated the same amount that is charged the general ledger control account. Thus we see that the modern journal, such as the Sales Development of Special Journals 65 Journal or the Purchase Journal, has at least two func- tions. It acts as a posting medium for the General Ledg- er, and for that purpose its debits and credits must be equal. It also acts as a posting medium for a subsidiary ledger, which simply furnishes the detail of one general ledger account. Thus, the general ledger account and the CASH RECEIPTS JOURNAL DATE ACCOUNT TO BE CREDITED LF. AMOUNT 30 00 00 FIG. 18. Cash Eeceipts Journal subsidiary ledger " check " and prove each other. If there is any discrepancy between the two, it must be traced down, since it indicates the existence of at least one error in posting. Another important class of transactions which may be segregated are those that refer to cash. One journal may be reserved for cash receipts and another for cash dis- bursements. A simple form of Cash Eeceipts Journal is shown in Figure 18. 66 Principles of Accounting During the month the various general ledger accounts are credited, and at the end of the month the Cash Ac- count is debited. No provision is made in the ruling of this Journal for postings to subsidiary ledgers. This can be remedied by inserting another column in this Journal to take all credits to Accounts Eeceivable con- trolling account. CASH RECEIPTS JOURNAL DATE EXPLANATION LF ACCOUNTS RECEIVABLE Cr. CASH Dr. SJ Oc Jo SO FIG. 19. Columnar Cash Receipts Journal In regular journal form the general ledger entries for the transaction shown in Figure 19 would appear as fol- lows: Cash $26L50 Interest $ 5.00 Bent 30.00 Interest 50 Accounts Eeceivable 226.00 and, in addition, the following credits would have to be made in the subsidiary Customers' Ledger. Development of Special Journals 67 Walter Jones $ 45.00 John Dale 108.00 Joseph Smith 51.00 Arthur Brown 22.00 The Cash Disbursements Journal may be in the simple form like the first Cash Receipts Journal, but preferably a column will be provided to receive the detailed items which make up the lump sum charge to Accounts Payable controlling account. FIG. 20, Cash Disbursements Journal 68 Principles of Accounting Put in the conventional journal form shown in Figure 20, the general ledger entry to be made would appear as follows : Labor $ 50.00 Postage 5.00 Express Inward 13.50 Carfare 25 Accounts Payable 304.92 Cash $373.67 and, in addition, the following debits would be made in the subsidiary Creditors' Ledger. John Simons $ 63.00 Morris Johnson 121.00 Frederick Hampton 87.62 Charles Morton 10.00 Eichard Sexton 23.00 E. C. Herron 30 In a business of sufficient size it is quite satisfactory to have separate journals for cash receipts and cash disbursements, but the proprietor of a small establish- ment often desires to have the two combined into one Cash Journal. No change in the arrangements hitherto proposed is necessary, except that in the combined book the left-hand page will then register the cash receipts and the right-hand page will register the cash disbursements, as shown in Figure 21. Many bookkeepers claim that when the Cash Journal is kept in this form, it is not necessary to carry a General Ledger Cash Account at all that the Cash Journal itself takes its place. In this they are unquestionably right. The author, however, feels that very little is gained thereby, since the monthly posting of totals to the Cash Account consumes little time and, if it were omitted, no Development of Special Journals 69 CASH JOURNAL DISBURSEMENTS 13 * /; FIG. 21. Cash Journal Which Is Used Purely as a Posting Medium Compare this exhibit with Fig. 22. CASH JOURNAL DISBURSEMENTS ACCOUNTS' FJW C,. ACCOUNTS YAI D, CASH C, FIG. 22. Cash Journal Which Is Used as a Posting Medium and Which ^4Zso Serves as a Cash Account Such an exhibit is usually known as a "Cash Book." Compare with Fig. 21. 70 Principles of Accounting complete trial balance could be taken from the General Ledger. A Cash Journal which will take the place of the Cash Account is shown in Figure 22. Observe that the totals of the cash columns are not posted, but that the two sides are balanced and that the cash balance is carried forward, just as it is in a ledger account. Throughout this book we will assume that a Cash Account is carried in the General Ledger and that the Cash Journal is purely a posting medium. This is in accordance with the best accounting theory as well as good practice. We have now created four special journals for 1. Sales. 2. Purchases. 3. Cash Receipts. 4. Cash Disbursements. Thus our original journal is relieved of most of its entries. Through these special journals practically all necessary entries to the Accounts Receivable and the Accounts Payable Accounts can be made, although the original journal still handles a few of such items, for instance, when notes are given or received or special adjustments made. Instead of a highly columnarized book, the Journal (Figure 23) has become simple, and only a few entries pass through it monthly. It can never be entirely dispensed with, however, since there are always many special items which can be handled through no other medium. The Accounts Receivable and the Accounts Payable columns are retained in the Journal in order to receiv the occasional debits and credits affecting these accounts Development of Special Journals 71 These entries may arise from allowances, returns, notes, and other sources. CASH DISCOUNTS In almost every business it is customary to grant discounts to those customers who pay their bills promptly. The discount is usually a percentage of the total invoice JOURNAL ACCOUNTS PAYABLE Dr. ACCOUNTS RECEIVABLE Dr. GENERAL Dr. GENERAL Cr. ACCOUNTS RECEIVABLE Cr ACCOUNTS PAYABLE Cr. FIG. 23. Columnar Journal When Used as a Posting Medium for Notes Received and Given price f. o. b. shipping point, and is only allowed to cus- tomers if they make payment in cash within a definite time from the date of shipment. Such a discount is, in reality, a bonus for promptness and not a reduction in the selling price, although many people are confused into thinking so because it is a percentage of the sales price. The method of booking such discounts is very simple if all transactions are passed through the original jour- 72 Principles of Accounting nal. For example, we ship $1,000.00 worth of goods to A. S. Morton and grant him the privilege of a 2% discount if the bill is paid within ten days from date of shipment. Journal entry made at time of sale : Accounts Receivable $1,000.00 (A. S. Morton $1,000.00) Sales $1,000.00 Journal entry when bill is paid and discount taken : Cash $980.00 Sale Discounts (nominal account) 20.00 Accounts Receivable $1,000.00 (A. S. Morton $1,000.00) ^ On the other hand, suppose that we bought $500.00 worth of goods from Kiley & Co. on the same terms. At the time of the purchase we would make the following journal entry: Merchandise Purchases $500.00 Accounts Payable $500.00 (Riley & Co. $500.00) When we pay the bill and take the discount, we will make a journal entry as follows : Accounts Payable $500.00 (Riley & Co.) Cash % . $490.00 Purchase Discounts (nominal account) 10.00 If many such transactions occurred, we might adopt the columnar expedient in the Journal: one column headed " Sales Discounts Dr." and the other "Purchase Discounts Cr. ' ' How shall purchases and sales discounts be recorded in the system where several journals, instead of one, are employed? Development of Special Journals 73 It is clear that they may be handled through a special column in the Journal, but since they are intimately associated with receipts from customers and payments to creditors, which are handled through the Cash Eeceipts Journal and the Cash Disbursements Journal respec- tively, it is plain that economy and efficiency will not result from such a plan. A complete transaction including credit to Accounts Receivable and debits to Cash and Sales Discounts should be made through one CASH RECEIPTS JOURNAL DATE EXPLANATION FOLIO Dr. ACCOUNTS RECEIVABLE Cr. CASH Dr. 3.7$- 11 / 12. /S Z2 FIG. 24. Cash Eeceipts Journal, Showing Method of Handling Sales Discounts If put in conventional journal entry form it would appear as follows : Sales Discounts $ 56.48 Cash 3,247.54 Rent 14th St. Property $ 275.00 Interest Earned .46 Accounts Receivable 3,028.56 74 Principles of Accounting journal, and that one will naturally be the Cash Receipts Journal. The entire transaction of paying an account and taking the discount, involving a debit to Accounts Payable and credits to Cash and Purchase Discounts, should be made through the Cash Disbursements Journal. The two Cash Journals in revised form will then appear as in Figures 24 and 25. CASH DISBURSEMENTS JOURNAL DATE EXPLANATION L.F CHECK PURCHASE DISCOUNT Cr. ACCOUNTS PAYABLE Pr. CASH Cr. f-,3.00 oo /.Zoo IS 772. WO 65- IO 13 ft* /7o 2s- S83 32? 09 6-3 2./Z2 3/ a*. C^-tX 72 S.762 &.S23 FIG. 25. Cash Disbursements Journal, Showing Method of Handlin Purchase Discounts Putting it in journal entry form we get the following : Drayage and Hauling $ 15.00 Wages Payable 772.87 Interest Lost 10.21 Accounts Payable 5,762.58 Purchase Discounts $ 36.72 Cash 6,523.94 Development of Special Journals 75 This method of handling purchases and sales discounts is simple. Its chief disadvantage is that it introduces non-cash items into the Cash Journals, but this is a matter of small moment compared with the convenience and efficiency that result from such treatment. Strictly speaking, the Cash Journal should receive only such entries as refer to the receipt or the disbursement of cash, a.nd discounts, either purchase or sale, are not cash items, but refer to allowances or premiums for prompt- ness in paying. When a customer pays $980.00 in cash as full payment for a $1,000.00 account, the transaction, upon analysis, appears as follows: Cash $980.00 Accounts Eeceivable $980.00 Sales Discount 20.00 Accounts Eeceivable 20.00 In the second entry, no cash transaction occurred, and since, by definition, the Cash Journals receive only such items as refer directly to cash receipts or to cash disburse- ments, it is clear that purchases and sales discounts do not, by nature, belong in these two journals. To repeat, however, it is a matter of economy and efficiency to pass such discounts through the Cash Journals, and practically all accountants do so. NOTES AND BILLS JOURNALS In a business where the number of notes given or received is small, it is customary to pass them through the Journal in the same way that other infrequent entries are made, but where a large volume of note transactions occur, it is better to have special journals for handling them. These journals are the Notes and Bills Eeceivable Journal and the Notes and Bills Payable Journal. These 76 Principles of Accounting are two separate journals, although they are often bound into one book. A sample ruling of a Notes and Bills Eeceivable Journal is shown in Figure 26. The general ledger postings are made from the totals of columns 21 and 22 at the end of the month. The subsidiary ledger NOTES AND BILLS RECEIVABLE JOURNAL 1916 ACCEJtOR IT e NOTES AND RECEIVABLE JOURNAL 1916 H tei R^fiffi "T 1 " I TIG. 26. Posting Medium for Notes and Bills Eeceivable (Notes Receivable Ledger) postings are made day by day to the customers 7 accounts shown in column 19. Columns 7 to 18 inclusive are designed to show due dates of the various notes and are not posted at all. There is no standard practice as to the use of these, columns. They may show only the day of the month thus : a note due on August 5 would be handled by inserting the figure 5 in column 14. The use of these columns in this way Development of Special Journals 77 facilitates the preparation of schedules to show the amount of cash to be expected in any future month. The columns may be used as money columns. If so, the amount of the note is put under the proper " month " heading. For example, a note receivable for $75.00 due July 30 will be handled by putting $75.00 in column 13. This procedure enables the treasurer to obtain the exact amount to be expected from Notes Receivable during any one month by simply reading the columnar total. It may be still further elaborated by providing for both the day of the month and the amount under the name of each month. The illustration on the opposite page is ruled in accordance with the second plan. From the columnar totals we see that during the month of May $995.25 can be expected to come in to the treasury; in July, $1,579.40; and in September, $293.30. The Notes and Bills Payable Journal is constructed according to the same general plan as the form just discussed. If these two journals are bound in the same volume, care should be exercised in order that entries may not be made in the wrong journal. One of the journals may be printed and ruled in red ink and the other in black ink, and different styles of type may be used to emphasize the differences between the two. SPECIAL JOURNALS AND CONTROL ACCOUNTS When the principle is thoroughly grasped that journal items referring to the same account may be set aside unposted in a special column until the end of the month and then posted in one lump sum and the further principle has been established that special journals may be split off from the General Journal to record particular classes of facts, it requires no imagination to see that great 78 Principles of Accounting elasticity results. Special journals and special columns for those journals may be designed to fit any business, large or small. These journals and special columns have for their main purpose the collection and classification of financial facts in shape for posting to the General Ledger control accounts by totals and to subsidiary ledgers by items. This does not mean, of course, that every general ledger entry represents the total of a column in some journal. Certain kinds of items occur so infrequently that it would be unwise to provide special columns for them. We have seen that this is provided for in all journals by means of general columns. Figures appear- ing in these general columns are posted item by item to the designated general ledger accounts. THE LEDGERS Before considering the more complex types of journals it will be well to discuss, in some detail, the ledgers. The General Ledger is the book of the business, being the ultimate development of the "balance," which was dis- cussed in Chapter I. The General Ledger is a bound volume containing the accounts of the business. In it are recorded, in a more or less summarized form, the facts which are collected and classified by the journals. The General Ledger is the keystone of the whole account- ing system. Subordinate to it are certain other ledgers, such as the Accounts Receivable Ledger and the Accounts Payable Ledger, each of which gives the detail of one of the accounts in the General Ledger. It is clear that any clerk having access to the General Ledger is in a position to know as much about the results of the business as the owner or manager. Some book- keeper must have access to it, since postings must be made to it and the owner can hardly be expected to do the bookkeeping work himself. Most of the general Development of Special Journals 79 ledger accounts, however, are not confidential; only a few of them are strictly so. The General Ledger may be split into two books, one large enough to contain all except private accounts and the other for all accounts which contain confidential figures. The function of the General Ledger is certainly not changed by binding it in two volumes instead of one, and a very substantial advantage is gained, namely, that the larger of the two volumes in which most of the clerical work must be done can be freely turned over to the office force while the confidential ledger remains in the sole possession of the proprietor, manager, or a trusted employee. These two books are called the General Ledger and the Private Ledger, although in reality the General Ledger consists of the two books taken together. THE PKIVATE LEDGER It is usual to include in the Private Ledger only those accounts which are really significant, from which the true profit or loss is ascertained or the true values of fixed assets are determined. These accounts are not the ones which require much bookkeeping work, but they reflect the really vital facts of the business. In a trading partnership, the following accounts would probably be found in the Private Ledger: Land & Buildings. Furniture & Fixtures. Investments. Inventory of Merchandise. Capital Account Jones. Capital Account Smith. Trading Account. Profit and Loss Account. All other accounts would be found in the General Ledger. 80 Principles of Accounting Since these two books are, in reality, merely separate volumes of the same book, it is clear that they may be so regarded when the time comes to take a trial balance. A trial balance taken from either one alone will be incom- plete. When they are considered together, a complete trial balance results. For various practical reasons it is often desirable to take a trial balance of these two books separately, and to facilitate this, a "balancing" account is included in each ledger. Thus, the Private Ledger will contain a General Ledger Account, and the General Ledger will contain a Private Ledger Account. When this is done, a complete trial balance may be taken from either of these books alone. The method of operating these "balance" accounts is simple. Suppose, for example, that the Cash Account is carried in the General Ledger and that Jones ' Capital Account is carried in the Private Ledger. What happens when Jones draws $200.00? In the General Ledger the following entry may be made : Private Ledger Account $200.00 Cash $200.00 and in the Private Ledger this entry may be made : Jones ' Capital Account $200.00 General Ledger Account $200.00 The effect, eliminating the balance account, is to debit Jones ' Capital Account and credit Cash. When an entry affects accounts in the same ledger, whether it be Private or General, nothing need be posted to the balancing accounts, but when one account in the General Ledger and one account in the Private Ledger are affected, the balancing accounts will receive entries. For the sake of illustration, we will assume the case Development of Special Journals 81 of a company desiring to start a Private Ledger and indicate the procedure necessary. The balance sheet of Cutter & Wilson on December 31, 1915, is as follows : Liabilities Assets arid Capital Cash $ 5,000.00 Accounts Keceivable 18,000.00 Notes Eeceivable 15,000.00 Merchandise Inventory 30,000.00 Land & Building 25,000.00 Furniture & Fixtures 8,000.00 Accounts Payable $ 6,000.00 Notes Payable 15,000.00 Mortgage Payable 5,000.00 Cutter Capital Account * 50,000.00 Wilson Capital Account 25,000.00 $101,000.00 $101,000.00 As of January 1, 1916, they desire to open a Private Ledger, which will be kept in the possession of Mr. Wil- son, and they desire that the following accounts shall be included in that ledger : Merchandise Inventory $30,000.00 Land & Building 25,000.00 Furniture & Fixtures 8,000.00 Mortgage Payable 5,000.00 Cutter Capital Account 50,000.00 Wilson Capital Account 25,000.00 (Trading Account) (Profit and Loss Account) If the General Ledger could be taken apart and rebound in two volumes, one containing the above accounts and marked "Private Ledger " and the other containing the remaining accounts and marked "General Ledger," nothing further would be required save to open a balance account in each, which would be debited or credited with 82 Principles of Accounting amounts sufficient to bring the books to balance. Assume, however, that the original General Ledger is a substan- tially bound book, as it should be, and that it is better to close out the private accounts which appear in it, leaving the other accounts as they are, and to open a new book for the Private Ledger. To accomplish this, the following entry should be made in the General Journal and posted to the General Ledger : 1916 Jan. 1 Mortgage Payable $ 5,000.00 Cutter Capital Account 50,000.00 Wilson Capital Account 25,000.00 Merchandise Inventory $30,000.00 Land & Building 25,000.00 Furniture & Fixtures 8,000.00 Private Ledger Account 17,000.00 When this entry has been made, a trial balance of the General Ledger will appear as follows : Cash $ 5,000.00 Accounts Eeceivable 18,000.00 Notes Eeceivable 15,000.00 Accounts Payable $ 6,000.00 Notes Payable 15,000.00 Private Ledger Account 17,000.00 $38,000.00 $38,000.00 To open the Private Ledger, a Private Journal is appropriate. In that Private Journal the following entry will be made: 1916 Jan. 1 General Ledger Account $17,000.00 Merchandise Inventory 30,000.00 Land & Building 25,000.00 Furniture & Fixtures 8,000.00 Mortgage Payable $ 5,000.00 Cutter Capital Account 50,000.00 Wilson Capital Account 25,000.00 Development of Special Journals 83 When this private journal entry has been posted to the Private Ledger, a trial balance may be taken. This trial balance of the Private Ledger will appear as follows : General Ledger Account $17,000.00 Merchandise Inventory 30,000.00 Land & Building 25,000.00 Furniture & Fixtures 8,000.00 Mortgage Payable $ 5,000.00 Cutter Capital Account 50,000.00 Wilson Capital Account 25,000.00 No definite statement can be made as to just what accounts should appear in the Private Ledger. This is a matter for the owner or manager of the business to decide. From the practical viewpoint no accounts should be included in the Private Ledger that receive more than a few entries a month, since it would be unwise to burden a high-priced manager or confidential secretary with routine bookkeeping work. The Trading Account, the Inventory Account, and the Profit and Loss Account should appear in the Private Ledger, at any rate. OTHER USES OF THE PRIVATE LEDGER In corporations it is customary to have a private salary roll for the executives, so that clerks and subordinates may not be advised what salaries their superiors' are receiving. This may be accomplished in several ways. One way is to carry a Private Cash Account in the Private Ledger and make salary payments from this. When the private cash runs low, a replenishing check may be issued from the general cash and debited, in the General Ledger, to the Private Ledger Account. In the Private Ledger the amount is debited to Private Cash and credited to General Ledger Account. The use of a Private Ledger is highly desirable in 84 Principles of Accounting a large corporation and appropriate in a smaller one. There is little or no advantage in it for a very small business under normal circumstances. There is noth- ing mysterious about it if the reader bears in mind that it represents nothing more than a few accounts which have been taken away from the General Ledger and that, to obtain a complete trial balance, showing all accounts, both books must be used. The use of balancing accounts between the two books permits the taking of an independent trial balance of each. Hereafter when we speak of the General Ledger, we shall be referring not to one specific bound volume but to the collection of general ledger accounts, whether part of them are in a private volume or whether they are all contained within the same binding. It is abso- lutely immaterial so far as accounting theory is con- cerned whether the collection of accounts, which we call the General Ledger, is loose leaf or on cards or firmly bound in one volume or two volumes. The General Ledger exercises certain functions, and the interest is in these functions and not in the physical form which this collection of accounts assumes. THE LEDGER ACCOUNT In the preceding chapter we traced the development of the account and showed the standard form of ruling for a ledger account. This form is the one most con- stantly used for the General Ledger. The general ledger accounts, as we have seen, receive many of their entries in lump sum totals at the end of each month. The general ledger accounts which are not represented by special columns in the journals, and hence do not receive postings by totals, are not particularly active. The result is that posting to general ledger accounts involves but a small Development of Special Journals 85 percentage of the total time of bookkeepers and clerks. The comparatively small number of general ledger entries renders unnecessary the introduction of special forms of account ruling. This is far from being true of the subsidiary ledger accounts where the volume of transactions may be very large. For example, suppose DATE NUMBER ITEM DEBIT CREDIT BALANCE FIG. 27. Accounts Eeceivable Ledger Page There is little difference between this and the standard ledger ruling, save that the debit and credit items are placed side by side and next to them a balance column. It is often desirable to ascertain a customer's balance quickly. If the account is a long one, it will require some time to determine the balance, unless the balance is continuously brought forward in a special column, as shown in this illustration. a company made five hundred sales on credit during a given month. For these sales the general ledger entries might number only two a debit to Accounts Eeceivable and a credit to Sales Account for the total credit sales of the month as shown by the Sales Journal. In the subsidiary Accounts Eeceivable Ledger there will be five 86 Principles of Accounting hundred entries to be made. This makes a total of five hundred and two postings, only two of which are made to the General Ledger. In a similar way five hundred receipts of cash from customers recorded in the Cash Receipts Journal would DATE ITEM DEBIT CREDIT OLD BALANCE FIG. 28. Accounts Receivable Ledger Page This form of account provides for a current balance and also an old balance. This old balance column is used only when bookkeeping machines are employed. To the figure shown in that column the debits are added and the credits subtracted to secure the new balance. involve five hundred postings to the subsidiary Accounts Receivable Ledger and only two to the General Ledger; i. e., debit Cash and credit Accounts Receivable for the total cash received from customers as shown by the columnar totals in the Cash Receipts Journal. It is because of the great amount of clerical work involved in keeping the subsidiary Accounts Receivable and Accounts Payable Ledgers that attention has been Development of Special Journals 87 given to the problems of reducing bookkeeping cost and increasing accuracy. The manufacturers of adding and bookkeeping ma- chines do not intend that their products shall operate on the General Ledger, where the postings are compara- tively few, but on the subsidiary ledgers, where the DATE MEMO CHARGES CREDIT V BALANCE FIG. 29. Accounts Receivable Ledger Page This is a somewhat more elaborate form of account ruling. The narrow columns are used for "checking" purposes. postings are many, the errors are frequent, and the opportunity for cost reduction is apparent. For the same reasons the general ledger accounts are in the standard account form, but the subsidiary ledger accounts are especially ruled and often bear no resem- blance to the standard form. Standard rulings for such accounts are shown in Figures 27, 28, and 29. 88 Principles of Accounting THE COLUMNAR LEDGER The columnar ledger is a useful device under certain restricted circumstances where the number of customers is large and the monthly transactions are few, such as the electric light business. The ledger page may contain PURCHASE JOURNAL MERCHANDISE PURCHASES ACCOUNTS ACCOUNTS PAYABLE O. 370 / 2.2S /t? 119 FIG. 30. Columnarized Purchase Journal as many as fifteen or twenty accounts. Each account consists of one or more lines, depending upon cir- cumstances. Banks formerly employed the columnar ledger, but have just about abandoned it because of the introduction of moderi} mechanical bookkeeping methods which give better results. Where used by banks, the columnar ledger is often called the "Boston Ledger.' 7 Development of Special Journals 89 Owing to the fact that this form is falling into disuse, we will neither illustrate or describe it. THE COLUMNAR PURCHASE JOURNAL The Purchase Journal, which we have already dis- cussed, has two functions : (1) Its total is posted to the debit of Merchandise Purchases and credited to Accounts Payable Account in the General Ledger. (2) Its detail is posted, item by item, to the various personal accounts in the Accounts Payable Ledger. If it seems desirable to show greater detail on the General Ledger, the single debit to Merchandise Purchases may be split into several debits to several classes of Merchandise Purchases Accounts. Suppose, for example, that a business has five depart- ments and carries in its General Ledger five departmental Merchandise Purchase Accounts. In order to charge purchases direct to the proper accounts, it will require a columnar Purchase Journal. Such a Purchase Journal might be ruled as shown in Figure 30. Putting the same items in conventional journal entry form we have the following: Merchandise Purchases Account, Dept. A $8,521.00 " << B 998.00 " " " " C 4,006.00 " " " '* D 1,250.00 " " " " E 3,081.00 Accounts Payable $17,856.00 In addition to the above general ledger entries, there will be the usual credits to the individual creditors' accounts in the subsidiary Accounts Payable Ledger. THE VOUCHER REGISTER A form of journal like this may be greatly expanded, of course, by the insertion of extra columns. It may 90 Principles of Accounting also be changed in character somewhat, since it forms an ideal medium for the distribution of charges not only in connection with purchases, but of other items which are to be paid out in money. By including debit columns for expenses such as wages, salaries, selling expense, general overhead expense, etc., and columns for the various charges to capital accounts, such as Machinery, Tools, etc., we change the character of the Purchase Journal, forming another journal commonly called the "Voucher Register. " This name arises because of the common use of vouchers in modern business. According to Webster's New International Dictionary, a voucher is ' i a book, paper, or other thing which serves to vouch (affirm) the truth of accounts. " Where the voucher system is in use, every invoice or bill that is received must be vouchered before the disburs- ing office may pay it. By this we mean that it must be O. K. 'd or approved by two or more responsible persons as to: 1. Authentication of purchase (approved by purchasing agent). 2. Quantities, prices, grades, sizes, quality, etc. (approved by purchasing agent). 3. Actual receipt (approved by receiving clerk). (a) Quantity. (b) Sizes. (c) Class. (d) Kind. (e) Quality. (f) Condition. 4. Mathematical accuracy of extensions (approved by checking clerk). Development of Special Journals 91 5. Terms of payment (approved by purchasing agent). 6. Distribution (approved by bookkeeper or auditor). The usual method is to have a standard form of voucher, which is technically called a "voucher jacket." (See Figures 31 and 32.) The data shown on the invoice or bill is entered on the voucher jacket, and the invoice itself is pinned to the voucher jacket and temporarily filed, alphabetically, in the accounting department. From time to time other invoices from the same creditor may be received. If so, they are entered on and pinned to the same voucher jacket. At the end of the month or the week the voucher 2 with all invoices attached is sent to the proper employees and department heads for their O. K., after which it comes back to the accounting depart- ment, where it is entered in the Voucher Eegister. It is then refiled until a check is issued in payment. This check may be accompanied by the voucher jacket (the invoices being detached), which must be signed and returned by the payee as a receipt. Paid vouchers are permanently filed in the accounting department numer- ically by voucher numbers. The technique of handling the Voucher Register is a matter of bookkeeping and has no place in this volume. It may be a matter of some interest, however, to illustrate some typical transactions and the manner of booking them. The following transactions are illustrated in the 2 When a discount is obtainable, it is customary to voucher the invoice and make payment without actually waiting until the end of the month or week. 92 Principles of Accounting CHICAGO. li_i THE BLANK COMPANY TO EMS SUB-TOTALS CORRECT AS TO: EXTENSIOf TCRMS QU ANTPTI E AUDITED AND O. K.'O BY; APPROVED: VOUCHER NO.. .BY FiQ. 31. Front of Voucher Jacket For reverse, see Fig. 32. VOUCHER No.____ I THE BLANK COMPANY CHICAGO. ll_l_ ; |! 1 j ii 1 5 I p 5 n KV N - o o O O O IO CO O CO CO iH O CXJ iH O 06 co cxi OS CXI rH S rnoa 00 rH O O CQ rH O O 00 CO O3 tH O 00 rH CO* CO s g g fr- O Oi -* O ^ co d oq O O rH co o^ o oT co~ oo o o !>. O O . co* o d t* ^ 10 iO P OJ^ CO O^ co* i-T g QO rH O O OJ rH O O GO CO* OJ rH *a rt s g s :i^ PQ Illlllllill 120 Principles of Accounting of transferring balances of nominal accounts to the Pro- prietor 's Account or one of its main subsidiaries. The working balance sheet which modern accountants and auditors employ differs from the simple six-column statement mainly in that provision is made for handling adjustments. A simple form of working balance sheet is illustrated in Figure 41, using the same trial balance as before. As a further illustration of the principles involved in constructing a balance sheet from a given trial balance, the following problem and solution are offered: TRIAL BALANCE J. J. WILLIAMS December 31, 1915 Debit Credit Cash $ 7,860.00 Accounts Receivable 32,550.00 Merchandise Inventory 1-1-15 22,000.00 Furniture & Fixtures 3,300.00 Accounts Payable $ 9,722.00 Notes Payable 12,000.00 Williams Capital Account 19,824.00 Sales 132,298.00 Returned Sales 2,619.00 Interest Earned 612.00 Purchases 84,200.00 Returned Purchases 1,106.00 Salesmen 's Salaries 11,204.00 Rent 600.00 Salesmen 's Expense 3,009.00 Office Salaries 4,032.00 Office Expense 1,618.00 Interest Expense 721.00 Sales Discount 1,849.00 $175,562.00 $175,562.00 Balance Sheet 121 INVENTORIES, DECEMBER 31, 1915 Merchandise ............................................... $25,180.00 Bent Paid in Advance ....................................... 55.00 Taxes Accrued ............................................. 290.00 Office Salaries Due but Not Paid .............................. 263.00 Interest Accrued on Notes Payable ............................ 96.00 It is estimated that Furniture and Fixtures have depre- ciated about After the adjusting entries are posted a trial balance should be taken of the Ledger. This trial balance will contain the same figures as are shown in columns (5) and (6) of the working balance sheet (Figure 42). The next step is to make and post the closing journal entries. EXPLANATION OF ADJUSTMENTS Adjustment entry (a) is for the purpose of setting up the new inventory ($25,180.00) as an asset and elim- inating the old inventory ($22,000.00). In journal entry form this adjustment would appear as follows : Dec. 31, 1915, Merchandise Inventory 12-31-15 ...... $25,180.00 Profit and Loss ................ $25,180.00 Profit and Loss ............. ....... 22,000.00 Merchandise Inventory 1-1-15... 22,000.00 or better still the following form : Dec. 31, 1915, Merchandise Inventory 12-31-15 ..... $25,180.00 Merchandise Inventory 1-1-15... $22,000.00 Profit and Loss ................ 3,180.00 Adjustment entry (b) is for the purpose of setting up Rent Paid in Advance ($55.00) as a deferred expense item (an asset). This is the same as $55.00 in cash so far as meeting the rent expense of the next accounting period is concerned. Because it was paid in this period does 122 Principles of Accounting Accounts WORKING BALANCE SHEET As of Trial Balance Adjustments (1) (2) (8) (4) Cash $ 7,860.00 Accounts Eeceivable 32,550.00 Merchandise Inventory, 1-1-15 22,000.00 $22,000.00(a) Furniture & Fixtures 3,300.00 330.00(f ) Accounts Payable $ 9,722.00 Notes Payable 12,000.00 Williams' Capital Account 19,824.00 Sales 132,298.00 Returned Sales 2,619.00 Interest Earned 612.00 Purchases 84,200.00 Returned Purchases 1,106.00 Rent 600.00 55.00(b) Salesmen 's Salaries 11,204.00 Salesmen 's Expense 3,009.00 Office Salaries 4,032.00 . $ 263.00 (d) Office Expense 1,618.00 Interest Expense 721.00 96.00 (e) Sales Discount 1,849.00 $175,562.00 $175,562.00 Merchandise Inventory, 12-31-15 25,180.00 (a) Profit and Loss 22,000.00 25,180.00 (a) Rent Paid in Advance. ... 55.00 (b) Taxes 290.00 (c) Taxes Payable Accrued.. 290.00 (c) Accrued Office Salaries Payable 263.00(d) Accrued Interest Payable 96.00 (e) Depreciation Furniture & Fixtures 330.00 (f) Net Profit to Balance.. $48,214.00 $48,214.00 FIG. 42. Working Balance Sheet Balance Sheet 123 J. J. WILLIAMS December 81, 1915 Trial Balance Assets, Liabilities and Capital (5) (6) (7) (8) $ 7,860.00 $ 7,860.00 32,550.00 32,550.00 Loss and Gain (9) (10) 2,970.00 2,970.00 $ 9,722.00 $ 9,722.00 12,000.00 12,000.00 19,824.00 19,824.00 132,298.00 2,619.00 2,619.00 612.00 84,200.00 84,200.00 1,106.00 545.00 545.00 11,204.00 11,204.00 3,009.00 3,009.00 4,295.00 4,295.00 1,618.00 1,618.00 817.00 817.00 1,849.00 1,849.00 $132,298.00 612.00 1,106.00 25,180.00 55.00 290.00 3,180.00 290.00 25,180.00 55.00 290.00 290.00 3,180.00 330.00 263.00 96.00 263.00 96.00 330.00 $42,195.00 $110,776.00 26,420.00 26,420.00 $179,391.00 $179,391.00 $68,615.00 $68,615.00 $137,196.00 $137,196.00 FIG. 42. Continued 124 Principles of Accounting not mean that it is necessarily chargeable against this period. In conventional journal entry form this would appear as follows: Dec. 31, 1915, Eent Paid in Advance $55.00 Eent $55.00 Adjustment entry (c) is for the purpose of setting up an accrued liability. If the tax period does not coin- cide with the accounting period, such an adjustment will always have to be made; otherwise one period will be unfairly favored at the expense of the other. Such an item as this is a liability inventory. Journal entry form : Dec. 31, 1915, Taxes $290.00 Taxes Payable Accrued $290.00 Adjustment entry (d) is for the purpose of setting up as a liability (an account payable) the amount due to office employees for services, but unpaid because the end of the accounting period (December 31) came before the regular pay day. Journal entry form : Dec. 31, 1915, Office Salaries $263.00 Accrued Office Salaries Payable $263.00 Adjustment entry (e) is for the purpose of setting up as a liability the interest accrued, on notes payable. This interest must be paid during the following account- ing period, but it is chargeable to the expenses of this accounting period. Journal entry form: Dec. 31, 1915, Interest Expense $96.00 Accrued Interest Payable $96.00 Adjustment entry (f) is for the purpose of reducing the value of the asset account, Furniture and Fixtures, Balance Sheet 125 to accord with its estimated loss. This amount is chargeable to the nominal account. "Depreciation Furniture and Fixtures. " 1915 CLOSING JOURNAL ENTRY Dee. 31 Sales $132,298.00 Interest Earned 612.00 Returned Purchases 1,106.00 Purchases $84,200.00 Eeturned Sales 2,619.00 Eent 545.00 Salesmen 's Salaries 11,204.00 Salesmen 's Expense 3,009.00 Office Salaries 4,295.00 Office Expense 1,618.00 Interest Expense 817.00 Sales Discount 1,849.00 Taxes 290.00 Depreciation Furniture & Fixtures 330.00 Profit and Loss 23,240.00 After this entry has been posted the balance of the Profit and Loss Account will be $26,420.00. This repre- sents the profit of the period and should be transferred to the Proprietor's Account. A trial balance of the Ledger at this point will be, in reality, a balance sheet. POST-CLOSING TRIAL BALANCE Debit Credit Cash $ 7,860.00 Accounts Keceivable 32,550.00 Furniture & Fixtures 2,970.00 Merchandise Inventory 25,180.00 Kent Paid in Advance 55.00 Accounts Payable $ 9,722.00 Notes Payable 12,000.00 J. J. Williams 46,244.00 Taxes Payable Account 290.00 Accrued Office Salaries Payable 263.00 Accrued Interest Payable 96.00 $68,615.00 $68,615.00 126 Principles of Accounting From these unarranged figures the finished balance sheet is constructed as shown in Figure 43. UNDERLYING PRINCIPLES From the problems and solutions so far considered cer- tain general principles may be derived. These governing principles are few in number and of theoretical simplicity, BALANCE 8HKR /. 3. WIUIAM3 D*0. 81. 1915 Cash Accounts Receivable Merchandise Inventory Total Quick Assets Furniture i Fixtures Deferred Expense Other Assets Total Assets , 7.860 38.550 25.180 00 00 00 00 00 Accounts Payable Hotes Payable Accrued Taxes Payable Accrued Office Salaries Payable Accrued Interest Payable Total Current Liabilities J. J. Williams Cap. Acct. net Profit for the Period Total Proprietorship Total Inabilities and Capital 9.722 12.000 290 263 96 00 00 00 oo 1 00 2.970 55 00 00 65.690 19.624 26.420 00 00 E2.371 46.244 68.615 " '__' ."I....'.'"'. 3.025 68.615 00 FIG. 43. Balance Sheet of J. J. Williams but their practical application is oftentimes difficult, owing to the complexity of modern accounting practice. 1. An asset may be exchanged for another asset of equal value without affecting Proprietorship, i. e., Capital In- vested, Expense, and Income Accounts. (Example A) TRIAL BALANCE Debit Cash $ 1,000.00 Land 5,000.00 Other Assets 10,000.00 Expense 3,000.00 $19,000.00 Liability $ 2,000.00 Capital Invested 12,000.00 Income 5,000.00 $19,000.00 Balance Sheet 127 If land is purchased for $600.00 in cash, Land Account will be debited for $600.00 and Cash credited for $600.00 with the following result: TRIAL BALANCE Debit Credit Cash $ 400.00 Land 5,600.00 Other Assets 10,000.00 Expense 3,000.00 $19,000.00 Liabilities $ 2,000.00 Capital Invested 12,000.00 Income 5,000.00 $19,000.00 This change took place without affecting proprietor- ship. The principle holds good in this simple example and is, of course, equally true in every case even though there might be a large number of subsidiary proprietor- ship accounts, L e., nominal accounts. 2. A liability may be exchanged for another liability of equal amount without affecting proprietorship. (Example B) TRIAL BALANCE Debit Credit Cash $ 1,000.00 Land 5,000.00 Other Assets 10,000.00 Expense 3,000.00 $19,000.00 Accounts Payable $ 1,000.00 Notes Payable 1,000.00 Capital Invested 12,000.00 Income 5,000.00 $19,000.00 One of the accounts payable for $100.00 may be extinguished by issuing a note for the same amount. This might involve a debit to Accounts Payable and a credit to Notes Payable for $100.00. After this entry is been made, the following trial balance results : 128 Principles of Accounting TRIAL BALANCE Debit Credit Cash $ 1,000.00 Land 5,000.00 Other Assets 10,000.00 Expense 3,000.00 $19,000.00 Accounts Payable $ 900.00 Notes Payable 1,100.00 Capital Invested 12,000.00 Income 5,000.00 $19,000.00 This change took place without affecting proprietor- ship. The principle holds true regardless of the number or kind of proprietorship accounts. 3. An asset may be used to extinguish a liability of equal amount without affecting proprietorship. (Example C) TRIAL BALANCE Debit Credit Cash $ 1,000.00 Land 5,000.00 Other Assets 10,000.00 Expense 3,000.00 $19,000.00 Accounts Payable .$ 1,000.00 Notes Payable 1,000.00 Capital Invested 12,000.00 Income 5,000.00 $19,000.00 If $300.00 in cash is used to settle a note payable of the same amount, Cash must be credited and Notes Payable debited for $300.00. The resulting trial balance appears as follows: TRIAL BALANCE Debit Credit Cash $ 700.00 Land 5,000.00 Other Assets 10,000.00 Expense 3,000.00 $18,700.00 Accounts Payable $ 1,000.00 Notes Payable 700.00 Capital Invested 12,000.00 Income 5,000.00 $18,700.00 Balance Sheet 129 Proprietorship was not affected by this change. The principle holds true regardless of the number or kind of proprietorship accounts. 4. Every change in the status of general ledger ac- counts, except the three above noted, must affect one or more of the proprietorship accounts. This is a perfectly logical conclusion, since by the fundamental law of double entry a change in one account must be reflected by a counterbalancing change in another. There are only two basic classes of accounts real accounts and nominal accounts. A change in a real account must, therefore, be balanced by an opposite equal change in (1) another real account or (2) a nominal account. 5. Whenever a real account is credited, extreme care should be exercised in making the proper debit. If a real account is erroneously debited in place of a nominal account, the result will be an overstatement of assets resulting in an overstatement of profits (or an under- statement of expense which amounts to the same thing). If a real account is erroneously credited in place of a nominal account, the result will be an understatement of assets resulting in an understatement of profit (or an overstatement of expenses which has a similar effect). (Example D) TKIAL BALANCE Debit Credit Cash $ 1,000.00 Land 5,000.00 Other Assets 10,000.00 Expense 3,000.00 $19,000.00 Accounts Payable $ 1,000.00 Notes Payable 1,000.00 Capital Invested 12,000.00 Income 5,000.00 $19,000.00 If $250.00 in cash is paid for salaries, the proper book- g is to credit Cash and debit Expense (or one of its 130 Principles of Accounting subsidiary accounts). This would be reflected in the following trial balance: TRIAL BALANCE Debit Credit Cash $ 750.00 Land 5,000.00 Other Assets 10,000.00 Expense 3,250.00 $19,000.00 Accounts Payable $ 1,000.00 Notes Payable 1,000.00 Capital Invested 12,000.00 Income 5,000.00 $19,000.00 But if an error is made and in place of debiting Ex- pense, the Land Account is debited instead, the trial balance would show figures as follows: TRIAL BALANCE Debit Credit Cash $ 750.00 Land : 5,250.00 Other Assets 10,000.00 Expense 3,000.00 $19,000.00 Accounts Payable $ 1,000.00 Notes Payable 1,000.00 Capital Invested 12,000.00 Income 5,000.00 $19,000.00 The error, therefore, has caused two misstatements in the trial balance land is overstated $250.00, and ex- pense is understated $250.00. The balance sheet made from the correct trial balance would appear thus : CORRECT BALANCE SHEET Cash $ 750.00 Land 5,000.00 Other Assets 10,000.00 $15,750.00 Accounts Payable $ 1,000.00 Notes Payable 1,000.00 Capital Invested 13,750.00 $15,750.00 Balance Sliest 131 The balance sheet resulting from the incorrect trial balance must itself be incorrect. INCORRECT BALANCE SHEET Cash $ 750.00 Land 5,250.00 Other Assets 10,000.00 $16,000.00 Accounts Payable $ 1,000.00 Notes Payable 1,000.00 Capital Invested 14,000.00 $16,000.00 6. Each accounting period must be charged with only its proper proportion of expense and credited with only its proper, proportion of income. Suppose that a certain firm has an excess of cash and that a favorable opportunity is offered for it to pay its rent for five years in advance, the total amount involved being $500.00. The journal entry for booking this trans- action would be as follows : Expense $500.00 Cash $500.00 If, at the end of the accounting period, the total balance of the Expense Account were to be transferred to the main Proprietor's Account a serious mistake would appear. The current accounting period would be charged with all the rent for the whole five years, and the four following years would be charged with none. This means that the profits of the current period are wrongfully reduced by $400.00 and that those of each succeeding period will be wrongfully inflated by $100.00 each. The comparison of the results of successive years would be valueless if the profits for one year were thus robbed in favor of other periods. The proper procedure would be to distribute this $500.00 equitably over the five accounting periods. Each period should obviously be 132 Principles of Accounting charged with $100.00 rent. The proper method of handling such a situation on the books would be to take an inventory of the Expense Account at the end of each accounting period and to set this inventory up as an asset. Such an asset is usually called a " Deferred Asset,*' or a "Deferred Debit Item," or a "Deferred Expense Item." At the end of the first period, the inventory indicated that $400.00 of the Expense Account is a deferred asset. An adjusting entry is, therefore, made, crediting Expense and debiting Deferred Expense. JOURNAL ENTRY Deferred Expense $400.00 Expense $400.00 At the beginning of the next accounting period, i. e., the following day, a reverse entry is made throwing Deferred Expense back into Expense. JOURNAL ENTRY Expense $400.00 Deferred Expense $400.00 At the end of that period another expense inventory is taken, amounting to $300.00, and is handled in the same way. This is continued until the end of the five years. The result is that the prepaid expense has been justly distributed over the proper accounting periods instead of being dumped into the first one. As a further illustration, it often happens that Insur- ance premiums are paid in advance. Suppose that on September 1, 1915, a year's policy is taken out and the year's premium of $48.00 is paid in cash. On December 31, 1915, at the close of the accounting period, it would be entirely improper to consider the entire $48.00 as an expense. Only 4/12 of it, or $16.00, should be so Balance Sheet 133 considered, and the balance of $32.00 should be handled as a deferred asset. This deferred asset will, of course, expire in the following period. Such deferred asset accounts as have been discussed represent the prepayment of expense, and their purpose is to adjust properly profits between the various account- ing periods. They represent assets since they are the same as cash in so far as meeting future expenses is concerned. The principle which we have elaborated is equally applicable to the credit side of the books. Income received in advance must not be absorbed into the current period's profits. It represents an advance payment and is a deferred liability until it is earned. Accrued assets and accrued liabilities are just the opposite of deferred assets and deferred liabilities so far as their creation is concerned. If an expense is paid in advance, a deferred asset is formed, but if an expense belongs to a period and has not been recorded, an accrued liability must be set up. The entry in such a case is to debit the proper expense account and to credit an accrued liability account. An example of this is seen in connection with taxes. If the accounting period does not coincide with the tax year, part of the taxes must be charged against one accounting period and part against the one following. Since taxes are paid at the end of the tax year, it means that an accrued liability must be set up at the end of the first accounting period. JOURNAL ENTRY Taxes (expense) $ Accrued Taxes Payable (liability) $ This entry will be reversed at the beginning of the following fiscal period. 134 Principles of Accounting Deferred liabilities and accrued assets are opposite in character and effect. A deferred liability relates to income received before it is earned, while an accrued asset indicates that income has been earned but not received. The accrued asset will be set up by means of an entry, crediting the income account and debiting the accrued asset account. SUMMAKY The most important use of an accounting system is that of comparison. The figures of one period alone mean little. The figures of successive accounting periods, when arranged in comparative form, are invaluable. The importance of seeing that these figures represent the truth is self-evident. They will be valueless for com- parative purposes, unless each accounting period bears no more than its proper share of expense and takes credit for no more than its proper share of income. They will be of inestimable value if the accounting rule that ' ' every expense shall be distributed over the accounting periods benefited by that expense ' ' is adhered to. The problems used so far in this chapter have been elementary in order that proper presentations of the principle might not be . obscured. Many readers will desire to follow through a more complex set of figures, and to that end the following trial balance and working balance sheet are submitted. PROBLEM (Adapted from Michigan C. P. A. Examination, June 25, 1910) The trial balance of The Michigan Manufacturing Company's General Ledger on May 31, 1910, appeared as follows: Balance Sheet 135 Debit Credit Cash on Hand and in Bank $ 430.15 Notes Keceivable 7,907.62 Customers ' Accounts 20,797.80 Land & Buildings 35,333.83 Machinery & Equipment 12,344.88 Horses, Wagons, etc 1,265.40 Power Machinery Co 727.77 Inventory of Manufacturing Materials 6-1-09 27,214.41 Purchases of Manufacturing Materials 106,634.12 Miscellaneous Factory Supplies 1,631.09 Productive Labor 63,8-42.23 Freight, Express and Cartage ' ' In " 1,734.70 Stable Expense 1,694.11 Miscellaneous Non-Productive Labor 1,993.50 Fuel 5,554.82 Insurance 3,872.32 Eepairs to Machinery 507.73 Water Tax 140.53 Advertising 378.58 Discount Allowed to Customers 3,362.19 Postage 264.42 Salaries 6,170.00 Stationery and Office Supplies 296.02 Miscellaneous Main Office Expense 241.08 Interest Paid 3,386.80 Accrued Pay Kolls $ 487.66 Notes Payable 22,344.81 Accounts Payable 5,512.34 Sundry Creditors 2,511.89 Allowance for Bad Debts 1,059.51 Capital Stock 85,000.00 Sales 187,540.38 Discounts Earned on Purchases 2,081.59 Interest Earned 463.17 Miscellaneous Earnings 724.75 $307,726.10 $307,726.10 The inventory of Manufacturing Material on hand May 31, 1910, was $51,358.58; of Finished Goods, $3,210.00; of Factory Supplies, $200.00 ; of Fuel, $2,188.40 ; of Horse Feed, $14.22; and of Goods in Process, $1,820.00. The 136 Principles of Accounting WORKING BALANCE SHEET As of Trial Balance Journal Adjustments Dr. Cr. Dr. Cr. Cash on Hand and In Bank $ 430.15 Notes Receivable 7.907.62 Customers' Accounts 20.797.80 Land and Buildings 35,333.83 Machinery and Equipment 12.344.88 Horses. Wagons, etc 1.265.40 Power Machinery Co 727.77 Inventory of Mfg. Materials 6-1-09.. 27,214.41 $ 27,214.41 (a) Purchases of Mfg. Materials 106.634.12 106,634.12 (a) Miscellaneous Factory Supplies 1.631.09 ..- 200.00 (b) Productive Labor 63,842.23 Freight. Express and Cartage "In". 1.734.70 Stable Expense 1.694.11 14.22 (d) Miscellaneous Non-Productlve Labor. 1,993.50 Fuel 5,554.82 2.188.40 (c) Insurance 3.872.32 1,720.18 (e) Repairs to Machinery 507.73 Water Tax 140.53 Advertising 378.58 Discount Allowed to Customers 3.362.19 Postage 264.42 Salaries 6,170.00 Stationery and Office Supplies 296.02 Miscellaneous Main Office Expense.. 241.08 Interest Paid 3.386.80 $ 134.83 (f) Accrued Pay Rolls $ 487.66 Notes Payable 22,344.81 v Accounts Payable 5,512.34 Sundry Creditors 2,511.89 Allowance for Bad Debts 1.059.51 9,128.11 (h) Capital Stock 85,000.00 Sales 187.540.38 Discounts Earned on Purchases 2,081.59 Interest Earned 463.17 Miscellaneous Earnings 724.75 $307.726.10 $307.720.10 Ultimate Credit to Trading Account 3,210.00 (m) Ultimate Credit to Mfg. Account 1,820.00 (k) Manufacturing Materials Used. $82.489.95 (a) Inventory of Manufacturing Materials 5-31-10 51.358.58 .(a) Factory Supplies 5-31-10 200.00 (b) Goods In Process... 1,820.00 (k) Fuel 5-31-1* 2,188.40 (c) Finished Goods 3.210.00 (m? Horse Feed 5-31-10 14.22 (d) Unexpired Insurance 5-31-10 1.720.18 (e) Accrued Interest Payable 134.83 (f) Accrued Taxes Payable 376.75 (g) Taxes 376.75 (g) Bad Debts 9,128.11 (h) Depreciation. Mach. and Equip 1.234.49 (j) Allowance for Depredation. Machinery and Equipment 1.234.49 (J) Net Profit to Balance $153,875.51 $153.875.51 FIG. 44. Working Balance Sheet Balance Sheet 137 MICHIGAN MANUFACTURING COMPANY May 81, 1910 Trial Balance After Posting the Journal Adjustments Losses Gain* Assets Liabilities Dr. Cr. $ 430.15 $ 430.15 7.907.62 7,907.62 20,797.80 20.797.80 35,333.83 35.333.83 12.344.88 12.344.88 1,265.40 1.265.40 727.77 727.77 1.431.09 $ 1.431.09 63,842.23 63,842.23 '.. 1,734.70 1,734.70 1,679.89 1,679.89 1.993.50 1.993.50 3,366.42 3,366.42 2,152.14 2,152.14 507.73 507.73 140.53 140.53 378.58 378.58 3,362.19 3,362.19 264.42 264.42 6,170.00 6,170.00 296.02 296.02 241.08 241.08 3.521.63 3,521.63 $ 487.66 $ 487.66 22,344.81 22,344.81 5.512.34 5.512.34 2.511.89 2,511.89 10.187.62 10,187.62 85,000.00 85,000.00 187.540.3J' $187,540.38 2,081.59 2,081.59 463.17 463.17 724.75 724.75 3.210.09 3.210.00 1,820.00 1,820.00 82,489.95 82,489.95 51,358.58 51,358.58 .... 200.00 200.00 1,820.00 1.820.00 2,188.40 2.188.40 3.210.00 3.210.00 14.22 14.22 1.720.18 1.720.18 134.83 134.83 376.75 376.75 376.75 376.75 9,128.11 9.128.11 1,234.49 1.234,49 1,234.49 1.234.49 11.528.44 11,528.44 $323.630.28 $323.630.28 $195.839.89 $195.839.89 $139.318.83 $139.318.83 FIG. 44. Continued 138 Principles of Accounting unexpired insurance premiums amounted to $1,720.18. The accrued interest on Notes Payable amounted to $134.83, and the accrued taxes amounted to $376.75. Of the Customers ' Accounts, $9,128.11 was very doubt- ful of collection. Depreciation of 10% should be pro- vided on Machinery and Equipment. The item, Power Machinery Co. $727.77, represents an advance payment for machinery in process of installation. With the working balance sheet solution (Figure 44) as a basis, the adjusting entries may be drafted, entered in the Journal, and posted to the Ledger. ADJUSTING JOURNAL ENTRIES L. P. Debit Credit 1910 May 31 Inventory of Manufacturing Material 5-31-10 (a) $51,358.58 Manufacturing Materials Used (a) 82,489.95 Purchases of Manufacturing Mate- rials (a) $106,634.12 Inventory of Manufacturing Mate- rials 6-1-09 (a) 27,214.41 31 Inventory Goods in Process 5-31-10. (k) 1,820.00 Ultimate Credit to Manufacturing Accounts s (k) 1,820.00 31 Inventory Finished Goods 5-31-10. . (m) 3,210.00 Ultimate Credit to Trading Account s (m) 3,210.00 31 Inventory Factory Supplies 5-31-10. (b) 200.00 Miscellaneous Factory Supplies. .. (b) 200.00 31 Inventory Fuel 5-31-10 (c) 2,188.40 Fuel (c) 2,188.40 " For the purpose of ready cross reference between the journal entries and the working balance sheet (Figure 44) a somewhat artificial plan has been fol- lowed. In actual practice the adjusting and the closing entries would not be separated quite as distinctly as in this case and would not attempt to follow the working balance sheet as closely. The purpose of the latter is to furnish correct figures, and it is not intended to control the arrangement of the journal entries themselves. In solving this problem it has been thought best to "link-up" the various exhibits as closely as possible for the convenience of the reader. Balance Sheet 139 ADJUSTING JOURNAL ENTRIES Date L. P. Debit Credit 1910 May 31 Inventory Horse Feed 5-31-10 (d) 14.22 Stable Expense (d) 14.22 31 Unexpired Insurance (e) 1,720.18 Insurance (e) 1,720.18 31 Taxes (g) 376.75 Accrued Taxes Payable (g) 376.75 31 Bad Debts (h) 9,128.11 Allowances for Bad Debts (h) 9,128.11 31 Depreciation Machinery & Equip- ment (j) 1,234.49 Allowance for Depreciation Ma- chinery & Equipment (j) 1,234.49 31 Interest Paid (f) 134.83 Accrued Interest Payable (f) 134.83 After these journal entries are posted, a trial balance of the Ledger will show the figures contained in the third pair of columns in the working balance sheet. The Ledger is now adjusted and ready to receive the closing journal entries, which are made from the figures shown in the fourth pair of columns in the working balance sheet. CLOSING JOURNAL ENTRIES Date 1910 May 31 Ultimate Credit to Manufacturing Account * Manufacturing Account 31 Manufacturing Account Manufacturing Materials Used. Freight, Express and Cartage "In" Productive Labor Miscellaneous Factory Supplies. Miscellaneous Non-Productive Labor Repairs to Machinery L,. F. Debit $ 1,820.00 156,740.64 Credit $ 1,820.00 82,489.95 1,734.70 63,842.23 1,431.09 1,993.50 507.73 4 See the footnote to Exhibit of Adjusting Journal Entries. 140 Principles of Accounting CLOSING JOURNAL ENTRIES Date L. F. Debit Credit 1910 May 31 Depreciation Machinery & Equipment 1,234.49 Fuel 3,366.42 Water Tax 140.53 Trading Account 154,920.64 Manufacturing Account 154,920.64 To close the latter account 31 Sales 187,540.38 Ultimate Credit to Trading Ac- count * 3,210.00 Trading Account 190,750.38 31 Trading Account 35,829.74 Operating Profit and Loss Ac- count 35,829.74 31 Operating Profit and Loss Account 9,029.99 Advertising 378.58 Salaries 6,170.00 Stationery & Office Supplies 296.02 Stable Expense 1,679.89 Postage 264.42 Miscellaneous Main Office Ex- pense 241.08 31 Operating Profit and Loss Account 26,799.75 Profit and Loss Allocation Ac- count 26,799.75 31 Purchase Discounts 2,081.59 Interest Earned 463.17 Miscellaneous Earnings 724.75 Sundry Profit and Loss 3,269.51 31 Sundry Profit and Loss 18,540.82 Insurance 2,152.14 Discount Allowed to Customers. 3,362.19 Interest Paid 3,521.63 Taxes 376.75 Bad Debts 9,128.11 31 Profit and Loss Allocation Account 15,271.31 Sundry Profit and Loss 15,271.31 31 Profit and Loss Allocation Account 11,528.44 Undivided Profits 11,528.44 This entry to be made upon au- thority of the Board of Directors. * See the footnote to Exhibit of Adjusting Journal Entries. Balance Sheet 141 If it is assumed that the directors have authorized the last entry, a trial balance of the Ledger at this point will appear as follows : Debit Credit Cash $ 430.15 Notes Eeceivable 7,907.62 Customers ' Accounts 20,797.80 Land & Buildings 35,333.83 Machinery & Equipment 12,344.88 Horses, Wagons, etc 1,265.40 Deposit on Machinery (Power Machinery Co.) .... 727.77 Inventory of Manufacturing Materials 51,358.58 Inventory of Factory Supplies 200.00 Inventory of Goods in Process 1,820.00 Inventory of Fuel 2,188.40 Inventory of Finished Goods 3,210.00 Inventory of Horse Feed 14.22 Unexpired Insurance 1,720.18 Accrued Pay Bolls $ 487.68 Notes Payable 22,344.81 Accounts Payable 5,512.34 Sundry Creditors 2,511.89 Allowance for Bad Debts 10,187.62 Capital Stock 85,000.00 Accrued Interest Payable 134.83 Accrued Taxes Payable 376.75 Allowance for Depreciation Machinery & Equip- ment 1,234.49 Undivided Profits 11,528.44 $139,318.83 $139,318.83 This exhibit, which we have called a " trial balance, " is, in reality, an after-closing or "post-closing" trial balance. Strictly speaking, a balance sheet is nothing more nor less than a post-closing trial balance. This is a highly important point and should be fully understood by the student, because he will see many statements or exhibits labeled "Balance Sheet" that are not balance 142 Principles of Accounting sheets within this strict definition, although they are balance sheets to all intents and purposes. The term "balance sheet, " as it is used most commonly, refers to a statement or exhibit constructed from a post-closing trial balance. Such a balance sheet is shown as follows : BALABCE SHEET ASSETS Current and trading Assets Cash on Hand and in Bank 430 15 Accounts Receivable $20.797.60 I,eee-*Allowance for Bad Debta 10.187.68 10.610 18 Motets Receivable 7,907 62 Finished Goods Inventory 3.210 00 68.157 95 Working Assets Manufacturing Material Inventory 51.358 58 Goods in Process Inventory 1.820 00 Factory Supplies Inventory 200 00 * Fuel-- Inventory 2,188 40 Horse Peed-- Inventory 14 22 55.581 20 Fixed Assets Machinery and Equipment $12.344.88 Less Allowance for Depreciation 1,234.49 11,110 39 727 77 land & Buildings 35.333 83 Horses. Wagons, etc. 1.265 40 48.431 39 Deferred Expense Item Unexplred Insurance 1.720 18 127,896 72 FIG. 45. Balance Sheet in Account Form FOEM OF THE BALANCE SHEET A balance sheet may, and usually does, classify and summarize the figures given by the post-closing trial balance in an endeavor to present the facts and tell its story in the most effective way. There are almost as many ways of constructing a balance sheet as there are accountants, but there are, at least, two forms of pre- sentation that are fairly well standardized. The first method (Figure 45) is to list the assets in the order of realization, starting with the most liquid asset "cash," and closing with deferred expense items or other assets which probably will never be realized in cash. The liabilities follow the same order, running from the most current, such as accounts payable, to capital invested which probably will never be paid. Balance Sheet 143 Quick assets. Fixed assets. Deferred expense items. Current liabilities. Secured liabilities. Capital liabilities. Undivided profits or surplus. VICHIGAM MAMUPACTURIHG COMPANY May 31 t 1910 LIABILITIES ANC CAPITAL Current Liabilities 5,512 34 Accounts Payable 487 66 Accrued Wages Payable Accrued Interest Payable 134 376 83 75 Accrued Taxes Payable Sundry Creditors Rotes Payable 2,511 22.344 89 81 31.368 28 Capital and Undivided Profits Capital Stock Outstanding Undivided Profits 86,000 11.528 00 44 96.528 44 $127.896 72 FIG. 45. Continued The second standard form of balance sheet arrange- ment (Figure 46) is almost the reverse of the above. Fixed assets. Quick assets. Deferred expense items. Capital liabilities. Secured liabilities. Current liabilities. Undivided profits or surplus. Either of these forms permits of easy comparison between the amount of quick assets and current liabilities, or the amount of fixed assets and secured and capital liabilities. If the "report form" of balance sheet (Figure 47) is adopted, 'it is customary to list the assets in the order of realization and the liabilities running from current to permanent. The report form has found popu- larity due to the ease with which it may be typewritten on a standard carriage machine. 144 Principles of Accounting CONSTRUCTION OF THE BALANCE SHEET This operation of remolding and reconstructing the post-closing trial balance into the finished balance sheet BALANCE SHS33 As of ASSSTS Fixed Assets Machinery & Eoulpment |12.344. 88 LessAllowance for Depreciation 1,834.49 11,110 39 Deposit on Machinery Purchase Land & Buildings 787 35,333 77 83 Horses. Wagons, etc 1.265 40 48,437 39 Working Assets Manufacturing MaterialInventory 61,368 58 Goods in Process Inventory 1.880 00 Factory Supplies Inventory Fuel Inventory 800 8,188 00 40 Horse Peed Inventory 14 22 55.581 20" Current and Trading Assets Cash on Hand and in Bank 430 15 Accounts Receivable $20,797.80 Less Allowance for Bad Debts 10.187.62 10.610 18 Finished Goods Inventory 7,907 3.210 62 00 22,157 95 Deferred Expense Items Unerpired Insurance 1,720 18 127.696 72 FIG. 46. Balance Sheet in Account Form affords the accountant an excellent opportunity to exhibit his skill, but it also opens the way to serious misrepre- sentation by improper classification. For example, the post-closing trial balance might show as assets "TT. S. Steel Corporation bonds, $1,000.00" and "Wild Cat Mining Co. bonds, $32,000.00." If the accountant is honest, he will carry them separately on the balance sheet, but if he is morally weak, he may be persuaded to lump the two items for balance sheet purposes in some such way as this: U. S. Steel Corporation and other bonds $3,000.00 0.00 Balance Sheet 145 This would be strictly true but very misleading to the balance sheet readers, i. e., the stockholders or creditors of the company. MICHIGAN IUHUFAC TURING COMPANY" May 31. 1910 LIABILITIES AMD CAPITAX Capital Invested Capital stock Outstanding 85,000 00. Current Liabilities Notes Payable Accounts Payable Sundry Creditors Accrued Wages Payable Accrued Interest Payable Accrued Taxes Payable Surplus and Undivided Profits Undivided Profits 2.344 5.512 8,511 487 134 376 81 34 89 66 83 75 31.368 11.528 28 44 127 896 78 TIG. 46. Continued The fine points of balance sheet construction and pres- entation can best be learned by the consistent study of corporation balance sheets, as published in the financial manuals, financial journals, and yearly reports. Such manuals, journals, and reports are to be found in any good public library. THE SEVEN STEPS The steps involved in making up a balance sheet are seven in number. 1. Take a trial balance of the General Ledger after all postings for the accounting period have been made. 2. Draw up a working balance sheet in the form sug- 146 Principles of Accounting MICHIGAN MANUFACTURING COMPANY Balance Sheet a* of May 31, 1910 ASSETS Current and Trading Assets Cash oa Hand and in Bank 430 L5 Aoounts Receivable 0,797.80 Less - Allowance for Bad Debts 10-, 1617. 62 10,610 18 Ictea Receivable 7,907 62 Finished Goods - Inventory 3,210 00 Total Current and Trading Assets 22,17 95 Working Assets Manufacturing Material - Inventory 51,368 58 Goods in Process - Inventory 1,820. 00 Factory Supplies - Inventory 200 00 Fuel - inventory 2,188 40 Sorse Feed - Inventory Total Working Assets 14 22 55,581 20 Fixed Assets Machinery it Equipment IB ,344. 88 Less - Allowance for Depreciation 1,234.49 11,110 39 727 77 Land & Buildings 35,333 83 Horses, Wagons, etc. Total Fixed Assets 1,265 40 4ft 437 39 Deferred Expense Items %& , to * Uoexpired Insurance 1*720 18 Total of All Assets 127,896 72 LIABILITIES Current Liabilities Accounts Payable 5,512 34 Accrued Wages Payable Accrued Interest Payable 487 134 66 83 Accrued Taxes Payable 376 75 Sundry Creditors 2,511 89 Votes Payable 22,344 81 Total Liabilities 31,368 28 Net Worth 96,528 44 Represented by Capital Stock Outstanding 85,000 00 Undivided Profits 11,528 .44 96,588 44 FIG. 47. Balance Sheet in Keport Form gested, making the adjusting entries and distributing the resulting figures into the four columns : 1. Loss. 2. Gain. 3. Asset. 4. Liability. Then foot all columns and prove the accuracy of the work by comparing the debit and credit footings of the 1 Balance Sheet 147 "Journal Adjustment " columns, which should be equal, and by adding the footing of the "Loss" and " Assets " columns and comparing that total with the sum of the footings of the "Gain" and "Liability" columns. The sum of "Losses" and "Assets" should equal the sum of "Gains" and "Liabilities." 3. Construct, enter, and post to the Ledger the adjust- ing journal entries. 4. Construct, enter, and post the closing journal entries. These closing journal entries should debit all nominal accounts with credit balances and credit all nominal accounts with debit balances. The contra entries go to intermediate proprietary accounts, such as the Manu- facturing Account, Trading Account, Operating Profit and Loss Account, Miscellaneous Profit and Loss Account, and Profit and Loss Allocation Account. It is not strictly necessary to close the nominal accounts by sections, since all the items may be transferred direct to the Profit and Loss Account. It is considered much better practice, however, to close out the various loss and gain accounts by classes. (See Chapter VII.) The figures to be used in the closing journal entries may be obtained from the "Loss" and "Gain" columns on the working balance sheet. 5. All balancing accounts are ruled off. All other accounts are balanced and brought forward. 6. A post-closing trial balance is taken from the Ledger. 7. A balance sheet is constructed from the post-closing trial balance. NATURE OF DEPRECIATION The balance sheet, at best, is no more than an approxi- mation. It cannot even tell the exact truth. It is nothing more than a guess at the truth, albeit, a scientific guess. 148 Principles of Accounting It wanders farthest from accuracy in its representations as to the values of fixed assets, such as buildings and machinery; it is approximately accurate as to the value of working assets such as inventories of raw material, semi-finished and finished goods, and its figures as to cash should be absolutely true. The reason for these unavoidable inaccuracies is obvious. Suppose a machine is bought new for $10,- 000.00. The proper entry is: Machinery $10,000.00 Cash $10,000.00 At the end of the year the trial balance shows "Machinery $10,000.00. > ' If it is assumed that the ma- chine was worth $10,000.00 new, is it still worth $10,000.00 at the end of the accounting period? The machine has been operated steadily, it is slightly worn, some of the paint has been scratched it has undoubtedly deteriorated. It is no longer worth $10,000.00. What is it worth? That is an important question and one that no person can ever answer with absolute accuracy. One man's guess may be as good as another's. The junk man will only pay a few hundred dollars for it. The second-hand machinery dealer will pay $4,000.00 for it. Another manufacturer might pay $6,000.00 for it. Its value to the company itself is approximately the same as at date of purchase. Whatever value is assigned to it is, at best, no more than an expert guess. There are a number of different methods of estimating its value at a given time, and these will be discussed more fully in Chapter XII. One way is to estimate the "life" of the machine, that is, the Balance Sheet 149 length of time it will last. Such an estimate should be based on experience. If a hundred manufacturers have found that it was not necessary to "scrap" and replace similar machines until they were nine years old, at which time the machines could be sold for an average of $1,000.00 each, sufficient evidence is at hand to warrant a guess that this particular machine will last nine years and will have a remainder value of $1,000.00. If the machine is worth $10,000.00 when purchased and $1,000.00 nine years hence, it is plain that it has lost $9,000.00 value in nine years. What is more natural than to say that its loss in value is $1,000.00 per year? Value = $10,000.00 when purchased. Value = 9,000.00 end of first year. Value = 8,000.00 end of second year. Value 7,000.00 end of third year. Value = 6,000.00 end of fourth year. Value = 5,000.00 end of fifth year. Value = 4,000.00 end of sixth year. Value = 3,000.00 end of seventh year. Value 2,000.00 end of eighth year. Value = 1,000.00 end of ninth year. At the end of each year an adjusting journal entry will be made, debiting the nominal account, "Depreciation," and crediting the asset account, ' ' Machinery. ' ' The clos- ing entry will then throw the balance of the Depreciation Account into Profit and Loss where it will serve to reduce the credit balance, or profit, of the year. At the end of the ninth year the Machinery Account might appear as shown in Figure 48. On January 1, 1909, this asset of "machinery" will appear on the balance sheet as being worth $7,000.00, but this is a crude guess after all. The only two times that 150 Principles of Accounting MACHINERY ACCOUNT 1906 Jan. 1 Purchased $10,000*00 $10,000.00 1907 Jan. 1 Balance forwarded.. $ 9,000.00 $ 9,000.00 1908 Jan. 1 Balance forwarded.. $ 8,000.00 $ 8,000.00 1909 Jan. 1 Balance forwarded.. $ 7,000.00 $ 7,000.00 1910 Jan. 1 Balance forwarded. .$ 6,000.00 $ 6,000.00 1911 Jan. 1 Balance forwarded.. $ 5,000.00 $ 5,000.00 1912 Jan. 1 Balance forwarded.. $ 4,000.00 $ 4,000.00 1913 Jan. 1 Balance forwarded.. $ 3,000.00 $ 3,000.00 1914 Jan. 1 Balance forwarded. .$ 2,000.00 $ 2,000.00 1915 Jan. 1 Balance forwarded.. $ 1,000.00 1906 Dec. 31 Depreciation $ 1,000.00 31 Balance f orwarded. . 9,000.00 $1Q,000.00 1907 Dec. 31 Depreciation $ 1,000.00 31 Balance f orwarded. . 8,000.00 $ 9,000.00 1908 Dec. 31 Depreciation $ 1,000.00 31 Balance f orwarded. . 7,000.00 $ 8,000.00 1909 Dec. 31 Depreciation $ 1,000.00 31 Balance forwarded. . 6,000.00 $ 7,000.00 1910 Dec. 31 Depreciation $ 1,000.00 31 Balance forwarded .. 5,000.00 $ 6,000.00 1911 Dec. 31 Depreciation $ 1,000.00 31 Balance f orwarded. . 4,000.00 $ 5,000.00 1912 Dec. 31 Depreciation $ 1,000.00 31 Balance forwarded.. 3,000.00 $ 4,000.00 1913 Dec. 31 Depreciation $ 1,000.00 31 Balance f orwarded. . 2,000.00 $ 3,000.00 1914 Dec. 31 Depreciation $ 1,000.00 31 Balance f orwarded. . 1,000.00 $ 2,000.00 FIG. 48. Machinery Account Balance Sheet 151 the value of the machine will be actually known is at the time of purchase and at the time when it is sold for scrap. It is convenient for bookkeeping purposes to say that its value decreases uniformly each year, but few would claim it strictly true. Many assets other than machinery are just as difficult to value correctly, the result being that many accounts do not show the truth. The proprietary accounts will be out of agreement with facts by the net amount that the other accounts are inaccurate. Eecognizing the foregoing arguments, the modern accountant does not attempt the impossible. It is now almost universally the rule to charge the asset account with the cost of the asset, leaving that figure unchanged until the business has parted with it. Instead of credit- ing the asset account itself each year with a figure supposed to represent the amount of value which the asset has lost, a separate and distinct account is created to receive such credits. This account 5 may be called " Depreciation Not Written Off" or "Allowance for Depreciation." It really takes the place of the credit side of the asset account and is called a "valuation account, ' ' By using an Allowance for Depreciation Account to register the shrinkage in value of the $10,000.00 machine, the following situation appears at the end of nine years : MACHINERY ACCOUNT 1906 Jan. 1 $10,000.00 6 The term ' ' Reserve for Depreciation ' ' is often erroneously used in this connection. See page 333. 152 Principles of Accounting ALLOWANCE FOE DEPRECIATION ACCOUNT 1906 Dec. 31 Depreciation . ..J $1,000.00 1907 Dec. 31 Depreciation . ..J .1,000.00 1908 Dec. 31 Depreciation . ..J 1,000.00 1909 Dec. 31 Depreciation . ..J 1,000.00 1910 Dec. 31 Depreciation . ..J 1,000.00 1911 Dec. 31 Depreciation . ..J 1,000.00 1912 Dec. 31 Depreciation . ..J 1,000.00 1913 Dec. 31 Depreciation . ..J 1,000.00 1914 ' Dec. 31 Depreciation . ..J 1,000.00 The difference at any time between the asset account and the Allowance for Depreciation Account is approxi- mately equal to the value of the asset itself at that time. The asset account represents the original cost and the Allowance for Depreciation Account represents the approximate diminution in the value of the asset. The reader should bear in mind, therefore, that asset accounts usually reflect the cost of the assets when pur- chased and that any particular asset account conveys no information as to the present worth of the asset until the proper Allowance for Depreciation is deducted from it. Even then it cannot state the exact truth, since the shrinkage in value of the asset, as registered in the Allowance for Depreciation Account, is only an estimate at best, being a doubt cast as to the accuracy of the asset account. INCOMPLETE DOUBLE ENTKY In a system of incomplete double entry or single entry it is impossible to obtain a balance sheet. A substitute Balance Sheet 153 for the balance sheet is seen in the exhibit known as the "Statement of Resources and Liabilities. " This state- ment is not drawn from the books as is the balance sheet. It is nothing more than a list or written inventory of the various items of assets and liabilities and may be made independently of the records. The arrangement of such a statement may be identical with that of a balance sheet, and it may be more accurate. But, as a general rule, a post-closing trial balance of a double entry Ledger, rearranged and properly classified in balance sheet form, is to be preferred because it is supported by all the records, journals, and subsidiary ledgers. It is thus subject to verification or audit. CONCLUSION Under the elementary system of accounts, proposed in Chapter I, where every loss is debited to the Proprietor's Account as soon as the loss occurs and every gain is credited to that account when the gain is made, the trial balance will always show exactly the same figures as the balance sheet. With such a system all changes in the assets and liabilities are permanently recorded when they happen. Therefore, the balance of the Proprietor's Account at any time represents the amount due to the proprietor by the business. Such a simple system involves no adjusting entries because the adjustments are made day by day. It calls for no closing entries because there is but one Proprie- tor's Account. When the Proprietor's Account is split up into numerous classified subaccounts (nominal accounts), and when adjustments are not made day by day, it becomes necessary to obtain the facts at the close of certain periods, known as ' ' accounting periods. ' ' At the end of 154 Principles of Accounting one of these periods adjustments are made and the nominal, or sub-proprietary, accounts are closed into the one main account representing the proprietor's interest. If a man carries all his money in one pocket, he will have no difficulty in determining his financial standing at any time. If he has twenty pockets each containing money, he cannot determine what the total is at any time but must wait until he can transfer the money from all the various pockets into one pile. The several expense and income accounts correspond to the different pockets . the net figure representing loss or gain for the period cannot be ascertained until the various expense and income items are brought together. TEST QUESTIONS 1. Why may a prepaid expense be considered in the nature of an asset? 2. Why is it impossible to obtain a balance sheet in a single entry system? 3. Suppose an expense account is improperly charged instead of an asset account. What will be the effect on the balance sheet? On the net profit? 4. What is an accrued liability? A deferred asset? A de- ferred liability? An accrued asset? 5. What are the seven steps leading up to a balance sheet? CHAPTER V ASSETS AND THEIR VALUATION The preceding chapters have developed the fact that the left-hand side of a properly arranged balance sheet is made up of assets and deferred charges, 1 and it has already been hinted that the assets differ from one an- other in (1) nature, (2) ease of liquidation, and (3) accuracy of valuation. Some writers make a fundamental distinction between assets, asserting that any asset must represent either actual property owned or valid and enforceable claims to property. This distinction is unquestionably sound. A man's house and lot differ fundamentally from accounts receiv- able, notes receivable, or other forms of claim which he also regards as assets. However, a valid and enforceable claim to property is, under modern economic conditions, fully as valuable as the property itself. Such a claim is often negotiable in its nature. That is, it may be passed from one person to another by indorsement or by mere delivery to effect a negotiation. An example of such a negotiable claim is the bank check, promissory note, or accepted draft. It is characteristic of such a negotiable claim that it is represented by a document of some sort. 1 To make this statement inclusive it should be amended to read * ' assets, deferred charges, and losses not written off." It occasionally happens that an extraordinary loss is allowed to stand on the books with the idea of writ- ing it off from year to year out of profits. If such a loss item is clearly labeled, it may properly be shown on the asset side, although it is actually a valuation account offsetting the capital accounts. 155 156 Principles of Accounting A non-negotiable claim may, nevertheless, have approx- imately equal convertibility to a negotiable instrument. A good example of such a claim is an ordinary debt receivable, which is often no more than an implied promise on the part of one person to deliver property, usually cash, to another person. 2 Such a claim to property, owing to the convenience with which it may be turned into property, is properly regarded as the equivalent of property. Any extended treatment of this subject would involve an examination of the nature of credit, which seems hardly desirable here. Money is the universal medium of exchange. All property is commonly translated into terms of money- its value is estimated in dollars and cents. Money itself, however, except to the goldsmith and the silversmith, is nothing more than a medium of exchange. The olden- time storekeeper traded commodity for commodity, and even in comparatively modern, times many transactions took place by barter, pure and simple. The cobbler may trade or barter five pairs of shoes for one overcoat, or he may trade five pairs of shoes for $25.00 and then trade the $25.00 for the overcoat. The use of a medium of exchange, therefore, is a matter of convenience. The dollar is the fiscal yardstick by which the value of goods is measured. Money is, in itself, nothing more than a universal claim to property a claim not against one person, but against all the civilized world. Accounting, by its very nature, must employ the monetary unit in recording all trans- actions. The accountant must express all values in terms 2 The use of the word * ' person ' ' in this sense refers, not only to an individual human being, but to an artificial entity, such as a copartnership or corporation. Assets and Their Valuations 157 of such a unit. This is so obvious as to require no elaboration and, yet, it sets the stage for discussion of some of the most difficult problems in accounting theory, viz., the valuation of assets. PRIMARY CLASSIFICATION OF ASSETS The conventional treatment of assets is to classify them first as positive and negative, the negative asset being a liability, but the accounting problems in connection with liabilities are comparatively simple and will not be discussed until a later section. The usual and most convenient classification of the positive assets is the one normally employed by the accountant in drawing up a balance sheet. Fixed assets. Working assets. Assets -{ Current assets. Deferred assets. DEFINITIONS Very roughly these four classes of assets may be defined as follows : Fixed assets consist of tangible or intangible proper- ties which are more or less essential to the continuation of the business which owns them and which, therefore, may reasonably be expected to remain in the possession of that business for an indefinite period. It is usual to classify as fixed assets such items as "land," " build- ings, " "machinery," "equipment," "franchises," and "goodwill." A current asset is one which is readily convertible into cash and which, by its nature, probably will be converted into cash. Such assets are often spoken of as being liquid, and this adjective is a good one, since it 158 Principles of Accounting conveys the impression of a ready convertibility and implies "flowing, " as in a stream. Examples of such assets are cash itself, certain types of negotiable instru- ments, such as bank checks, which are normally regarded as cash by the average business man, accounts receivable, and notes receivable. Working assets usually consist of supplies and materials of various sorts. They are not readily convertible into cash without some loss in liquidation, but in a going business they ultimately are converted into cash through the ordinary operations of manufacturing and selling. It is often difficult to make a clean-cut line of demarcation between working assets and current assets. Some working assets may be converted into cash before certain of the current assets. The idea back of the name " working assets" is that they are "in process" that something remains to be done to them before they can be properly classified as "current." Raw materials, work in process, and supplies of various sorts are ordinarily embraced in working assets. Deferred assets have been rather elaborately treated in the preceding chapter. A deferred asset represents an expense paid in advance. Such deferred items are properly classed as assets, because they serve equally as well as cash itself so far as payment for the expenses of a future period is concerned. THE ECONOMIC CYCLE The function of the normal business is that of adding utility to commodities. These are economic phrases, which may be more broadly defined as follows : ' ' Utility ' ' is the quality of being desired and must always be sharply distinguished from "usefulness." Water is useful, but has no utility. Absinthe is not useful, but Assets and Their Valuations 159 has utility. Utility in a commodity may usually be obtained by effort or sacrifice. In a natural state, water may be obtained without effort; hence it has no utility and cannot be bought or sold. A harmful liquor, on the other hand, has a distinct utility, because effort must be exerted in order to produce or obtain it. The function of business, therefore, is that of adding utilities to commodities. There are a number of different kinds of utilities, such as " place'' utility, "time" utility, and "form" utility. The railroad adds "place" utility to commodities. A cold storage company adds "time" utility to the commodities which are stored. The manu- facturer adds "form" utility to his raw materials. With the foregoing in mind, it is easy to trace the ordinary business cycle. At the beginning of a business, a certain amount of cash may be provided by the proprie- tor. A portion of this cash is invested in fixed assets, a portion in commodities to which utility is to be added, and the balance of the cash is expended or outlaid in the process of adding utility to the commodities, this being done with the expectation that sales at an advanced price will more than repay all such outlays. Eaw material comes into the business and is a working asset. It is acted upon by the use of fixed assets such as machinery, and by labor which is purchased for that purpose. It remains a working asset until it has gone through the regular routine of manufacture, storage, or transporta- tion. Sales are then made of this finished product which, therefore, disappears as an asset, and in its place appears a current asset, such as an account receivable, a note receivable, or actual cash. These current assets are again utilized for the purchase of more raw material, for the services of labor, etc., and this cycle repeats itself all during the life of the business, the entire basic purpose 160 Principles of Accounting of this activity being the 'acquisition of profit. Each time the cycle is made, a profit should normally be made, and this profit consists of the difference between the selling price and the amount which it cost to purchase the commodity and add utility to it. It may clearly be seen that no arbitrary standards of value may be adopted in connection with assets. What is a working asset today may be a current asset tomorrow, subject to transformation into a deferred asset, or perchance a fixed asset, the following day. It is neces- sary, however, in order that a basis may be afforded for further analysis that all assets be classified in the manner proposed. At any given instant of time such a classification may be made and, since the balance sheet is a picture of the business at a given instant of time, the items on the balance sheet may be quite accurately classified. PBIMAKY BASIS OF VALUATION It is now almost uniformly recognized that the only proper basis of valuation of an asset is that of its cost to the "going" business. The value at which it appears on the balance sheet should not be equivalent to the price which would be obtained for it if sold "under the hammer" at an auction. If, for balance sheet purposes, assets were valued at the amount they would bring at a forced sale, it is safe to say that no business could claim to be solvent on the basis of its yearly report. In every case the value of the asset must be viewed from the standpoint of the "going" business, not a liquidating business. VALUATION OF CURRENT ASSETS There is one asset which is automatically self -valued. That asset is money. It does not have to be translated Assets and Their Valuations 161 into terms of dollars and cents, because it consists of dollars and cents. The ordinary business man, however, looks upon money as consisting, not only of gold and silver, but of certain very liquid forms of claims, i. e., promises to pay made by others to him. First and fore- most are various kinds of paper money which, in reality, are nothing more than governmental promises to pay upon demand a given amount of gold or silver. These promises may be direct governmental obligations or indirect as in the case of national bank notes. The note issues of national banks are secured by depositing United States bonds with the government. Under normal economic conditions, with a stable form of gov- ernment, such promises are worth their face value. There is no question as to valuation. Under abnormal economic or governmental conditions, paper money may be worth much less than its face value. This occurred at the time of the Civil War in the case of the Confederate paper money, which depre- ciated very badly. We may, however, disregard such abnormal fluctuations in the value of paper currency and for balance sheet purposes regard it as being equivalent to gold and silver. Bank checks are commonly regarded by the business man as the equivalent of cash. Checks are the principal media of exchange in this country. Nearly all purchas- ing and selling is done by the use of checks. A "check" is a written order on a bank by a depositor to pay to another person a certain amount in cash. The use of checks is so prevalent that they are readily accepted in lieu of cash where the maker or indorser is favorably known. Cash, as it appears on the balance sheet, does not necessarily refer to gold, silver, paper money, and checks 162 Principles of Accounting on hand. Cash may be on hand, or it may be in the bank. Cash in the bank is really not cash at all. It is an account receivable a claim against the bank but, as a matter of fact, cash at the bank is regarded equal in status to cash on hand. Often no distinction is made between the two. This comes about, owing to the con- fidence which the average citizen has in the average bank. Bank deposits are usually safeguarded so care- fully that the accountant feels justified in regarding the bank deposit as being the equivalent of cash on hand. DEBTS RECEIVABLE Debts receivable form a somewhat different class of asset. The value of cash is expressed in terms of itself. A debt receivable is expressed in terms, not of itself, but of cash, and the problem is at once presented as to the valuation of such assets. Debts receivable really include both open accounts and notes, but we find it convenient to confine the title to those items which are receivable in the immediate future and which are unsecured beyond the implied, verbal, or informal promise of the debtor to pay. The time of payment is governed by the terms of sale. Thus, if goods are sold on thirty days' time, it means that the purchaser impliedly, verbally, or informally contracts to pay in thirty days. This promise may not be evidenced except by the original signed purchase order for the goods and subsequent correspondence. Further- more, such a promise of payment is not always strictly observed as to amount and as to time. A debt may be due for payment in thirty days, but any man who was ever engaged in business knows that there is a very strong probability that many of his debts receivable will not be paid when due. Some customers will take sixty days, others ninety days, some a year or more, and some, Assets and Their Valuations 163 perhaps, will never pay. A debt receivable is a legal and enforceable claim, hence it is considered as an asset under the title of "Accounts Receivable, " but credit is granted so loosely by the ordinary business man that it is not safe to take all these "promises to pay" at their face value. Insolvency and bankruptcy are common in this country, which simply means that losses on accounts receivable are constant. Knowing that such losses are constant, the business man may make provision for them. His past experience shows him that, on the average, 5% of the total face value of his debts receivable will prove worthless. He, thus, has an adequate basis for properly valuing this asset. At the end of each fiscal period he may arbitrarily reduce the value of this asset by 5%. This, of course, implies a debit to the account usually called "Bad Debts " and, theoretically at least, a credit to the asset account. We have already seen, however, that it is not customary to credit the asset account, but rather to credit another account, which is technically known as a "valuation account. " The effect of such a valuation account is that of subtraction. It simply represents the credit side of the asset account, and includes only those deductions from the value of the asset account which have been charged to proprietorship. For example, if accounts receivable stood on the books at $100,000.00, either of the following two entries would be correct in case it was desired to charge off 5%. Bad Debts (an expense account) $5,000.00 Accounts Eeceivable (an asset account) $5,000.00 or Bad Debts (an expense account) $5,000.00 Allowance for Bad Debts (a valuation account) $5,000.00 164 Principles of Accounting After the first entry was posted the Accounts Receiv- able Account would show a debit of $100,000.00 and a credit of $5,000.00. This would . leave a balance of $95,000.00 as representing the value of accounts receiv- able. If the second entry were made instead of the first, the Accounts Receivable Account would show on the debit side $100,000.00 and on the credit side nothing at all, but there would have been set up a valuation account with a credit for $5,000.00. To arrive at the actual value of accounts receivable, it would be necessary to make a combination of the two accounts, viz., the Accounts Receivable Account and Allowance for Bad Debts. The net result of these two taken into combina- tion would be $95,000.00. It is important to bear in mind that a valuation account is not a liability, nor is it a proprietary account. It is an account set up for valuation purposes, which does nothing more than register the deduction which may have to be made from the corresponding asset account. It is always wrong, for balance sheet purposes, to show the balance of such a valuation account on the liability side. Such a balance should be deducted from the asset account in an interior column of the balance sheet and extended into the regular column at the net figure. Debts receivable are always booked at their face value. In addition to the fact that the face value does not tell the truth, owing to possible losses by bad debts, it also is inaccurate because payment of the account in cash is deferred until some future time. Everyone is familiar with the force called "interest," and everyone knows that a present dollar is worth more than a future dollar. If an interest rate of 6% is assumed, a present dollar is worth $1.00, but a claim for $1.00, payable a year from the present time, is worth approximately only 94 cents. It Assets and Their Valuations 165 is, therefore, clear that all accounts receivable are worth less than their face value, but inasmuch as the time of payment is not definitely known, it would prove an impossible task to obtain the present value of such a future promise to pay. It is, therefore, an inaccurate, but common and entirely justifiable, custom to ignore this slight difference existing between the face value of such a claim and its discounted value. NOTES RECEIVABLE Notes receivable differ from accounts receivable in that they are formal written promises instead of implied verbal or informal promises to pay. A note receivable contains a definite promise in written form and is fre- quently negotiable. It specifies the date of payment and the place of payment, and lawsuit can be brought on the note itself as prima facie evidence of debt, wherein it differs from an account receivable. An action at law to enforce payment of an account receivable item requires the production of evidence that a service has been actually performed or value given. A note receivable imports consideration, that is, that value has been given and, except under special conditions, requires no collateral evidence. The Statute of Limitations in the several states may be different for notes and accounts. A note receivable may or may not be paid, just as in the case of any debt, but it is usually unnecessary to make as large a provision for uncollectible notes as it is for ordinary debts. This is because a man very often will buy a bill of goods without knowing exactly how he is going to get the money to pay for them, but that same man will usually be much more careful about signing a note, since it is a formal instrument, and he is far more likely to make provision for paying it at the due date. 166 Principles of Accounting In the case of ordinary debts receivable it was observed that no accurate determination could be made of their discounted value, that is, the difference between their value now and their face value. This was found to be true because the due date was not definitely known. In the case of a note, however, the due date is specifically a part of the note itself, and by use of mathematical pro- cesses or formulae it is possible to make an accurate determination of the present value of notes receivable, always assuming they will be paid when due. Thus, the present value of a non-interest bearing note for $103.00, payable in six months, is exactly $100.00, if the current rate of interest is 6%. The rule which is used in deter- mining the present value is as follows: To find the present worth of an amount due at a future date, divide the amount by the amount of $1.00 placed at interest for the given time. For example, a non-interest bearing note for $1,000.00 due in two years has a present value of approximately $890.00, if the current and accepted rate of interest be 5%. The formula for obtaining this figure is as follows : Amount due in two years $1,000.00 = = $890 Approximate present worth Value of $1.00 in two years at compound 5% interest $1.1236 Theoretically, such a determination of present worth of all notes receivable should be made at the end of every accounting period. This, however, is often omitted, since the amounts involved may not be large. For practical purposes it is more convenient to omit the detailed calculation on each note. Where the notes receivable are for large amounts and where they run for a considerable period, such a determination should be made. 3 3 Where a note receivable is interest bearing, it is obvious that the present worth is equal to the face value. It is only in the case of non-interest bearing notes that this calculation would ever have to be made. Assets and Their Valuations 167 BILLS RECEIVABLE Bills receivable are unconditional written orders by one person upon another (or by us upon a debtor) to pay us a sura of money named. They are negotiable instru- ments of exchange which must be " accepted " by the debtor before being set up on our books as an asset. The time of payment is "on demand " or at a fixed future date. Until " accepted " such orders have no standing so far as the books of account are concerned. After being accepted they may be set up as assets. Accepted bills, or acceptances, as they are called, are considered the equivalent of notes and are governed by the same general principles of valuation. MERCHANDISE OR FINISHED GOODS ACCOUNT There is still another kind of current asset which might be considered. Various names are applied to the account which represents this asset. It is frequently spoken of as the Merchandise Account or the Finished Goods Account, and it represents commodities which are on hand ready for sale. Although a discussion of the problems incident to the valuation of this asset properly belongs here, it is deemed better to consider them later in connection with the valuation of working assets. WORKING ASSETS The items that appear on a balance sheet under the classification of "working assets" consist of inventories of raw material, supplies, and partly finished goods. The generally accepted policy with regard to the valuation of such items is that they shall be carried at cost price and, furthermore, that this cost price shall represent, not only 168 Principles of Accounting the bare material cost, but all other costs which have been incurred in 1. Getting the material to the factory. 2. Labor in unpacking and uncrating material. 3. Labor and overhead expense directly assignable to partly finished goods. It must be further recognized in valuing such assets that the basis of valuation is not the liquidation value but that to a going concern. FLUCTUATING VALUES . It sometimes happens in the case of raw material that the market price fluctuates so greatly, owing to speculative conditions of the commodity markets, that the original cost price will sometimes be greater than the current market quotations. For example, copper might be purchased at 16 cents a pound and within a few weeks the market for copper might slump down to 11 cents a pound. From the standpoint of pure theory, this should not affect the price at which the copper would be carried on the books, but from a practical standpoint, it is deemed wiser to inventory the copper at the lower of the two prices. It is practically an unwritten law 4 among accountants, in the case of the valuation of merchandise, that the cost price must be used as the basis, unless the market price hap- pens to be lower. This appears to be a somewhat unfair and unreasonably conservative doctrine. It means that a company must value each asset at the lowest possible figure that it must recognize fluctuations when they are * It should be noted that many cost accountants quarrel with this doc- trine, insisting that material should be shown on the books at cost, regardless of fluctuations. Assets and Their Valuations 169 unfavorable in their nature, but that it may take no account of any favorable fluctuations. It is conceded by accountants to be a dangerous thing to take appreciation into consideration. The accountant argues that human beings are too optimistic any way that they will, out of sheer hopefulness, overvalue their holdings if given a chance. Experience certainly proves that it is much wiser to be ultra-conservative with respect to balance sheet valuations, particularly in so far as the working assets are concerned. ELEMENTS OF BOOK COST Incoming freights, incoming express, and incoming drayage costs are all proper additions to the cost of merchandise, since it is clear that their cost to the pur- chaser is not the f . o. b. cost, but rather the cost laid down in his own warehouse. Materials and merchandise are often quoted for sak at a list price subject to a trade discount. These trade discounts are often large in amount, sometimes as much as 50%. Such trade discounts must always be deducted from the value of merchandise purchased. If a certain material was listed at $20.00, subject to a 25% trade dis- count, the proper charge to the Material Account would be $15.00 and not $20.00. Trade discounts amount simply to reductions in price. There is considerable diversity of opinion among ac- countants as to the treatment of cash discounts on pur- chases. Should such discounts be considered as deduc- tions from the cost of material purchased! This ques- tion can be answered with a "yes" or "no," depending upon the viewpoint. It is certainly true that if the amount of the discount is not deducted from the cost of the goods that an anomalous situation results. 170 Principles of Accounting Suppose $20.00 worth of merchandise is purchased and a cash discount of 2% is taken. If this cash discount is not considered a reduction in the cost price, the books will show that $19.60 in cash was paid out for certain goods which were charged in to the Material Account at $20.00. It would seem, however, that the accountants who support such procedure have the best of the argu- ment. They claim that cash discounts, given or taken, are financial in their nature and that they measure the adequacy or inadequacy of the capital invested in the business. If a company has capital enough to take ad- vantage of purchase discounts, the credit is due to the sufficiency of capital, which makes such savings possible. The company which has insufficient capital cannot take advantage of such opportunities. A cash discount may be taken by that concern which is financially able, but the sufficiency or insufficiency of cash should not be allowed to affect the value of merchandise. If such a cash dis- count is considered a deduction in price, then the concern which had sufficient capital to take a discount of 40 cents on a $20.00 invoice, would be penalized by being forced to value the purchase at only $19.60, while the other con- cern with insufficient capital would, because of its sheer inability to take the discount, be privileged to value the same merchandise at $20.00. MATERIALS IN PROCESS The problems entering into the valuation of materials in process are peculiarly those of the cost accountant. The same general rules, however, apply to their valuation as in the case of raw material and supplies. Cost price only must be used, the one exception to this rule being in the case of a business which handles long-time contracts. It is then sometimes allowable for a certain proportion Assets and Their Valuations 171 of the estimated profit to be taken into the accounts each period. Conservative auditors always view such a pro- cedure with a suspicious eye, however, and are prone to guard carefully against the danger of "anticipating pro fits. " Suppose, for example, that a contractor had a $100 r 000.00 contract, which would require three years for com* pletion. It would seem unreasonable and unfair to insist that for the first two years he should show no profits at all and for the last year a very large profit. In such a case, which would occui* but rarely, the accountant feels justified in permitting the contractor to take credit for a reasonable proportion of the profits each year and at the same time carefully safeguards him by establishing ample reserves for contingencies. MATERIAL AND SUPPLY ACCOUNTS There are two general ways of handling material and supply accounts : The first method is to charge all incom- ing material to a purchases account. To determine the amount used and the balance on hand under this system, it is necessary to take a physical inventory. The taking of such an inventory is a laborious task ; hence this system is not ordinarily employed where there is a shorter accounting period than one year. The second method of handling such accounts is to charge all incoming mate- rials and supplies to material and supply accounts and to credit those accounts, at cost, whenever materials and supplies are withdrawn for use. Such a procedure as this contemplates a modern system of keeping stores with some responsible person in charge of the stores. This individual, who is usually known as the " storekeeper, " is held strictly responsible for the supplies and material in his care. He is required to give a receipt for all incoming 172 Principles of Accounting material and supplies and to take a receipt for all mate- rial or supplies which he relinquishes. By operating under such a system as this, it is compara- tively easy for the storekeeper to keep what is known as a ' ' perpetual inventory system ' ' or a l ' Store 's Ledger. ' ' In its simple form a Store's Ledger may be very much like an ordinary ledger. One sheet in this ledger is assigned to each kind or class of stores. Whenever mate- rial is received, it is debited to the proper account in the Store 's Ledger. Whenever a quantity of the same mate- rial is issued, it is credited to the Store's Ledger Account. The balance of that account, therefore, should always coincide with the amount of material actually left on hand for which the storekeeper is responsible. In a large storeroom of a manufacturing plant there may be thou- sands of kinds of materials and supplies with an account for each size or grade of each kind. The Store's Ledger is a subsidiary ledger and is represented in the General Ledger by a controlling account called "Materials Account." (Instead of one control account there may be several classified control accounts.) ACCOUNTING FOE MATERIALS One common method of accounting for materials may be outlined as follows: Each stock ledger account (Figure 49) should indicate the maximum and minimum quantity which it is desirable to keep in stock. When the supply of any article runs below the minimum, the store- keeper should 1. Notify the proper department head of the shortage. 2. Take a physical inventory of the goods. 3. Reconcile the stock ledger account balance with the true balance. 4. Send an overage or shortage report to the auditor. Assets and Their Valuations 173 FiQ. 49. Common Forms of Stock Ledger Accounts 174 Principles of Accounting REC/ FR< kPITULATIOfN DM n 1 C EFT H )F REQUISITIONS . TO STORES DERT. F 181 DURING MONTI REQUISITIONS CREDITS TO STORES ACCOUNTS DAY NUMBER SUPfllES RAW MAT1 No. 1 RAW MAFL No. 2 RAW MAT'L No. 3 FINISHED GOODS PARTS MISC. N I ' ' -> ' DATE. .191 SlGNEO. STOREKEEPER FIG. 50. Eecapitulation of Eequisitions Assets and Their Valuations 175 When the department head receives the notification, he may make a requisition upon the purchasing agent, who will order a new supply. This purchase order may be made up with one original and four carbons, disposable as follows : 1. Mailed to the supplying company. 2. Filed in the "Unfilled Orders File." 3. Filed in the office file. 4. Sent to receiving clerk. 5. Sent to receiving clerk. Copies 4 and 5 are made with short carbons. They may show the price but not the quantities. When the goods are received, they are checked against these carbons and the receiving clerk's count or weight is inserted. One of the carbons then goes to the auditor, where it is attached to the proper voucher jacket. The other one forms the basis of the storekeeper's charges to the stock ledger accounts. When materials or supplies are needed in the shop, they are requisitioned from the storekeeper. The storekeeper should never release materials to the shop except upon requisition, the latter being his receipt for the goods. From the requisitions, the storekeeper makes his credits to the stock ledger accounts. At the end of each month a Recapitulation of Requisitions (Figure 50) is made up and sent to the Cost Department. From this the General Ledger control accounts receive credits for the total requisitions. CONTROLLING ACCOUNTS Charges Credits From Voucher Register From Requisition Recapitulation 176 Principles of Accounting STOCK LEDGER Charges Credits From copy of original purchase or- From original requisitions der, which has been " checked" by receiving clerk The general ledger entries are made monthly in lump sums. Materials Account 8 $ Vouchers Payable $ For the monthly total of vouehered material purchases Work in Process Materials Account 5 For the total material requisitioned from the storeroom during the month The method of handling discrepancies between book and actual inventories is for the storekeeper to adjust his book inventories to bring them into accord with the facts, reporting the overages and shortages to the auditor. The latter then makes the following general ledger entry for each shortage: Over and Short Account $ Materials Account $ A reverse entry is made for overages which will be infrequent. The Over and Short Account should not be absorbed into "Operation," but should remain on the books as an index of the storekeeper's efficiency. When the balance reaches a certain fixed account, the storekeeper should be called upon for explanation or, per- haps, discharged. It is well to keep the existence of this Over and Short Account a secret from the storekeeper since, otherwise, he might be tempted to falsify his re- ports. It is also a good idea for periodical "surprise" These entries are only suggestive. As a matter of fact, there would prob- ably be a number of classified material control accounts in the General Ledger. Assets and Their Valuations 177 inventories to be made of selected classes of stores for the purpose of checking the storekeeper's reports. A detailed description of the methods used in handling materials and supplies more properly belongs to a treatise on factory accounting than to the present work, but a general description of it at this point seems necessary because of the problem which comes up in connection with the valuation of working assets under any perpetual inventory scheme. The cost price must be used, but this must be an averaged cost price. For instance, suppose that 1,000 pounds of copper were purchased for 11 cents a pound f. o. b. destination and that 600 pounds of that copper were used. The entry in the Copper Account in the subsidiary store ledger would consist of a debit of $110.00 (representing 1,000 pounds of copper at 11 cents a pound) and a credit of $66.00 (representing 600 pounds of copper at 11 cents a pound). The balance of copper on hand according to that material account would then be 1,000 pounds minus 600 pounds, or 400 pounds. The value of the copper left on hand would be $110.00 minus $66.00, or $44.00. Suppose that 100 pounds of copper were now purchased at 16 cents a pound. What would be the value of the copper on hand? The value would ob- viously be the sum of 400 pounds at a cost of $44.00 and 100 pounds at a cost of $16.00, or 500 pounds costing $60.00 a ' ' unit price ' ' of exactly 12 cents a pound. This is the price which should be used in recording the issu- ance of further copper. In determining this price of 12 cents a pound it will be noted that a weighted average was taken and not a straight average. Taking the straight average would result in a unit price of 13% cents, but it is clear that this figure would be incorrect. When we speak of the necessity of using cost prices in valuing working assets, we mean that actual cost prices 178 Principles of Accounting must be used. Unless this is done, serious misrepresen- tation will result. Two policies should be strictly avoided : 1. All the material and supplies should not be valued at the cost price of the last lot purchased. This is impor- tant since otherwise a dishonest or unwise manager might purchase 40,000 pounds of copper at 10 cents a pound and later purchase 100 pounds at 20 cents a pound. If he were allowed to value all the copper on hand at the cost of the last consignment, the result would be a gross inflation of the inventory and, consequently, a better bal- ance sheet showing. In the particular illustration used, the misrepresentation would amount to $4,000.00. 2. Prices should not be averaged according to the method of straight averages instead of weighted aver- ages. The average unit cost of 40,000 pounds of copper at 10 cents and 100 pounds of copper at 20 cents is not 15 cents, but only a very small fraction over 10 cents. Precisely the same principles which apply to the valua- tion of working assets also strictly apply to the valuation of finished goods, although finished goods may be classi- fied as a current asset. FIXED ASSETS Fixed assets may be roughly classified into tangible and intangible. Tangible fixed assets include such items as 1. Land. 2. Buildings. 3. Machinery, Furniture and Fixtures. 4. Investments, Assets and Their Valuations 179 Intangible fixed assets include 1. Goodwill. 2. Franchises. 3. Patents. The general principle underlying the valuation of fixed assets is that they shall be carried at cost regardless of current fluctuations in value, but that- accounting devices to measure lessening value must be taken into considera- tion. There is always some justification for arguments that favor a recognition of the market price in the case of working assets, but no sound arguments can be brought forward in justification of a similar treatment of fixed assets. The reason for this is clear. Working assets consist either of materials or of supplies. The materials are intended for ultimate resale in some altered form, while the supplies are consumed in making the materials marketable. Both materials and supplies, therefore, are transitory and are either directly or indirectly intended for resale. The state of the commodity markets has a direct effect upon the prices which will be ultimately real- ized for the finished goods and the merchandise into which the working assets are to be transformed. Hence there is a logical justification for a partial recognition of com- modity market fluctuations. The status of fixed assets is entirely different. A fixed asset is a permanent holding and ordinarily may not be parted with until dissolution of the business. Fixed assets are essential to and inseparable from the business which owns them. Since they are not intended for resale, market fluctuations in their value will have no effect upon the current profits of the business. There is a corollary to the foregoing. Market fluctua- tions may be ignored, but it is of prime importance that 180 Principles of Accounting some well-considered plans of depreciation and amortiza- tion 6 be followed. Certain classes of fixed assets depre- ciate more than others. This, however, does not affect the rule as above laid down. It only affects the rate. Sometimes a peculiar situation results from a rigid adoption of these two policies. For example, let us con- sider the case of an industry purchasing real estate on the outskirts of a city, and building thereon a factory. The total investment in land might be $10,000.00 and in buildings $20,000.00. If they followed a conservative practice such as has been outlined, they would charge off each year a certain percentage of their Buildings Account to Depreciation (note that land, in and of itself, is not usually subject to depreciation, although it may be under certain circumstances). In twenty years they may have charged off the entire $20,000.00 represented by their Buildings Account, and the books would then show real estate valued at $10,000.00 and buildings valued at noth- ing. Owing to the growth of the city during the twenty- year period, the management might decide to sell its property and move elsewhere. It is far from inconceiv- able that, in such a period of time and under favorable e The following definition is the one proposed by the Committee on Accounting Terminology of the American Association of Public Accountants under date of August 31, 1915. Amortization The gradual extinguishment of the amount of an asset, liability, profit, or loss by prorating it over the period, during which it will exist or during which its benefit will be realized. Specifically, 1. The gradual extinction of a debt as, for instance, by means of a sinking fund. 2. The gradual reduction in the valuation of an asset, thus anticipating the time when it shall eventually become worthless; as distinguished from provision for depreciation or replacements. 3. The absorption in the income or profit and loss accounts during the pending of the debt, of a discount incurred or of a premium realized in the sale of an obligation, which discount or premium may be carried in the meantime, in a debit or in a credit suspense account, Assets and Their Valuations 181 circumstances, real estate values might have increased several hundred per cent and that the land which they bought for $10,000.00 might be sold for $75,000.00. Sales price of land $75,000.00 Original cost of land 10,000.00 Profit on sale of land $65,000.00 It would clearly be improper to treat this $65,000.00 as a profit of the last accounting period. What it really is, is the accumulation of twenty years' profits, due to a regular appreciation in value of the land. This figure of $65,000.00 must be credited not to Profit and Loss of the current period, but direct to some capital account such as Capital Surplus. Accountants realize that such occurrences are not improbable, but they deem it more conservative to ignore the gradual appreciation in value of real estate and to take no credit for such gains until the profit is actually realized. It is then creditable directly to a capital account instead of one of the current income accounts. Managers and owners often protest bitterly when told that they must make provision for depreciation of the fixed assets, but they are not allowed to offset this by an increased value of land. If a building is depreciating at a rate of $2,000.00 a year and land is appreciating at a rate of $3,000.00 a year, it seems reasonable to the owner or manager to consider that a $1,000.00 gain has been made. There appears to be some justice in the claim that an unfair 'showing of profit and loss is made when current depreciation is required and current appreciation is ig- nored. The rule is, however, a very sound one. To a going concern, rapidly appreciating real estate has no 182 Principles of Accounting more value than when it was first purchased, and on the principle of regarding assets from the viewpoint of the going business, real estate and similar assets must plainly be valued at cost. As a further justification for the conservative prac- tices recommended in connection with the valuation of fixed assets, it should be noted that it is very difficult to appraise real estate properly. To make such an apprai- sal every year for the purpose of taking credit for antici- pated profits due to appreciation of the land would lead to inaccuracy, particularly if different appraisers were employed each year, since the judgment of one real estate expert might be widely different from that of another. Fixed tangible assets, other than real estate, should be subject to a well-considered depreciation policy. As indicated in the case of other classes of assets, fixed assets, both tangible and intangible, should be booked at cost price the cost to the "going" concern. In the light of the foregoing principles we may now consider the case of particular kinds of assets. LAND Land should be valued at the cost of acquisition. This may not necessarily be equal to the purchase price. Grading, street improvements, etc., may be necessary be- fore the land is ready for use, and such items may be included in the book cost of the land. Broadly speaking, the various items of expenditure which are necessary to bring the land into condition for use are properly ele- ments of the book cost. When the land is in use, subse- quent expenditures should be very carefully scanned to determine whether they are properly chargeable to the asset account or whether they are items of expense. An expenditure should never be charged to a fixed asset Assets and Their Valuations 183 account such as Real Estate, unless it unquestionably adds real value to the asset. Ordinarily neither appreciation nor depreciation of land should be taken into consideration. This, however, may not be true under certain special conditions. For example consider the case of a mining property where the amount of mineral is known. Every ton that is brought to the surface decreases the value of the mining property. Such a property is known as a " wasting asset, ' ' and it is clear that a consistent plan of amortiza- tion must be followed in such cases. If a mining property cost $100,000.00 and a careful estimate indicates one mil- lion tons of ore, then for every ten tons of ore taken out of the mine the property would decrease $1.00 in value. If mining is conducted at the rate of 100,000 tons a year, then the property has an approximate life of ten years and depreciates $10,000.00 every year. In such cases as this the rate for amortizing all the other fixed assets must be based upon the ' ' depreciation rate" of the wasting asset. In the case above mentioned the mine buildings and equipment might have an average life of twenty-five years, but if the mine has only a life of ten years, the amortization of the mine buildings must also be based upon a ten-year life, since they will have no value when the mine is exhausted. The rule, therefore, in connection with wasting assets like mines, is that the depreciation rate of accompanying fixed assets having an estimated life less than the life of the mine may base their depreciation rate upon estimated life, but that fixed assets having an estimated life greater than the life of the mine must be amortized at the same rate as the mine itself. Should this rule not be strictly followed it is clear that the profits of any one year may consist partly of real profits and partly of the original 184 Principles of Accounting capital invested. Dividend declarations based on such apparent profits would be illegal in many states, since it is a fairly well-settled rule that a dividend may be declared only out of profits. LAND PURCHASED WITH STOCKS OB BONDS Land is not always purchased for cash. It is some- times purchased with stocks and bonds. When this is done, a very difficult problem arises as to what the actual cost of the property is. Theoretically, at least, a double valuation must be made, since the property is valued in terms of the securities and the securities are valued in terms of cash. The proper theoretical procedure, since securities are seldom, if ever, worth exactly par, would be to calculate the cash value of the securities and then to book the land at the cash value of the securities with which it was purchased. While theoretically correct, such a procedure is not followed in actual practice. The situation usually occurs in connection with corporations, and the law accepts the judgment of the directors as to the value of the asset so acquired. In the absence of fraud the judgment of the directors is considered final. 7 BUILDINGS The problems in connection with the valuation of build- ings are very similar to those discussed in the foregoing 7 There seems to be some difference of opinion among lawyers regard- ing the exchange of capital stock for property. At common law there are two general rules the "good faith" rule and the "true value" rule but these may be modified by statute in the several states. The "good faith" rule simply requires good faith on the part of the directors in valuing the property, but a gross overvaluation is held to be presumptive evidence of bad faith. The "true value" rule states that the fair market price is the one to be used and, on behalf of the creditors, the court may "go back" of the directors 7 valuation, regardless of their good faith. The basis of this rule is the idea that the capital stock of a corporation is a trust fund for the benefit of the creditors. Assets and Their Valuations 185 section, except that where the land account represents a wasting asset, depreciation should be considered, other- wise land should be kept on' the books at original cost. A building, on the other hand, must always be depre- ciated. With buildings, as in the case of land, a very careful distinction should be made as to the proper charges for expenditures. After the property has been acquired, no expenditure should be charged to the asset account, unless it represents an actual betterment and increase in the value of that asset. This distinction is sometimes very difficult to make. In a going business improvements to buildings are constantly made, repairs and replacements are always under way, and expenditures for such pur- poses should be carefully examined to determine whether they are in the nature of upkeep and, therefore, charge- able to expense or are bona fide improvements properly chargeable to the asset account. The only safe rule to follow is the one previously laid down; viz., where the expenditure results in increased operating facilities which will permanently increase the net profits of the business or permanently increase its real value or permanently increase its rental value, the proper charge is direct to the asset account, but where the only effect of the expendi- ture is to maintain the property, the proper charge is to an expense account. Where renewals of assets are more valuable than the property replaced, the excess is prop- erly and legitimately chargeable to property accounts. Buildings which are constructed by the company own- ing them should be valued at the actual cost of construc- tion and not at the price which they would have cost if purchased from outside parties. The difference between the construction cost and the purchase price of a building is not a profit but a saving. 186 Principles of Accounting The original amount at which a building should be booked is its value to the "going" concern. The proper elements of that cost include any expenses necessarily involved in constructing or purchasing the building, plus the expenditures which must be made in order to put it into condition for use. Examples of such expenditures are building permit fees, legal fees, insurance during con- struction, interest on investment during construction, wages of night-watchman during construction, etc. LEASEHOLDS It frequently happens that buildings are erected on leased ground. Depreciation should, of course, be charged on such buildings based on their estimated life, unless the life of the lease is less than the estimated life of the building. In such a case the cost of the building should be written off over the life of the lease. For exam- ple, assume that John Doe on Jan. 1, 1915, leased certain land for twenty-one years and that he erected a $40,000.00 building, which was completed Jan. 1, 1916. He esti- mated that the life of the building would be about thirty years. What provision should he make for depreciation? 1. Yearly depreciation charge based on life of $40,000.00 (cost) building = = $1,333.33 30 (years of life) 2. Yearly depreciation charge based on life $40,000.00 (cost) of lease = = $2,000.00 20 (years to run) Under the first plan the Buildings Account will show balance of $13,333.34 on December 31, 1936, whereas th< actual value of the building to John Doe will be zero, indi- cating that his accounts have failed to tell the trul Assets and Their Valuations 187 Under the second plan the cost of the building will be dis- tributed over the life of the lease, and when the latter expires, the cost of the building will be entirely wiped off the books. If a lease is purchased, its purchase price may be set up as an asset, to be amortized over the number of years the lease has to run. The reader should understand that this discussion of the valuation of land and buildings assumes that such assets are fixed in their nature. The treatment of sim- ilar items on the books of a real estate company which deals in land and buildings as personal property is entirely different. In that case land and buildings are in the nature of merchandise and should be handled in a similar way. MACHINEKY Machinery, as a fixed asset, is subject to the same gen- eral rules as have been given for the valuation of land and buildings. Machinery should be charged to the Ma- chinery Account at cost, and this cost may very properly include the f. o. b. cost, plus the freight, plus the expense of installation. As in the case of other assets, the value of machinery is its value to the "going" concern; hence all expenditures which must necessarily be made before the machine can be put in operation are properly included in the cost of that machine. Adequate provision for depreciation should be made as in the case of buildings. The rate of depreciation de- pends upon a great many factors and will in certain cases have to be determined by a qualified expert for each indi- vidual case. Machinery, which is built by a company for its own use, must be booked at actual cost, i. e., materials, labor, and 188 Principles of Accounting factory expense. The fact that such cost is less than the price at which the machinery could be purchased is no argument in favor of charging the asset account with the latter. The difference between actual cost and the mar- ket price is not a profit but a saving. Machinery that is purchased primarily for resale is not a fixed asset but is equivalent to merchandise and is subject to the same rules of valuation. INVESTMENTS Two general classes of investments may be recognized ; i. e., those that are fixed assets in their nature and those held for the purpose of resale. The United States Government bonds, which are held by national banks, are permanent investments. The bank cannot continue its note-issuing function if the bonds are disposed of. Similarly, the investment which a railroad company has in smaller tributary lines is a fixed asset. From the foregoing two examples we see that invest- ments may be regarded as fixed assets if they are essential to the business in the same way that land, buildings, and machinery are essential to the business. Securities that are purchased for speculation are not fixed assets they more nearly resemble current assets. Securities which a bond-dealer has on hand for the pur- pose of resale are merchandise. Investments may be roughly divided into two broad general classes stocks and bonds and the accounting treatment of these two classes is very different. The treatment of stock purchased is simple. It may be booked at actual cost, regardless of par value the fluctuations in its value may be ignored if it is an asset actually " fixed " in its nature. If stocks are purchased for speculative purposes or as short-time investments Assets and Their Valuations 189 DIFFERENCES BETWEEN STOCKS AND BONDS Stocks Bonds Stocks are not liabilities but certifi- Bonds are secured liabilities cates of ownership Stockholders may share in profits in Bondholders do not share profits but the form of dividends receive interest at a definite rate Stockholders may share in assets Bondholders expect return of invest- upon dissolution of the company ment intact at maturity according to the terms of the agreement A share of stock represents a pro- A bond is a limited interest in a cor- portionate share of assets poration Stockholders have control of the cor- Bondholders as long as they receive poration regular interest and principal at maturity have no voice in the man- agement A stockholder is a part owner A bondholder is a creditor for idle funds or for purpose of resale, they are equiva- lent to merchandise, and the rule of "cost or market price, whichever is lower," applies. Bonds which are purchased for a permanent investment and which are equivalent to fixed assets, may be bought either at par, below par, or above par. If they are bought at par, they are booked at cost and allowed to remain at that figure until maturity. If they are bought above par (at a premium), they may be booked at cost; but the excess of cost over par value must be amortized written off during the life of the bond. The theory underlying this doctrine is that the premium merely represents bond interest purchased in advance which must be applied against the actual interest received during the life of the bond. For example, suppose a $1,000.00 bond, run- ning for 25 years with interest rate of 5%, is purchased at a price of $1,250.00. The yearly interest which will be received is $50.00, but the actual or effective interest which will be earned is $40.00, because each year the book value of the bond must be depreciated $10.00, so that at the end of last year its book value will only appear 190 Principles of Accounting as $1,000.00. This is the amount which will be received in cash when the bond is called for payment. The reason why the bond sold for more than par is because a 5% return was considered too high a return on a bond of such class. The holder of such a high-class bond is not willing to sell it at par because it gives him such good return for his money. If, however, he sells it for $1,250.00, he implies that a 4% return is sufficient and, therefore, sells it on a 4% basis. The purchaser of the bond by paying such a premium impliedly admits that a 4% basis is correct but, since the bond actually returns 5% on par, he pays the holder of the bond an amount sufficient to make the return on his own investment approximately 4%. When the bond is paid off by the company issuing it, it will pay only $1,000.00. There- fore, the $250.00 premium must be equitably spread over the life of the bond, and the yearly amount written off must be treated as a deduction from the income received. To be strictly logical, bonds purchased at a discount, i. e., below par, should be marked up each year, and there is no particular reason from a theoretical point of view why this may not be done. Many accountants object, however, to such procedure on the ground that it is dangerous to permit marking up the values of fixed assets. They always insist on taking depreciation into account but seldom, if ever, are willing to allow appre- ciation. Hence, it is usually customary to book such bonds at actual cost and to hold them at that figure until the bonds are paid ; thus, a $1,000.00 bond due in ten years at 5% interest if purchased for $880.00 will be left at that figure for the entire ten years. At the end of the last year, in addition to the $50.00 interest, there woulc be a $120.00 increase in the value of the asset, bringing it up to par value. Such an extraordinary profit Occur- Assets and Their Valuations 191 ring in one accounting period should, under no circum- stances, be treated as profit of that period, but should be credited direct to a capital account. The accountancy of investment is a science in itself, and it would serve no useful purpose to discuss it here. There have been several excellent manuals written on the subject, the principal one being Accountancy of Investment, by Chas. E. Sprague, which gives a detailed presentation of the calculation of interest, annuities, bond valuations at varying rates, and amortization. DEFERRED ASSETS Very little difference of opinion can exist as to the principles of valuing deferred assets. A deferred asset is a prepayment, and its original value is equal to its cost. If correctly handled, each deferred asset appears at a value which constantly diminishes as time goes on until it is finally extinguished altogether. Development expense in connection with mines and experimental ex- pense in factories are good examples of deferred assets. In every case, deferred assets should be written off against the accounting periods to which the expense is properly chargeable. INTANGIBLE FIXED ASSETS When a business is sold, it frequently happens that the price received for it is considerably in excess of its net worth as shown by the books. The difference be- tween the net worth and the price actually received is often spoken of as " goodwill. ' ' Goodwill is made up of a number of elements. It takes into consideration the loyalty of constant customers and the force of habit which causes them to continue trading at one place. When an individual gets into the habit of trading at 192 Principles of Accounting one particular place of business, he is a far more valuable customer than the one who must be attracted by means of expensive advertising and selling effort. Concerns that have been in business for a long time gradually accumulate a clientele of satisfied customers. The busi- ness which has such a well-established patronage is worth considerably more than a business with a similar net worth which has none. GOODWILL Goodwill is defined by Webster's New International Dictionary as "the custom of any trade or business; the favor or advantage in the way of custom which a business has acquired beyond the mere value of what it sells, whether due to the personality of those conducting it, the nature of its location, its reputation for skill, prompti- tude, etc., or any other circumstance incidental to the business and tending to make it permanent. " The Treasury Department of the United States has given the following short definition, "Goodwill represents the value attached to a business over and above the value of the physical property.'' Goodwill represents the value of the physical organization of a business, its trade-marks, its advertising, and its relationship with others. When a business is purchased for more than its net worth, the difference between its net worth and the purchase price may be charged to the Goodwill Account. This goodwill then appears on the Ledger as an asset, and it may rightfully be so considered. It represents the purchase of something which would otherwise have to be acquired by the expenditure of money for advertising, salesmen, etc. That concern which is able to purchase a crowd of satisfied customers customers who will be Assets and Their Valuations 193 likely to continue trading where they have traded in the past will certainly have to spend less money in adver- tising than a concern which has to build up an entirely new clientele. Theoretically, goodwill should appear on the books of a concern as an asset when that concern begins to make more than a normal rate of return on the capital invested, and as the concern gets more prosperous and its actual goodwill increases, it would be theoretically justified in increasing its Goodwill Account. This, however, is re- garded as a very dangerous procedure, and no reputable accountant would permit it. A well-established rule is that goodwill shall not appear as an asset, unless it has been purchased. John Jones may have a business with a net worth of $10,000.00. That business may be actually worth $30,000.00 from an income-producing standpoint, but Jones will not be allowed to set up goodwill of $20,000.00. However, if Smith purchases the business from him for $30,000.00, Smith may book goodwill as being worth $20,000.00 without being criticized. The reason for this is that Smith has demonstrated his belief in the existence of goodwill by paying cash for it. Some question exists as to whether goodwill should remain permanently an asset or whether it should be charged off against profits year by year until finally extinguished. There are several ways of looking at this matter. Some accountants declare that goodwill should be charged against the profits for which it is responsible. This assumes that the only value which goodwill has is that of a profit-producer. As extraordinary profits are made which are clearly due to goodwill, then that goodwill should be charged against those profits. Some accountants consider it allowable to retain good- will indefinitely upon the books; they claim that' its 194 Principles of Accounting appearance in the balance sheets deceives no one, that it represents very little more than a bookkeeping con- venience, and that it should not be allowed to disturb profits. Still other authorities consider that goodwill should be charged off during prosperous years and not during lean years. This is fallacious, since if no profits are made it is apparent that goodwill is valueless and should, therefore, be charged off. If extraordinary profits are made, it is pretty good evidence that the goodwill is worth face value or more and should, therefore, not be charged off at all. Following such a logical line of rea- soning it leads to the absurdity of charging off goodwill during unprofitable years and thus further increasing the loss and of not charging it off during the years when the business could best afford it. The author submits the following as being a logical method of treating goodwill. When goodwill is pur- chased, it is paid for on the same basis as any other asset, namely, its inherent value to the purchaser. The purchaser either does or does not get his money 's worth. If he does get his money's worth, it will be indicated by substantial profits, since goodwill that does not produce profits has no value. If large profits are made during the first few years, then the goodwill should be amortized during those years. If the expected profits do not materialize, it is a sign that the investment was an unfor- tunate one and that the purchaser did not get value received for his money, or that he did get value received but that the goodwill disappeared because of some fault of his own. In either case the goodwill should be charged off not against current profits but against the capital invested. The situation is analogous to the purchase of a business purporting to own certain assets which do * Assets and Their Valuations 195 not exist. When it is determined that these assets do not actually exist, they will not be charged against current profits but will be charged against the capital account. The question as to the period of time over which goodwill should be written off resolves itself back to the question ' t What has been purchased f " Clearly nothing has been purchased save anticipated profits. The purchase of a business at a premium is very much like the purchase of a bond at a premium. The bond premium represents future interest ; the business premium or goodwill repre- sents future profits. Since the rate of amortization of bond premium is dependent upon the time factor, the life of the bond determines the yearly amount to be charged off. In the case of goodwill the number of years' profits which have been purchased determines the number of years over which goodwill shall be charged off. No one can afford to be dogmatic about the treatment of goodwill. So many excellent authorities disagree absolutely as to the treatment of goodwill that it would seem as if almost any of the methods discussed would be justifiable. FKANCHISES AND PATENTS Franchises and patents are usually classed with goodwill. Payment for a patent is nothing more than payment for protection. It may be set up as an asset, but it normally should be written off in equal, annual installments over the life of the patent. The payment for a franchise is also an asset which should be written off in equal annual installments during the life of a franchise. Franchises may be perpetual in their nature, in which case they need not be amortized; but when a franchise has a definite number of years to run, sound accounting policy calls for its amortization. 196 Principles of Accounting OKGANIZATION EXPENSE When a corporation is organized, certain expenses are always necessary before the corporation is in shape to do business. Fees must be paid, expenses must be met, stationery and printing must be paid for. All these are legitimate charges to asset accounts, since they must be incurred before the corporation can begin business. Such pre-existence expenses are bona fide assets which need never be amortized or charged off, since they are perpetual in their nature, unless the life of the corpora- tion is limited to a definite number of years, in which case they should be charged off during the life of the corporation. The proper method of booking such charges is to debit them to an account called "Organization Ex- penses/' Many concerns do not like to show this item quite so openly and, therefore, make the charge to one of the fixed asset accounts, such as Land, Buildings, or Machinery. This is not considered the best practice but it is allowable, owing to the sanction which custom has given it. TEST QUESTIONS 1. What is the fundamental rule of asset valuation? 2. Outline the procedure for material accounting. 3. Differentiate between weighted and straight averages. 4. What are the components of raw material value? CHAPTER VI LIABILITIES It has already been stated that liabilities are negative assets. A positive asset is owned. A negative asset is owed. For purposes of discussion liabilities may be classified into 1. Current. 2. Long time. 3. Deferred. 4. Contingent. 5. Proprietary. The first four items are true liabilities. The fifth is a liability only in the bookkeeping sense, as has previously been explained. Treatment of proprietary liabilities will be deferred until the following chapter. CURRENT LIABILITIES Current liabilities usually are those having an early due-date. In other words, they are liabilities which must be paid shortly after date of the balance sheet upon which they appear, although this is not necessarily true. Strictly speaking, all debts that are not raised for permanent purposes are current liabilities. From the viewpoint of the banker or credit man, however, any liability is current that has an early due-date. All other liabilities, whether funded or not, are considered " long- time " obligations. In the ordinary business, current liabilities will consist 197 198 Principles of Accounting mainly of two general classes of items, i. e., accounts payable and notes payable. An "account payable " is an implied, verbal, or informal promise to pay. A * ' note payable " is a definite written promise to pay. Practi- cally no problems of importance need be discussed with reference to the Accounts Payable Account. Normally this is a controlling account over a creditor's ledger (which may be in ledger form or in the form of a voucher file). No question of valuation is present, since liabilities do not diminish in value with the passage of time. The figures at which they are booked remain the same until payment is made (either in cash, notes, or allowances). ACCRUED LIABILITIES In the preceding chapter the subject of accrued assets was discussed at some length. Accrued liabilities are of the same general nature except that they are nega- tive instead of positive. Accrued liabilities are those depending upon the passage of time regardless of the due-date, and they consist of such items as accrued wages payable, accrued salaries payable, accrued interest pay- able, accrued taxes payable, etc. Accrued liabilities are booked by means of an adjusting journal entry at the end of each accounting period. This entry charges the expense accounts and credits the accrued liability accounts. The purpose of such entries is to include among the expenses of any accounting period all items which are properly chargeable against that period and to include among the liabilities at the end of the period the amounts which have accrued to that date, even though the time for payment has not arrived. For example, it may be the practice to pay employees every Saturday, but the yearly accounting period may end on Wednesday. The wages Liabilities 199 earned by employees on Monday, Tuesday, and Wednes- day would be properly chargeable as expenditures of the accounting period. They would also be liabilities, since they have unquestionably been earned by the employees and are due to them. If these accrued wages equaled $300.00, the adjusting journal entry would debit Wages Account (an expense account) and credit Accrued Wages Payable (liability account) for $300.00. It should be noted that such accrued items are in the nature of nega- tive, or liability, inventories. It is usually customary at the beginning of the fol- lowing accounting period to reverse the entries by which the accrued liabilities were booked and then to charge the actual cash payment to the expense account instead of to the accrued liability account. This need not be done, however, since it is equally proper to charge the disbursement of cash to the accrued liability account. OTHEK CURRENT LIABILITIES When a corporation declares a dividend, that dividend is a liability of the corporation to the stockholders and must be set up on the books. This is done by means of a debit to Profit and Loss (or Undivided Profits or Surplus) and a credit to Dividends Payable Account. When the dividends are actually paid in cash, Dividends Payable Account will be debited, thus wiping out the liability, and Cash will be credited. Dividends Payable might be classified as "accounts payable/' but for balance sheet purposes it is usually desirable to show it as a separate item. DEFERRED LIABILITIES A deferred liability is nothing more than a deferred credit to Income. The philosophy underlying this class 200 Principles of Accounting of liabilities is similar to that discussed in connection with deferred assets. They represent liabilities not ultimately payable in cash but in goods or services. Such items as sales paid for in advance, deposits on contracts, etc., are classified as deferred liabilities. They will ultimately appear as items of Income but are liabilities until earned. CONTINGENT LIABILITIES A contingent liability, as its name implies, is uncertain. It represents a possibility that an amount will have to be paid, or a responsibility which may lead to the creation of an unconditional liability. The best example of a contingent liability is found in the case of discounted notes receivable. A company which receives many notes from its customers may find that it is tying up a goodly portion of its capital in these notes receivable. Since notes receivable are a real asset, they may be sold, in which case it would seem natural to debit Cash for the amount received and to credit Notes Receivable (disre- garding the loss due to discount). Such an entry, how- ever, will not tell the exact truth. The notes are sold, but a responsibility still exists in connection with those notes. In disposing of them the seller must indorse them, and in law such an indorsement acts qualifiedly as a guarantee. This means that if the maker of the note does not pay it, the indorser may have to do so. The entry, debiting Cash and crediting Notes Eeceivable, does not show the exist- ence of this contract of indorsement. One way to handle this is to make the entry as above indicated but to insert a footnote to the balance sheet calling attention to the fact that a contingent liability exists for ' ' Notes Eeceivable Discounted. ' ' A still better Liabilities 201 plan is to indicate this current liability right in the Ledger itself. This may be done by omitting the entry charging Cash and crediting Notes Eeceivable and sub- stituting therefor an entry debiting Cash and crediting Notes Receivable Discounted. The Ledger will then show two misstatements. It will overstate the amount of notes receivable as an asset and will also show an equal amount set up as an offset thereto on the liability side. For balance sheet purposes the balance of Notes Receivable Discounted Account should not appear as a liability but as a deduction from the total of Notes Receivable, the net amount being extended into the asset column. (First Method) BALANCE SHEET BEFORE DISCOUNTING NOTES Cash $ 2,000.00 Notes Receivable 20,000.00 Other Assets 25,000.00 $47,000.00 Accounts Payable $ 7,000.00 Capital 40,000.00 $47,000.00 JOURNAL ENTRY Cash $12,000.00 Notes Receivable $12,000.00 BALANCE SHEET AFTER MAKING ABOVE ENTRY Cash $14,000.00 Notes Receivable 8,000.00 Other Assets 25,000.00 $47,000.00 Accounts Payable $ 7,000.00 Capital 40,000.00 $47,000.00 The contingent liability of $12,000.00 for notes receiv- able discounted is not shown on this balance sheet. 202 Principles cff Accounting (Second Method) BALANCE SHEET BEFORE DISCOUNTING NOTES Cash $ 2,000.00 Notes Eeceivable 20,000.00 Other Assets 25,000.00 $47,000.00 Accounts Payable $ 7,000.00 Capital 40,000.00 $47,000.00 JOURNAL ENTRY Cash $12,000.00 Notes Eeceivable Discounted $12,000 00 BALANCE SHEET AFTER MAKING ABOVE ENTRY Cash $14,000.00 Notes Receivable 20,000.00 Other Assets 25,000.00 $59,000.00 Accounts Payable $ 7,000.00 Notes Eeceivable Dis- counted 12,000.00 Capital 40,000.00 $59,000.00 or a better form of balance sheet presentation would be BALANCE SHEET Cash $14,000.00 Notes Eeceiv- able $20,000.00 Less Notes Discounted.. 12,000.00 8,000.00 Other Assets 25,000.00 $47,000.00 Accounts Payable Capital .$ 7,000.00 . 40,000.00 $47,000.00 There are other kinds of contingent liabilities which occur less frequently than notes receivable discounted, and it is usual to indicate their existence only by means of footnotes on the balance sheet Such contingent lia- Liabilities 203 bilities occur in connection with guarantees of various kinds. BONDED INDEBTEDNESS When a corporation desires to raise money, it may place a mortgage on certain of its properties. Such a mortgage is the same instrument that the ordinary indi- vidual executes, but owing to the difficulty of selling mortgages in inconvenient amounts it is customary for corporations to make the mortgage payable to a trust company who acts as a trustee. Bonds are then issued in round amounts, i. e., $100.00, $500.00, or $1,000.00. These bonds are promises to pay secured by the mortgage held by the trustee. A bond contains a promise to pay a definite sum of money at the end of a certain period, and the interest rate is named on the face of the bond. When bonds are sold, the bond account is credited, and Cash is debited for the amount realized. It is clear that the face or par value of the bond may not be equal to its real value. The purchaser of a bond after taking into consideration the number of years it has to run and the interest rate, may feel that the bond is not worth par value to him. It may be only worth 95% of par value. On the other hand, a bond may be easily worth more than par value, particularly when the specified interest rate is high. The price of a sound bond is determined by its actual return of rate, and there is always some interest rate at which any bond can be sold for exactly par. The interest rate being fixed, the only way to obtain a different rate on the investment is to adjust the price paid for the bond. Suppose a hundred- year bond was issued with a par value of $1,000.00 at an interest rate of 4%, the annual return will evidently be 204 Principles of Accounting $40.00. If the current rate for money is 5%, the bond can be sold for approximately $800.00, since $40.00 a year is 5% of $800.00. Suppose, on the other hand, that the same bond was offered for sale at a specified interest rate of 6%. The income from such a bond would be $60.00 a year, but if the current market rate for money was in the neighbor- hood of 5%, the company issuing this bond could probably sell it for more than par, or around $1,200.00. The reader should, therefore, discriminate between the two kinds of interest rate. The nominal interest rate is the one indi- cated on the face of the bond. The effective or real interest rate is the actual rate of return on the invest- ment and is roughly obtained by dividing the annual cash income by the actual cash investment. In the last example shown above the nominal interest rate was 6%, and the effective interest rate was 5%. The reader should have no difficulty in realizing that if he buys a bond for less than the par value, which guarantees a fixed yearly rate, the annual rate of interest on his actual investment will be greater than the nominal interest specified on the face of the bond. The company issuing a bond must book it at par value, since the par value always constitutes the real ultimate liability. The entry to Cash for the proceeds of the bond sale will probably be either more or less than the credit to the Bond Account, since we have seen that few bonds are really sold at exactly par. The difference between the liability thus set up and the cash received must cer- tainly be recorded on the books. This can best be illus- trated by a series of examples. Suppose a company has the following balance sheet: Liabilities 205 BALANCE SHEET Cash $ 4,000.00 Plant 50,000.00 Other Assets 20,000.00 $74,000.00 Accounts Payable $15,000.00 Capital & Surplus 59,000.00 $74,000.00 The company decides to sell bonds in order to raise money for an extension of its plant. After proper legal formalities, it issues $25,000.00 worth of 5% ten-year bonds. Let us suppose that it is able to sell these bonds for only $20,000.00. Cash will be debited $20,000.00, Bonds Payable will be credited $25,000.00, and $5,000.00 entry will have to be made to the debit of a new account which we may call "Discount on Bonds." The journal entry for this transaction will appear as follows : Cash $20,000.00 Discount on Bonds 5,000.00 Bonds Payable $25,000.00 When the entries have been posted, the following balance sheet will result: BALANCE SHEET Cash $24,000.00 Discount on Bonds 5,000.00 Plant 50,000.00 Other Assets 20,000.00 ),000.00 Accounts Payable $15,000.00 Bonds Payable 25,000.00 Capital & Surplus 59,000.00 $99,000.00 This item of discount on bonds is a deferred charge to the Interest Account. The company assumed a lia- bility of $25,000.00 but received only $20,000.00. This would indicate that the rate of return specified on the 206 Principles of Accounting face of the bond was insufficient to attract the purchaser. The issuer of the bond, therefore, was obliged to increase the rate of interest. This was done by paying a certain portion of the interest in advance. This will be readily grasped after we analyze the above journal entry. It consists of a sale of $25,000.00 worth of bonds for $25,000.00 in cash and the payment of $5,000.00 in cash to the purchaser of the bonds in prepayment of interest. In journal entry form this will appear as follows : Cash $25,000.00 Bonds Payable $25,000.00 To record sale of bonds Discount on Bonds 5,000.00 Cash 5,000.00 To record the prepayment of interest The interest on such bonds is, therefore, paid in two ways: (1) A portion of it, amounting in this example to $5,000.00, is paid in advance, and (2) the balance is paid at the rate of $1,250.00 a year (a total of $12,500.00 during the life of the bond). The total interest on these bonds actually paid in cash is $17,500.00, $5,000.00 of it being paid in advance and the balance being paid in yearly installments. The important thing is that this item of discount on bonds represents nothing more than a prepayment of the interest and can, therefore, be classed as a deferred asset which must be charged off during the life of the bonds in equal annual amounts. 1 At the end of each year, therefore, two entries will have to be i It has not been thought desirable to discuss the intricacies of this subject but to confine the discussion to an exposition of underlying principles. Whether this item of discount on bonds is charged off in equal annual in- stallments or according to some other plan has no effect on the principle involved, and for purposes of clear presentation it is much simpler to assume uniform amortization. Liabilities 207 made, one entry will credit Discount on Bonds and debit Interest Account for the annual amount written off, and the other entry will credit Cash and debit Interest for the installment paid in cash. Interest on Bonds $500.00 Discount on Bonds $500.00 To charge off yearly installment on bond discount Interest on Bonds 1,250.00 Cash 1,250.00 To pay the nominal interest at the rate of 5% on par value of bonds outstanding The account, Interest on Bonds, represents real or effective interest, the item of $1,250.00 being the nominal interest. Bonds issued at a premium are handled according to the same principles that have been outlined for bonds issued at a discount. For purposes of illustration, we may use the same starting balance sheet that was shown on the preceding page. BALANCE SHEET Cash $ 4,000.00 Plant 50,000.00 Other Assets 20,000.00 $74,000.00 Accounts Payable $15,000.00 Capital & Surplus 59,000.00 $74,000.00 The same 5% ten-year bonds are sold, but the price obtained for them is $30,000.00. It is clear that Cash must be debited with the amount of cash received and that the liability account, Bonds Payable, must be credited for the par of the bonds sold or $25,000.00. The differ- ence between these two figures represents premium on bonds and is a deferred credit item, representing income received but not earned. 208 Principles of Accounting BALANCE SHEET Cash $ 34,000.00 Plant 50,000.00 Other Assets 20,000.00 $104,000.00 Accounts Payable $ 15,000.00 Bonds Payable 25,000.00 Premium on bonds 5,000.00 Capital & Surplus 59,000.00 $104,000.00 Analysis indicates that the nominal rate of interest specified on the face of the bonds was in excess of the amount of interest it would actually be necessary to pay for the use of the money. Instead of reducing the nominal interest rate they sell the bonds for more than par. The difference between the sales price, $30,000.00, and the par value, $25,000.00, represents money that the purchasers of the bonds have paid to the company. It really represents a refund by them of interest which they expect to receive. The company is then in a position of having received as a refund, interest which it has not yet paid but has only promised to pay. It must set the amount up as a deferred liability and write it off during the life of the bond in equal annual installments. Each year one-tenth of the premium will be debited to Premium on Bonds and credited to Bond Interest. At the same time Cash will be credited and Bond Interest debited for the interest actually paid at the nominal rate (which is greater than the real, or effective, rate). In journal entry form these entries will appear as follows : Interest on Bonds $1,250.00 Cash $1,250.00 To pay the nominal interest at the rate of 5% on the par value of bonds outstanding Premium on Bonds 500.00 Interest on Bonds 500.00 To credit yearly installment of bond premiums to Interest Account Liabilities 209 The account, Interest on Bonds, shows, on the debit side, interest actually paid in cash and, on the credit side, the yearly installment of the deferred liability, Premium on Bonds. The difference between the two sides repre- sents the real or effective interest. Considering these discounts and premiums as deferred charges and credits to the nominal account, Interest on Bonds, renders it easy to see that when bonds are issued at less than par, the discount represents neither an immediate loss nor a charge to permanent asset accounts. When bonds are sold above par, the premium does not represent an immediate profit, and it is clearly improper to credit it either to Surplus or to Profit and Loss. In the past certain corporations have treated bond discount as similar to organization expense, merging it with one of the fixed asset accounts. Under the proper theory of bond discounts this procedure is self -evidently vicious. It tells two falsehoods it falsely inflates the value of the fixed assets, and it fails to tell the truth about the real cost of financing. In the past it has not been unusual to treat premiums realized on bond sales as immediate profits, crediting them either to Profit and Loss or to Surplus. In the light of the fundamental theory of bond premiums it is clear that such procedure is absolutely wrong. It results in a misstatement of profits or net worth and a misrep- resentation as to the actual cost of financing. There are several methods of handling bond premiums and discounts which vary according to the terms of the bond itself, i. e., as to its redemption. It is very often provided that the concern issuing the bonds must redeem a certain number of them each year either at current market price or at a fixed amount above par. Thus a twenty-year $1,000.00 bond may contain the provision 210 Principles of Accounting that it is redeemable or callable in ten years at 105. This means that the holder of the bond must surrender it for $1,050.00 at any time after ten years if he is called upon to do so. If, however, the corporation can buy its own bonds in the open market for less than $1,050.00, it will do so. Assuming that a reserve has been built up for the purpose of buying back bonds at 105, you will find that each purchase in the market at a less price will result in a profit which may very properly be credited to the Interest Account. The accounting treatment of redeem- able and convertible bond issues need not be elaborated here. Eeaders who are interested in this branch of accounting will find an excellent treatise on the subject written by Charles E. Sprague entitled, The Accountancy of Investment. This volume can be obtained at almost any good public library. Only one further point need be considered in connection with bonded indebtedness. Bonds which have been re- purchased may be either held alive in the treasury or cancelled. If the former course is adopted, they will appear on the balance sheets as assets, although many accountants favor showing them in an inside column as deductions from the total bonded indebtedness, extending only the net amount of outstanding bonds into the liability column. BALANCE SHEET All Assets $62,000.00 $62,000.00 Accounts Payable $ 3,000.00 Total Bonds... $40,000.00 Less Bonds in Treasury . . . 8,000.00 Outstanding Bonds 32,000.00 Capital & Surplus 27,000.00 $62,000.00 Liabilities 211 If the bonds are cancelled after having been repurchased, they should no longer appear on the books. The Bond Account should be debited, and Treasury Bonds should be credited for the par value of the cancelled bonds. Apparently the best practice is to reserve the term "treasury bonds " for bonds that have been reacquired either through purchase or through gift. Bonds which have never been issued may, if desired, be recorded in an account entitled "Unissued Bonds, " but on the balance sheet they should not appear as an asset but as a deduc- tion from the total amount of authorized bonds on the liability side, since the best authorities do not consider unissued bonds a real asset. TEST QUESTIONS 1. What are current liabilities? 2. What is the nature of accrued liabilities? 3. What is the best way to treat notes receivable discounted? 4. What is a bond? 5. (a) What is the nature of premium on bonds? (b) What is the nature of discounts on bonds? 6. Are unissued bonds a real asset ? CHAPTER VH PROPRIETORSHIP The primary classification of accounts is into two sub- divisions real and nominal. Real accounts are the asset and liability accounts. Nominal accounts are the proprie- torship accounts. When a business is created, a proprietorship account is also created. For the net worth with which the pro- prietor started in business, represented by the difference between the assets and liabilities, a credit is set up in his account. As expenses are incurred, losses suffered, and profits earned, appropriate debits and credits may con- ceivably be made daily to the original Proprietor's Account. With such a simple system it would be possible to determine the relation between the proprietor and his business at any time by glancing at the balance of his account. To determine the profit or loss during a given period, a comparison could be made of successive balance sheets. Thus, if one balance sheet showed a net proprie- torship credit of $1,000.00 and the one of a year later indicates $1,200.00 as being due the proprietor, it is clear that the condition of the business has improved by $200.00. MIXED ELEMENTS OF PROPRIETORSHIP Just how valuable is this information? It has very little value unless certain other facts are known, namely, the proprietor's withdrawals or additional investments during the year. The profit from operation might have been $500.00 and the withdrawals $300.00, or the loss from 212 Proprietorship 213 operations might have been $100.00 and the additional investment $300.00. Each period the balance of the account represents the net investment, distinguishing in no manner between the original investment of capital, subsequent investments or withdrawals, and operating surplus or deficit. In order to determine the profit or loss of a given period something more than comparative balance sheets is needed. A balance sheet shows the condition of a business at a given moment of time, but it gives no in- formation as to the causes leading up to that condition. Since every transaction resulting in a loss or a gain results ultimately in a debit or credit to the Proprietor's Account, an analysis of that account will supply the miss- ing information. Such an analysis, in proper form, is known as a "profit and loss statement. " * In its most primitive form it is a list of the various proprietorship credits and debits made during a given accounting period, the difference between the total debits and the total credits being the profit or loss. A better form of statement would not list all the items, but would eliminate those referring to withdrawals and investments. In order to do this easily the single original Proprietor's Account may be replaced by four main proprietorship accounts. 1. Capital Investment Account. 2. Surplus or Deficit Account. 3. Profit and Loss Allocation Account. 4. Profit and Loss Account. The Profit and Loss Account must not be confused with the profit and loss statement, since the former is a general i Also spoken of as an income statement, a revenue statement, or a loss and gain statement. Owing to the unsatisfactory condition of accounting terminology, these names are used interchangeably and indiscriminately. 214 Principles of Accounting ledger account and the latter a schedule or exhibit. To the Profit and Loss Account is credited the income of the period, and it is charged with the operating expenses of the period. The balance of the account is the net operating profit (or loss), which is transferred to the Profit and Loss Allocation Account. This account is debited with all the current profits taken from the busi- ness by the proprietor. Its balance represents the profits which are to remain in the business, and is transferred FIG. 51. Chart Showing Primary Subdivision of Proprietorship to the Surplus Account as an additional investment. If this figure should represent a loss, it would be carried to the Surplus Account as a debit, representing a reduc- tion in the investment. Should it happen that the Sur- plus Account had no credit balance, the loss would be charged to the Deficit Account. The Capital Account represents the investment and is credited with the original and all subsequent investments in the business. It may be debited with all withdrawals of capital (not of profits). Under such an arrangement (Figure 51) the profit and Proprietorship 215 loss statement may be constructed from the Profit and Loss Account, since this account represents the income and costs of the accounting period, other factors, such as withdrawals of profits, not being included. It is clear that the total net profit is the significant figure, not the net profit less withdrawals. PROPRIETORSHIP ENTRIES If it is assumed that all proprietorship debits and credits are made direct to one of these four accounts, the question which will immediately arise in any particu- lar case is, " which one shall receive the entry 1" Losses may be roughly divided into two classes capital losses such as are caused by the destruction of property by fire, hurricane, flood, etc., and current expenses which are incurred for the purpose of obtaining an increased income at a later time, such as salaries paid to salesmen, rent, etc. It is clear that these two classes of loss should not be confused. The loss of a capital asset is a misfortune, but it does not necessarily indicate operating inefficiency. If, however, current operating expenses are high as com- pared with current operating income, inefficiency may be the cause. There is no difference between the dollar which comes into the business as the result of the sale of merchandise and the dollar which results from the sale of a fixed asset, but careful distinction must be made between these two classes of income. The first is normal, and the second is abnormal. To lump them together would obscure results and make it impossible to compare the statements of different accounting periods. If, therefore, we restrict the Profit and Loss Account to the booking of current expenses and income only, the profit and loss statements which are prepared from such accounts can be com- 216 Principles of Accounting pared for successive accounting periods. Extraordinary profits, not applicable to any particular accounting period such as might arise from the sale of fixed assets, should not be credited to the Profit and Loss Account at all, but should go direct to the Surplus Account. All expense which is actually applicable to the accounting period may be debited to the Profit and Loss Account, but extraor- dinary losses not consequent upon operation and not applicable to any particular period such as losses by fire, flood, shipwreck, or war, should be debited to the Surplus Account. Such extraordinary losses and gains may be infrequent, but because of their infrequency it would be wrong to lump them with the operating profits and losses for the period. This distinction between capital profits and losses and current profits and losses must be care- fully observed, otherwise no enlightening information can be obtained from a comparison of results for successive accounting periods. SUBSIDIAKY ACCOUNTS To analyze the Profit and Loss Account is a wasteful and unnecessary procedure. The daily changes in pro- prietorship may be entered in temporary subsidiary proprietorship accounts. At the end of each accounting period these accounts will be closed into Profit and Loss. Thus, instead of debiting rent to the Profit and Loss Account whenever rent is paid, it may be debited to a Kent Account, wages may be debited to a Wages Account, salaries to a Salaries Account, heat and light to a Heat and Light Account, etc. It is when such classified expense and income accounts are kept that there is no need for analysis. The balances of these accounts may be used in constructing the profit and loss statement and, at the end of the accounting Proprietorship 217 period, transferred by means of closing journal entries to Profit and Loss, which is now only a summary account. The balance of that account represents the net profit (or loss) for the period. This figure may then be transferred to the Profit and Loss Allocation Account, offsetting any debit entries contained therein due to premature with- drawal of profits. The balance of the Profit and Loss Allocation Account then represents the amount which may be transferred to the Surplus or Deficit Account. THREE CLASSES OF PROPRIETORSHIP With this skeleton plan of classification in mind various forms of proprietorship may be discussed. There are three common forms: 1. The sole proprietor. 2. Co-partners. 3. Stockholders. SOLE PROPRIETORSHIP Sole proprietorship is very common in the small busi- ness. The fruit peddler, the bootblack, and the cobbler may be examples of sole proprietors. Nearly all small grocery stores and butcher shops have but a single owner. PARTNERSHIP The somewhat larger business is more commonly a partnership, involving two or more proprietors. In- sufficient funds often lead the sole proprietor to take another individual to share gains and losses with him. Frequently the partners have an equal investment in the business and share all profits and losses equally. Some- times their investments are unequal, and profits and losses are divided upon an agreed basis. 218 Principles of Accounting "Partnership" has been defined as "the contract relation subsisting between persons who have combined their property, labor, or skill in an enterprise or business as principles, for the purpose of a joint profit." A partnership ordinarily has the following elements: 1. It is a relation created by the agreement of the parties, not by law. 2. Ordinarily each member contributes to the establish- ment of a common fund. 3. It has in view the carrying-on of some lawful busi- ness. 4. Its purpose is the profit of the associates. 5. Each partner has the implied power to bind all other members within the scope of the business. 6. It holds a joint liability to outside parties for all debts and contracts of the firm. This means that any partner may be forced to pay the whole debt of a firm out of his private means. Some very interesting accounting problems arise in connection with partnership, but these will be discussed in a later chapter. The proper accounting procedure in connection with a partnership is to open separate capital, surplus, and drawing accounts for each partner. The net profit or net loss at the end of each accounting period is credited or debited to the Profit and Loss Allocation Account and from there transferred to the partners' drawing accounts in accordance with an agreed-upon ratio. 2 2 In reality partnership accounting is not on a truly scientific basin. While accountants agree as to the desirability of keeping the investment eparate from accumulated profits and losses due to operation, it is found that, in actual practice, nearly all partnerships omit the Profit and Loss Allocation Account, transferring the net profit for the period direct from the Profit and Loss Account to the partners ' drawing accounts. The unwith- Proprietorship 219 In forming a partnership it is usual to draw up an agreement, which is commonly known as the ' t articles of partnership. " A clause is usually incorporated in this document, stating how the partners shall share losses and gains. When no such agreement is in existence or where it does not state the ratio in which the partners shall divide losses and gains, it is a rule of law that they shall be divided equally among all the partners, regardless of the capital invested. COKPORATIONS "A corporation is an artificial being, invisible, in- tangible, and existing only in contemplation of the law." 3 It is composed of persons who are known as ' ' stockholders. " The interest of the stockholders is regarded as divided into equal shares, called "shares of stock. ' ' When a person purchases, or otherwise acquires, an interest in the capital stock, he is spoken of as owning a certain number of shares of stock. These stockholders, however, are not the corporation. A corporation has a name, an individuality, and an existence apart and distinct from its stockholders. It may conduct business, bring actions at law, or make contracts. A corporation carries on its business through officers and agents, and it may even enter into contracts with its stockholders and sue them and be sued by them just as any individual. Corporation accounting represents the most advanced type known. A corporation usually conducts a much drawn portions are then transferred to the partners' capital accounts. For convenience in presenting the subject of proprietorship, it will be assumed that proposed classification is actually in common use. In Chapter IX the subject of partnership will be more fully discussed and actual procedure explained. s The definition of Chief Justice Marshall in the case of the Trustees of Dartmouth College v. Woodward. 220 Principles of Accounting more extensive business than a sole proprietor or a partnership. It controls larger amounts of capital, and its business is more complex. All these things affect the accounting system. Some of the special problems con- nected with corporation accounting will be treated in Chapter X. CORPORATION PROPRIETORSHIP In the corporation, there may be a number of main pro- prietary acounts. The principal one is, of course, Capi- tal Stock. This account is credited with the par value of all shares of stock issued. Its debits, if there be any, are caused by the cancellation of stock. Its balance, therefore, represents the total number of shares of stock outstanding expressed in terms of money, since each share of stock has a par value, 4 usually $100.00. It is clear that a distinction should be made between capital stock and capital. The capital is the sum total of assets owned by the corporation. The capital stock rep- resents the interest which the stockholders have in those assets. The capital stock remains as fixed by legislative sanction, while we have already seen that the value of assets changes due to appreciation, depreciation, profits, and losses. The capital of the corporation and the capi- tal stock of the corporation may be, and usually are, rep- resented by very different figures. The net capital of the corporation, i. e., the total assets less the total outside liabilities, equals the proprietary interest. The proprietary interest may be greater or less than the capital stock, although at the beginning of business it would ordinarily be equal to the capital stock. As time goes on, however, profits may be made, and if * This is a matter of statutes, and some of the states, notably New York, permit the issue of stock without par value. Proprietorship 221 they are not all withdrawn, they serve to increase the proprietary interest. They cannot be credited direct to the Capital Stock Account, since it is fixed in amount. Another proprietary account is, therefore, provided for that purpose. This is known as the "Surplus Account/' and according to best usage it includes only undivided profits which may be declared as dividends. If the venture proves to be a disastrous one and sur- plus having been exhausted, losses are greater than profits, they should be debited to a Deficit Account, the balance of which will appear on the left-hand or debit side of the trial balance. It is not an asset but a negative surplus account, explaining the difference between the assets and the sum of the liabilities plus investment, and it must be taken into combination with the other proprie- torship accounts to determine the net worth of the corpo- ration. Practically never is the net worth of the cor- poration equal to the balance of the Capital Stock Account; therefore nearly every corporation carries either a Surplus or a Deficit Account on its books. In addition to these accounts, there may be other proprie- tary accounts, such as Undivided Profits or Reserves. Undivided profits, as the name implies, represent profits which have not yet been distributed. Undivided profits may be paid out as dividends, may be reserved for con- tingencies, or may be credited to Surplus. A reserve is surplus appropriated for a specific pur- pose. It is often desirable to " earmark " a certain por- tion of the surplus in order that it may not appear available for dividends. Such reserves are usually "set up" to care for contingencies, such as possible losses from bad debts or accidents, such as floods, fires, or ship- wrecks. 222 Principles of Accounting CLASSIFICATION OF NOMINAL ACCOUNTS Every trading business has for its fundamental func- tion the acquisition of goods at one price, having in con- templation the object of selling at a greater price. If a business could be run without any expense, its profit for any period would be equal to the difference between the total sales of merchandise during the period and the total purchase cost of the goods that were sold. No busi- ness ever does operate without expense ; hence the selling price of merchandise must be sufficient to pay for the goods, to pay for the expense incurred in operating and selling, and still leave a profit. If at the end of an accounting period it is discovered that no operation profit has been made, there may be two reasons ; i. e., either the goods cost more than they could be sold for or the ex- penses of the business are too high or both. For that reason it is desirable to show on the profit and loss state- ment separate tables for 1. Trading activities. 2. Expenses. That section of the profit and loss statement which reflects the trading activities is known as the "trading statement." The fundamental structure of the exhibit is simple, consisting of : Sales minus cost of sales equals gross trading profit. The cost of sales, or the cost of goods sold, is arrived at by adding the purchases of merchandise during the accounting period to the inventory of merchandise at the beginning of the period and from the total thus ob- tained, deducting the inventory at the end of the period. The gross profit furnished by the trading statement is Proprietorship 223 the profit before the expenses of the business have been considered. It is a figure which means very little, since it only expresses the relation between sales and cost of sales. According to the strict meaning of the word "profit," its title is a misnomer, but since it is in common use, we may adopt it here. Total Sales $ Inventory beginning of period $ Purchases during period Deduct Inventory end of period Cost of Goods Sold Gross Profit $ The first section of any profit and loss statement is, therefore, one which gives the gross profit, and from this figure must be deducted the expenses, the result being the net operating profit. It is clear that this may not be the total net profit of the business as a whole, since there may be other forms of income than that derived from the sale of goods. Interest may be received, and purchase discounts may be taken. These are both items of income, strictly connected with the business, which cannot be classified as income from sales. Therefore, to the net operating profit (or prime operating profit) is added the other income, and from the resulting total is deducted the sundry income charges, such as interest paid, sales discounts allowed, etc. These are items which must be taken into consideration before the net profit for the period can be obtained, and yet they cannot be classified as either selling, administration, or general expenses. They are often referred to as financial items. 224 Principles of Accounting . EXPENSE CLASSIFICATION The expenses may be classified by the objects of ex- penditure, one group of expense accounts being used for the business as a whole. Such a method of classifying expenses might yield the following subaccounts : Salaries. Wages. Supplies Used. Heat and Light. Rent. Depreciation of Equipment. Sundry Expenses. The chart shown in Figure 52 illustrates graphically the system of proprietorship accounts classified accord- ing to such a plan. The defects of this sort of classification are obvious. Efficiency in operation cannot be obtained when the ac- counts are classified only according to objects of expendi- ture, neglecting the various departmental lines. The manager wishes to know the reasons for high or low expenses. He wants to give credit to the departmental manager who operates on minimum expense and to cen- sure that one whose expenses are too high. Nearly every business is made up of certain broad functions. Thus, in the ordinary trading concern the purely merchandise operations are recorded in the Trad- ing Account, and the expenses naturally classify them- selves under the three heads of 1. Selling. 2. Administration. 3. General. Proprietorship 225 FIG. 52. Chart Showing Classification of Expense Accounts According to Objects of Expenditure 226 Principles of Accounting As subaccounts to Selling Expense, the following might appear : Salaries of Salesmen. Expenses of Salesmen. Advertising Purchased. Shipping Expenses. Telephone, Telegraph, and Postage. Heat and Light for Salesroom. Depreciation of Sales Office Equipment. Miscellaneous Sales Expense. Administration Expenses include all the costs of admin- istration, such as Salaries of Officers. Salaries of Clerical Help. Office Supplies Used. Telephone, Telegraph, and Postage. Heat and Light of Office. Depreciation of Office Equipment. Miscellaneous Expense. > Under the heading of General Expense are included the various items which cannot be classified as items of either sales or administration. Such a classification of expense accounts as this is illustrated in Figure 53. Under this scheme it will be seen that the expense accounts assume a somewhat differ- ent function from that which they assumed when the classification was only by objects of expenditure. The total selling cost as distinguished from the administra- tion expense may be obtained by properly grouping the several subaccounts. The general scheme of classified expense accounts having been developed, the funda- Proprietorship 227 FIG. 53. Chart Showing Common Classification of Expense Accounts 228 Principles of Accounting mental construction of the profit and loss statement may be considered. PKOFIT AND Loss STATEMENT When a trial balance is taken from the General Ledger, the balances of all the classified expense accounts appear SK2LBTOH OP TRADIUO AHD PBOFIT AHD LOSS STATEMENT Trading Sales during period *-.. Inventory beginning of period $ ... Purchases during period ... .. $ .-- Deduct- Inventory end of period ...... Coat of goods sold during period Gross profit for period $ ... Expenses Selling Costs of perlot $.*.... Administration Costs of psriod ...... Total "Selling and Administration Costs _mi~T_ Prime Operating Profit $ ... Financial Other Income of period .._ .. Charges to Income of period Bet Profit for period $ ... FIG. 54. Model Statement Form thereon and are used as a basis for the construction of the profit and loss statement. We have seen that the Profit and Loss Account may have three subaccounts, viz. : Proprietorship 229 Trading Account. Operating Expense Account. Financial Expense and Income Account. It is natural, therefore, that the profit and loss state- ment should follow these general divisional lines: the first section of the profit and loss statement, consisting of the trading items, the second section of the operating expense, and the third section of the financial income and expense items. The skeleton form of a profit and loss statement such as has been explained in the foregoing paragraphs is given in Figure 54. For the present this may be re- garded as a standard form, since all profit and loss state- ments are based upon this fundamental plan. Sales during the period are the net sales after all re- turns of merchandise by customers have been deducted. It is sometimes desirable to show the gross sales for the period and the net sales in order that the amount of cus- tomers ' returns may be compared for consecutive periods. As a subaccount to the Trading Account there may be carried a Returned Sales Account. Instead of charging Sales and crediting Accounts Receivable for returned goods, the entry may be Keturned Sales $ Accounts Receivable $ For merchandise returned by customers On the trading statement the balance of returned sales will be deducted from gross sales to obtain the figure rep- resenting net sales. Guided by the skeleton form of the profit and loss state- ment in Figure 54, we may construct a model profit and 230 Principles of Accounting loss statement (Figure 55) in detail form from the follow- ing trial balance accounts : SECTION OF BLANK COMPANY'S TRIAL BALANCE DECEMBER 31, 191 Debit Credit Total Sales $133,300.00 Returned Sales and Allowances $ 200.00 Purchases 73,000.00 Inventory of Merchandise, Jan. 1, 191 15,000.00 Salaries Sales Dept 7,000.00 " Advertising Dept ... 4,800.00 " General Office 11,500.00 Traveling Expense Sales Dept 3,000.00 Telephone, Telegrams, and Postage Sales Dept 700.00 Telephone, Telegrams, and Postage Advertising Dept 450.00 Telephone, Telegrams, and Postage General Office.. 1,500.00 Depreciation Sales Office Equipment 200.00 ' * Advertising Office Equipment. ... 350.00 " General Office Equipment 500.00 Shipping Expense 1,500.00 Light and Heat Sales Dept 700.00 " " " Advertising Dept 500.00 " " " General Office ;... 2,500.00 Miscellaneous Sales Dept. Expense 500.00 ' ' Advertising Dept. Expense 300.00 ' ' General Office 1,500.00 Advertising Purchased 10,000.00 Supplies Used General Office 2,500.00 Purchase Discounts 200.00 Interest Received 300.00 Miscellaneous Income 100.00 Insurance 800.00 Taxes 700.00 Interest Paid 100.00 Sales Discounts 200.00 Bad Debts 300.00 Surplus Adjustment Account 1,800.00 Surplus, Jan. 1, 191. 85,000.00 Note. The Merchandise Inventory Dec. 31, 191, equals $14,000.00. Proprietorship 231 MODEL ttCOIIE AHD PROFIT AMD LOSS STATEMBHT ~ BLABZ COJIPAIY Year Ending December 31, 191_ Tradlag Total Sales ................... .......................... $133,500.00 DeductReturned Sales and Allowance* . ................. 200.00 Gross Income ........................................ ............ $133 , 100 .00 Inventory of Merchandise, Jan.l,191_ ...................... $15,000.00 Purchases during period ........... 7 ............... . ..... .-73.000.00 Deduct Inventory of Merchandise, Dec. 31, 191 14_.OOO.OQ Cost of Goods Sold ..... ............... 77 ........................ Gross Profit . ........................ ... ................... ? 59,100.00 Selling Costs Salaries ........................................ $ 7,000.00 Traveling Expense ................................ 3,000.00 Telephones, Telegrams, and Postage ............... 700.00 DepreciationSales Office Equipment ....... ...... 200.00 Shipping Expense ............................ ..... 1,500.00 Light and Heat--Sales ............................ 700.00 MiscellaneousSales ............................. 500.00 Aivertising Purchased ............................ 10,000.00 Advertising Dept. Salaries ....................... 4,800.00 Advertising Telephones, Telegrams, and Postage .... 450.00 Depreciation Advertising Office Equipment ....... 350.00 Light and Heat- -Advert! sing ...................... 500.00 Miscellaneous Advertising ....................... 500.00 Total Selling Cost ......................... .......... $30,000.00- Administration Costs SalariesGeneral Office ......................... $11 ,500.00 Supplies General Office ......................... 2,600.00 Postage, Telephones, and TelegramsGeneral Office 1,500.00 Light and Heat General Office .................... 2,500.00 DepreciationOffice Equipment .................... 500.00 Miscellaneous General Office Expense ......... . . . 1 , 500 . 00 Total Administration Costs ........................... .20,000.00 Total Selling and Administration Costa ............................. 50.000.00, Prime Operating Profit ..................................... | 9,100.00 Other Income Purchase Discounts ............................................ $200.00 Interest Received ............................................. 300.00 Mlstellaneous ................................................. 100. PC Total Other Income ................ ........ ... .......... 600.00 $9,700.00 Charges to Income Sales Discounts ...................................... ,....,. $200.00 Interest Paid ............................................. . . 100.00 Insurance ............................... ..... ................. 800.00 Taxes ................................... .................... 700.00 Bad Debts ................................................... 300.00 Total Charges to Income ................................ - 2.100.00 Net Profit for Year ....... . ................................ .$7,600.00 Surplus Balance Sheet Surplus, Jan. 1,191 ........... ................ $65,000.00 Deduct Debit Balance of Surplus~AdJuatment Account ......... . 1.800,00 ^ 2QQ ^ Balance Sheet Surplus, De.31,191_ ............... ,-..i .................. .$90,800.00 FIG. 55. Statement for a Merchandising Organization 232 Principles of Accounting It will be noted that the company whose profit and loss statement is given in Figure 55 purchases all the merchandise which it later resells at a profit. Let us MODEL INCOME AND PROFIT AM) IOSS STATEMENT BLANK COfflPAH* Year Ending Dec. 31, 191_ Trading Total Sales |133 ,500.00 Deduct --Re turned Sales and Allowances 200 .00 Oroes Income $133 , 100 .00 Inventory of Merchandise, Jan.l, 191 ., $ 15,000.00 Goods Manufactured during period ...7 75.000.00 Deduct Inventory of Merchandise, Dec. 31, 191_ , 14 ! OOP.'" Cost of Goods Sold 74.000.00 OrosB Profit I 5ft.l66.66 Selling Coats Salaries ~ f 7,000.00 Traveling Expense Telephones, Telegrams, and Postage DepreciationSales Office Equipment Shipping Expense Light and HeatSales MiscellaneousSales Advertising Purchased Advertising Dept . Salaries AdvertisingTelephones, Telegrams , and Postage Depreciation Advertising Office Equipment ... Mght and HeatAdvertising MiscellaneousAdvertising Total Selling Cost 777777777. f 30,000.00 Administration Costs SalariesGeneral Office Supplies --General Office Postage, Telephones, Telegrams --General Office Light and Heat General Office DepreciationOffice Equipment Miscellaneous General Office Expense Total Administration Costs 20.000.00 Total Selling and Administration Costs ~ 6Q.QOO.OO Prime Operating Profit $ 9,166.60 Other Income Purchase Discounts ,. $200.00 Interest Received 300.00 Miscellaneous _100.00 Total Other Income " ~ 600.00 $ 9,700.00 Charges to Income inv. re BV Surplus FIG. 56. Statement for a Manufacturing Organization Compare with Fig. 55. suppose that instead of purchasing the goods it acquired the factory which made them. The two organizations would then be separate units under one ownership. The factory would make the goods, and the wholesale house Proprietorship 233 would handle them. The only difference that would nec- essarily be made in the profit and loss statement would be to change the trading section, eliminating the word " purchases " and substituting " goods manufactured." This revised statement is shown in Figure 56. MAITLTFACTURING STATEMENT The managers and owners would, doubtless, be inter- ested in knowing the detailed costs of producing the Production Coat* Inventory of Raw Materials, Jan. 1,191 $ 9,000.00 Purchases, Including In-Freight T. 41.OQO.oo f50.o6o.00 Deduct-- Inventory, Deo. 31, 191 10 .OOP. 00 Materials Put In Process 7. :.$40 ,000.00 Inventory of Supplies, Jan. 1,191 190.00 Purchases, Including In-Freight" 1,320.00 $1,510.00 DeductInventory, Dec .31, 191 210.00 Supplies Dsed ~ 777777777 1,300.00 Productive Labor 17.700.00 Prime Cost : $59,000.00 Ron -Productive Labor $2 ,400.00 Salaries, Chargeable to Factory 2,200.00 Power 2,100.00 Light and Heat. Chargeable to Factory 1,500.00 Depreciation- -Machinery 500.00 Repairs and Maintenance-- Machinery 950.00 Depreciation- -Bui ldlngs... 400.00 Repairs and Maintenance Buildings 800.00 DepreciationFactory Office Equipment 150.00 Miscellaneous 1. OOP. CO Fac tory Expense Cost of Manufacturing Inventory of Work in Process, Jan. 1, 191_ $8,000.00 Deduct-. Inventory of Work In Process, Deo .31, 191 6.000.00 2.000.00 Cost of Goods Manufactured 7.... ~" ~~ |73,000.00 FIG. 57. Manufacturing Statement Compare with Pig. 56. goods. This would amount to an analysis of the item, " goods manufactured during the period, $73,000.00. ' ' Such an analysis could take the form of a supplementary statement as shown in Figure 57. This supplementary statement shows in great detail the cost of manufactur- ing the goods which were turned over to the wholesale department for selling. It might be desired to incorporate this information in the profit and loss statement itself, and this could easily be done by striking out the item " goods manufactured 234 Principles of Accounting MAITOPACTURIHO, TRADIMO, AHD PROFIT AND LOSS STATEMENT- -BUSK COKPAHI Year Ending Dc.51, 191_ l Sales .. $133,300.00 $155,100.00 Inventory of Merchandl Inventory of Raw Material Purchases of~Raw*Material8, .41.000.00 JBO.000.00 Deduct Inventory of Ra n x Purchases of Supplies, JM.l. 191_ |40(000t00 : ...... * 1.320.00 Deduct- -Invent OPT of Supplies. Dec.31.191_ .. 210.00 Supplies Used 1.30O.OO Productive Laber 17.700.OQ Prime Cost $59,000.00 Non-Productlve Labor t 2,400.OO Salaries, Chargeable to Factory 2 ,200.00 Light and'Heatl'chargeabie'to'Faotory. 1)500. 00 Depreciation Machinery 500.00 Repairs and Maintenance Machinery ... 950.00 DepreciationBuildings 400.00 Repairs and Malntenence Buildings ... 600.00 Depreciation Factory Office Equipment 150.00 Miscellaneous 1.000.00 Factory Expense , 13,000. Cost of Manufacturing ,... Inventory of Work In Process, Jan 1,191_ $8,000.00 Deduct -Inventory of Work In Process, Deo .31, 191 C.000.00 AddDecrease ln~Inventory Cost of Goods Manufactured , ...; 73.000.00 | 88.000.00 Deduct --Inventory of Merchandise, Dec. 31, 191 14.OOO.OO Cost of Goods Sold ~ ;.' Gross Profit $ Selling Coeta Salaries | 7 ,000.00 Traveling Expense 3,000.00 Telephones, Telegrams, and Postage 700.00 Depreciation Sales Office Equipment , 200.00 Shipping Expense 1,600.00 Light and Heat Sales 700.00 MiscellaneousSales 500. OO Advertising Purchased 10,000.00 Advertising Dept-Sal Advertising, Telephone Depreciation of Advert Light and Heat Advert Miscellaneous Advert 1 Ing 4,800.00 450.00 350.00 600.00 Total Selling Cos Administration Coats Salaries General Office SuppliesGeneral Office Postage, Telephones, ana TelegramsGeneral. Of flee Light and Heat Qeneral Office Depreciation Off toe Equipment Miscellaneous --General Office Expense Total Administration Costs Total Selling and Administration Cost* Prime Operating Profit Other Income Purchase Discounts Interest Received . Mlecellaneou ~ Total Other Income Charges to Income Sales Discounts ~ Interest Paid Insurance Taxes Bad Debts Total Charges to Income Met Profit for t Surplus Balance Sheet Surplus, Jar .$11,500.00 2,600.00 1,600.00 2,600.00 600.00 1.800.00 Year $200.00 300.00 100.00 $200.00 100.00 800.00 700.00 300.00 $85,000.00 DeductDebit Balance of Surplus Adjust Balance Sheet Surplus, Dec. SI, 191_ Account .................. l.SOO.OO Fro. 58. Complete Statement for Manufacturing Organization Compare with Figs. 56 and 57. Proprietorship 235 MOrif AM) LOSS 3TATSGNT BLABS COUP1XT Year Ending December 31. m_ Inventory of Raw Material, Jan.l. 191_ Purchases Inventory of Raw Material Dec. 31. 191_ Supplies Used Productive Labor Prlne Cost Bon-productlve Labor Pectory Salaries Power Light and Heat-P-actory pep.& Halnt. -Machinery Depreciation-Buildings Rep.i llalnt. -Buildings Depreclatlon-Offlte Equip. Mlacellaneoua Cost of Manufacturing Inventories, Jan.l, 191_ Work In Process Finished Goods Orosa Profit (red) Salaries (Sales) Traveling Expense (Sales) Tel. .Tel..* Postage (Sales) Depreciation-Office Equip. (Sales).. Light and Heat (Sales) Miscellaneous Oalos) Shipping ?btpenae Advertising Purchased Salaries (Adv.) Tel., Tel.,* Poatage (Adv.) Depreciation- Of floe Equip. (Adv.) Light and Heat (Adv.) Miscellaneous (Adv.) Selling Cost Administration Salaries Supplies Tel.. Tel.. 4 Poatage Light and Heat Depreoiatlon-0ffie Eoui Miscellaneous Administration Cost Operating Profit (red) 117.000.00 3.000.00 700.00 00.00 700.00 500.00 1.500.00 10.000.00 4.800.00 460.00 350.00 SOO.OO _ 300, 00_ til. 500. 00 2,500.00 1.500.00 .500.00 500.00 1. SOO.OO Taxes Bad Debts Charges to Income Met Profit for year (red> Surplus Adjustments Surplus, Deo. 31, 191 9 200.00 100.00 600.00 700.00 300.00 Total Sales Deduot-Retum & Allowance Gross Income Inventories. Iieo 31, 191_ Work in Process rial abed Qoode Gross Profit Operating Profit Purchase Discounts Interest Received Miscellaneous Other Inoon Ht Profit for yer Surplus, tea 1. 191 $800.00 300.00 100.00 FIG. 59. Statement for Manufacturing Organization in Account Form 236 Principles of Accounting MODEL MABOFACTURIIIO.TRADIIO.AKD PROFIT AND LOSS STATEMENT --BLASK COMPAFT Tear Ending December 31, 191_ Gross Income Total Sales $133,300.00 Deduct- -Returned Sales and Allowance* 200.00 Oross Income 7777777777. $133, 100. Production Costs Inventory of Raw Materials, Jan.l, 191 $9,000.00 Purchases, Including In-Freight Deduct- -Inventory, Deo. 31, 191 ................... 10.000.00 Materials Put In Process ---- 77 ............................... $40,000.00 Inventory of Supplies, Jan.l,ll_ ................ $ 190.00 Purchases Including In-Freight ...... . .............. 1,320.00 1,510.00 DeductInventory, Dec. 31, 191 _ ................... 210.00 Supplies Used ................................................ 1,300.00 Productive Labor ..... ........................................ 17.700.00 Prlae Cost ........................................................ $69,040,00 Non- Productive Labor Salaries Chargeable to Factory Powe Light and Heat Chargeable to Factory Depreciation- -Machinery Repairs and Maintenance Machinery DepreciationBuildings Repa Depreciation Factory Office Equlpne Misc ngs ulpn $2,400.00 2,209.00 2,100.00 1,500.00 500.00 950.00 400.00 800.00 150.00 1.000. 00 Patory Expanse .................................................. 12.000.00 Cost of Manufacturing .................................... $71,000.00 Inventory of Work In Process, Jan.l.m^ .......... 48.000.00 Oeduct--inv<,rn.ory or ork In Process, Dec. 31, 191 .. 6^000.00 $2,000.00 Inventory of Finished Ooode, Jan. 1,191 ...... 77. . .$l76oo.OO" Deduct Inventory of Finished Goods, De~31,191_ . . .14.000.00 1,000.00 Cost to Produce Goods 'sold' ','.'.'.'. '.'.'.'.'.'.','.'.'.'.'.'.'.'. Gross Profit ............................................... Selling Cost* Salaries ................................................. J 7,000. 00 Traveling Expense ......................................... 3,000.00 ,. Telephones, Telegrams, and Postage . - .......... . ........... 700.00 DepreciationSales Office Equipment ..................... 200.00 Shipping Expense Light and HeatSales MiscellaneousSales Advertising Purchased Advertising Dept. Sala AdvertisingTelephones, Telegrams, and Postage , , Bepreclatlon--Advertlslng Office Equ Light and HeatAdvertisin Miscellaneous Advertising Total Selling Cost ipment 1,800.00 700.00 500.00 10 OOO.OO 4,800.00 450.00 350.00 800.00 300.OO - $30 000 00 AOmistratlon Costs SalariesGeneral Office ............................. $11 500 00 SuppliesGeneral Office .................................. 2, 500. CO Postage, Telephones and Telegrams General Office ........... 1,500.00 Light and float General Office ...... , ........ . .......... . .. 2,BOO.OO DepreciationOffice Equipment ............................ 60O.OO Miscellaneous General Office Expense 1 . ...... . ........... 1.500.00 Total Administration Costs ........................ 7 ~ 2000000 Total Selling and Administration Coato " ! Prime Operating Profit ............................................. , Other Incorce Purchase Discounts ................................................... $ 200. OO Interest Received .................. ; ............................. 300 OO Miscellaneous ................... . ...................... . . Total Other Incomes .............. .......... .. ..... '.. .... .... '.. . . .'. ...... Charges to Income Sales Discounts ...................................................... ..$200.00 Interest Paid ......................................................... 100.00 Tates 8 ??:.:::::::::::::::: Bad Debts Total Charges to Inooae ... Bet Profit for the Year ................ .....i. ........... '.'.'.'. Surplus Balance Sheet Surplus, Jan. 1,101 ............... $86 000 00 Deduct-Deblt Balance of Surplua~Aaju.ti.ent aeoouat' . ,[.'.. '. . '...'/.'.'.'. llsooioo Balance Sheet Surpl FIG. 60. Statement for Manufacturing Organization in Somewhat Different Form Proprietorship 237 during the period, $73,000.00," and putting in its place this entire manufacturing statement. (See Figure 58.) The reader should note that Figures 56 and 58 are the same except that one item, "goods' manufactured during the period," has been expanded so as to show the details composing it. Such a statement as the latter is known as a "manufacturing, trading, and profit and loss state- ment." Very often such a statement does not look at all like the simple forms heretofore illustrated, but they are exactly the same in their fundamental structure. A company that buys its goods is not interested in the cost of their production, but when it manufactures them, it should incorporate in the profit and loss statement a detailed statement of production costs. There are other standard forms of presenting such statements. Figures 59 and 60 show other arrangements of the same data which we have been using. The report form (Figures 58 and 60) is somewhat preferred because it can be typewritten more easily than the account form. Furthermore, it has the advantage of being more easily understood by the layman. BALANCE SHEET AND PROFIT AND Loss STATEMENT The profit and loss statement is equal in importance to the balance sheet. The latter is a snapshot of the assets, liabilities, and proprietorship of a business at a definite instant of time. The former shows the causes which have led up to that condition and bridges the gap between two successive balance sheets. The two exhibits are always considered together, and they form the two goals of the accountant. The one without the other is incomplete. The balance sheet shows the condition of the business and reveals its solvency, but it does not show its profit- making ability. The profit and loss statement shows the 238 Principles of Accounting current profits and may show the functional efficiency of the business, but it does not show its condition at any definite time. THE FUNCTIONAL. IDEA We have seen that a profit and loss statement whether in account form or in report form generally starts with " gross earnings from sales/' This amount should in- clude only the income resulting from direct operation. A dry goods firm might make total sales of a million dol- lars and might have an additional income of $200,000.00 from stocks and bonds which it owned. In the profit and loss statement, the income from its investments should not be merged with the figure representing gross sales. Here we have the functional idea very clearly illustrated. A house which has income from sales of merchandise and income from investments is engaged in two lines of busi- ness instead of one. The profits from its trading activi- ties should not be confused with the profits from its investments, otherwise the results of all activities would be obscured. This principle of "keeping separate" the various classes of income and expense is of fundamental importance. One engaged in two different lines of busi- ness will desire to know the results of each of those lines independently. If he gets only a lump sum representing profit or loss in his total activities, he cannot know which business is profitable and which business is causing him a loss. An excellent illustration of this principle of "keeping separate " occurs in dairy farming. Until very recently the ordinary farmer was content to know whether his herd of cows as a whole gave him satisfactory returns. When the era of scientific farming began, it was discov- ered that a great difference exists between individual Proprietorship 239 cows. The dairy farmer today keeps a record for each cow. He charges each with her total costs and credits her for the total value of milk produced, and when he finds that the animal is not up to high standard, he dis- poses of her, the result being that his herd produces a very much greater total profit than under the old system. This same principle of efficiency has been applied in busi- ness for many years. A man engaged in two, three, or four lines of business figures their expenses and profits separately. MODEL FORM OF STATEMENT Mr. A. Lowes Dickinson, a prominent certified public accountant, submitted the following model form of profit and loss statement to the St. Louis Congress of Account- ants in 1904 : Gross Earnings From Sales $ Less Returns, Allowances, and Discount Net Earnings from Sales $ . Deduct Cost of Production or Service Gross Profit $. Deduct Cost of Selling $ Expenses of Management Net Profit from Operations $ . Net Profit from Operations $ Other Income $ . Deduct Interest on Bonds $ Other Fixed Charges Surplus for Year $ . Extraordinary Profits (detailed) Surplus Brought Forward from preceding year $. 240 Principles of Accounting 1 Deduct Extraordinary Charges Total Surplus Available, Dividends on Stocks . . Surplus Carried Forward $. This form has been rather generally adopted by accountants, although individual variations are only to be expected. While not absolutely necessary, it is always desirable to reconcile the figure representing net profits for a period with the surplus as shown by the balance sheet of the same period. This surplus figure will be fully accounted for in this way. The proper method of handling such a reconciliation on the profit and loss state- ment is to append a supplementary section, as has been shown in the previous illustrations. TKADING ACCOUNT There are many widely different opinions as to just what items should be included in the trading section of the profit and loss statement. Authorities differ on this subject more than on any other. Professor Henry Rand Hatfield's standard work, Modern Accounting, speaks of the Trading Account as follows: "Ignoring variations and mere detail, two divergent customs are found. One includes in the Trading Account all the expenses con- nected with trafficking as distinct from the general ex- penses of management the second and more rigid method excludes from the Trading Account all items ex- cept those representing the direct cost price and the net selling price of the goods handled ; the balance then car- ried down is generally called gross trading profits. ' ' Dr. Joseph J. Klein in his book on accounting includes all selling expenses in the trading sections of his profit Proprietorship 241 MICHIGAN MANUFACTURING COMPANY MANUFACTURING, TRADING, AND PROFIT AND LOSS STATEMENT Year ending May 31. 1910 Income from Sales Total Sales $187.540.38 Cost of Goods Sold Prime Cost of Goods Finished during period Inventory Manufacturing Materials, June 1, 1909 $ 27,214.41 Add Purchases 106,634.12 Freight. Express & Cartage "In" 1,734.70 $135,583.23 Deduct Inventory of Manufacturing Materials, May 31, 1910 51,358.58 $ 84,224.65 Purchases Manufacturing Supplies- $ 1,631.09 Less Inventory of Manufacturing Supplies 200.00 1,431.09 Production Labor.... 63.842.23 Total Prime Cost $149,497.97 Factory Expense Non-Productive Labor $ 1,993.50 Depreciation Machinery and Equipment 1,234.49 Repairs to Machinery 507.73 Fuel Purchased $ 5,554.82 Deduct Inventory, Alay 31, 1910 2,188.40 3,366.42 Insurance Expired 2,152.14 Water Tax 140.53 $ 9,394.81 Total Manufacturing Cost for period $158,892.78 Deduct Inventory of Goods in Process, May 31, 1910 1,820.00 Manufacturing Cost of Goods Finished $157,072.78 Deduct inventory of Finished Goods 3,210.00 Manufacturing Cost of Goods Sold $153,862.78 153,862.78 Gross Profit $ 33,677.60 Selling Expense Advertising $ 378.58 Administrative Expense Salaries $ 6.170.00 Stationery and Office Supplies 296.02 Miscellaneous Office Expense 241.08 Postage .'. 264.42 $ 6.9.71.52 General Expense Stable Expenses $ 1,679.89 Total Selling, Administrative, and General Expense $ 9,029.99 9.029.99 $ 24.647.61 Additional Income Miscellaneous Earnings $ 724.75 Purchase Discounts 2,081.59 Interest Earned 463.17 Total Additional Income $ 3,269.51 3,269.51 Total $ 27,917.12 Deductions from Income Taxes $ 376.75 Bad Debts 9,128.11 Interest Paid 3,521.63 Sales Discounts 3,362.19 Total Deductions from Income $ 16,388.68 16,388.158 Net Profit for year ending May 31. 1910 $ 11,528.44 Undivided Profits as per Balance Sheet 11,528.44 FIG. 61. Illustration of the Profit and Loss Statement for the Problem Discussed in Chapter IV, pages 134 to 141 Compare with Fig. 44. 242 Principles of Accounting and loss statements. Professor Wm. Morse Cole's Accounts, Their Construction and Interpretation, does not follow any of the ordinary accounting practices. What most accountants would call the Trading Account, he designates as "Merchandise Account, ;> and in the Trading Account includes items of rent, wages, insurance, depreciation, advertising, losses from bad debts, and general expenses. In spite of the divergent opinions of certain eminent authorities, it would seem that the majority of account- ants favor the practice of including in the trading state- ment only those items representing the cost price and the net selling price of the goods sold. TREATMENT OF ERRORS If errors should be made in an accounting period and certain items of income or expense should not be discov- ered until after the books had been closed, they should not be considered as the income or expense of the subse- quent period. The reason for this is clear. Each accounting period must stand alone. A profit and loss statement for one period should include all income ap- plicable to that period and all expenses for which that period is responsible. If the income or expense of one period is treated as the income and expense of a subse- quent period, the results of both accounting periods will be wrong. The profits for one period will be understated and for the other period overstated by the same amount, and should the error involve a substantial sum, no just comparison can be made between the two periods. Should such omissions and errors be detected, the cor- rections should be made by means of charges or credits to the Surplus Account. If a $100.00 item of expense for one period is omitted, the profits for that period will be Proprietorship 243 overstated and the final credit to the Surplus Account will be too large by $100.00. When the error is discov- ered, the correction should be made to the account in which the error is reflected the Surplus Account. Even the best bookkeepers make such errors, and where they are likely to prove numerous, it is considered good prac- tice to open up a Surplus Adjustment Account, in which such correcting entries are assembled. The balance of the Surplus Adjustment Account is then transferred to the Surplus Account as one item. This prevents the Sur- plus Account, which is an important one, from being loaded up with a number of minor adjustments. MATEKIALS AND SUPPLIES In a profit and loss statement it is customary to show the starting inventory, the net purchases, and the final inventory in order to arrive at the cost of materials and supplies used. This form is universally employed be- cause of its clearness. Where the Purchase Account is not kept, being replaced by a Materials Account a con- trolling account over perpetual inventory records it is necessary to restate the Materials Account in order to obtain the figures for the profit and loss statement. In a perpetual inventory system the controlling account is charged with purchases at cost and is credited with withdrawals of materials at cost. The balance of such an account is equivalent at all times to materials actually on hand. Figures 62 and 63 show the Eaw Materials Account and the Supplies Account of the Blank Company. Postings are made to these accounts, in monthly totals, from the voucher register and the requisition journal. A comparison of the profit and loss figures shown in Illustration 58 with these two accounts, will indicate the 244 Principles of Accounting (V d K Q o v Q 03 V S*^ 3 a.2 ? |S fe lill 5 390 Principles of Accounting EXHIBIT A STATEMENT OF TRUSTEE J s TRADING For the Period Ending December 31, 1914 Total Sales $21,350.00 Merchandise Inventory, Jan. 1, 1914 $ 4,220.18 Merchandise Purchases 10,000.00 $14,220.18 Less Merchandise Inventory, Jan. 1, 1915 5,600.00 8,620.18 Gross Profit $12,729.82 Salaries $ 1,000.00 Interest on Mortgages (5%% on $21,000.00) 1,155.00 Office Expenses 800.00 2,955.00 Net Profit $ 9,774.82 EXHIBIT B STATEMENT OP TRUSTEE 's CASH EECEIPTS AND DISBURSEMENTS Presented January 1, 1915 1914 Jan. 1 On Hand $ 1,006.50 Sales 21,350.00 Accounts Eeceiv- able 3,950.00 Notes Eeceivable 8,000.00 $34,306.50 1915 Jan. 1 Balance $1,836,50 1914 Purchases $10,000.00 Payment to Bank 3,000.00 Notes Payable.. 6,000.00 Accounts Paya- ble 5,000.00 Taxes 315.00 Interest on Mort- gages 1,155.00 Salaries 1,000.00 Office Expenses. 800.00 Legal Fees 1,200.00 Trustee 's Com- missions 2,000.00 Withdrawals ... 2,000.00 Dec. 31 Balance 1,836.50 $34,306.50 Special Forms of Statements 391 COMPARATIVE BALANCE SHEETS OF ROBINSON AND HABT Increases Assets Jan. 1, 1914 Jan. 1, 1915 and Decreases Cash $ 1.006.50 $ 1,836.50 $ 830.00 Notes Receivable 8.000.00 8,000.00 Accounts Receivable 5,000.00 5,000*00 Merchandise 4.220.18 5.600.00 1,379.82 Plant 16,000.00 16,000.00 Real Estate 10.000.00 10,000.00 Total Assets .$44.226.68 $33,436.50 10,790.18 Liabilities Accounts Payable $10,000.00 $ 5,000.00 5,000.00 Notes Payable 6.000.00 6,000.00 Mortgage on Real Estate 8,000.00 8,000.00 Mortgage on Plant 13,000.00 13,000.00 Taxes 315.00 S15.00 $37.315.00 Additional Liability Discovered 3,000.00 S.000.00 Total Liabilities .S40.3ir>.no S2r>.000.00 14,315.00 Net Worth Robinson Capital $ 3,455.84 Less % of Additional Liability Discovered.. 1.500.00 Robinson Capital, Jan. 1, 1914 .$ 1,955.84 $ 1,955.84 Add % of Profits (% of $5,524.82) 2.762.41 $ 4,718.25 Less Withdrawal 1,000.00 Robinson Capital, Jan. 1, 1915 $ 3.718.25 Hart Capital $ 3,455.84 Less % of Additional Liability Discovered.. 1,500.00 Hart Capital, Jan. 1, 1914 .$ 1.955.84 $ 1,955.84 Add % of Profits ( % of $5,524.82) 2,762.41 $ 4,718.25 Less Withdrawal 1,000.00 Hart Capital, Jan. 1, 1915 $ 3.718.25 Summary Total Assets $44,226.68 $33,436.50 Total Liabilities 40,315.00 26,000.00 Net Worth .$ 3.911.68 $ 7.436.50 Represented by Robinson Capital $ 1,955.84 $ 3,718.25 Hart Capital 1,955.84 3,718.25 $ 3,911.68 $ 7,436.50 392 Principles of Accounting EXHIBIT c Loss on Eealization (Accts. Bee.) $1,050.00 Expenses and Fees 3,200.00 Net Profit (as per Kealiza- t i o n and Liquidation Statement 5,524.82 $9,774.82 Profit on Trustee 'a Trading as per Exhibit A $9,774.82 $9,774.82 Net Profit as per Balance Sheet $5,524.82 COMMENTS ON THE SOLUTION This problem is a very fair illustration of the type of problems which are required by C. P. A. examiners. In the solution it will be noted that cash on hand was in- cluded on both sides of the account, although this was not necessary. The treatment of the notes receivable discounted is worthy of some comment. It is assumed in the solution that the $3,000.00 loss is discovered by the receiver. This loss forms a real liability, since it must be paid to the bank. The Notes Eeceivable Account might be swelled by the $3,000.00 worth of bad notes, which were returned by the bank, and then this $3,000.00 wiped off in realization. This method would be perfectly proper, although the solution, as given, seems a little clearer. The treatment of the supplementary charges and supplementary credits will be immediately under- stood upon examination of the statement. Another solution of this problem in a somewhat dif- ferent form is shown herewith, it being thought desirable to indicate at least two of the standard methods of preparing such exhibits. Special Forms of Statements 393 EXHIBIT A STATEMENT OF KEALIZATION AND LIQUIDATION BY TRUSTEE FOE THE FIEM OP EOBINSON AND HART January 1, 1915 Assets to be Kealized Cash $ 1,006.50 Notes Eeceivable $18,000,00 Less N o t e s Eeceivable Dis- counted 10,000.00 8,000.00 Accounts Eeceivable 5,000.00 Merchandise 4,220.18 Plant 16,000.00 Eeal Estate 10,000.00 $44,226.68 Assets Eealized Cash $ 1,006.50 Notes Eeceivable 8,000.00 Accounts Eeeeivable 3,950.00 $12,956.50 Assets not Eealized Merchandise $ 4,220.18 Plant 16,000.00 Eeal Estate 10,000.00 30,220.18 43,176.68 Loss on Eealization of Assets $ 1,050.00 Liabilities to be Liquidated Notes Payable $ 6,000.00 Accounts Payable 10,000.00 Mortgages on Eeal Estate 8,000.00 Mortgages on Plant 13,000.00 Taxes 315.00 $37,315.00 Liability Discovered (Notes Eeceiv- able Discounted) 3,000.00 $40,315.00 Liabilities Liquidated Notes Payable $ 6,000.00 Accounts Payable 5,000.00 Notes Eeceivable Dis- counted 3,000.00 Taxes 315.00 $14,315.00 394 Principles of Accounting Liabilities not Liquidated Accounts Payable $ 5,000.00 Mortgage on Keal Estate 8,000.00 Mortgage on Plant 13,000.00 26,000.00 40,315.00 Gain on Liquidation None $ 1,050.00 Expenses and Fees of Trusteeship Legal Fees $ 1,200.00 Trustee 's Commission 2jOOO.OO 3,200.00 Total Loss on Eealization and Liquidation $ 4,250.00 (Transferred to Summary) EXHIBIT B TRUSTEE'S TRADING AND PROFIT AND Loss STATEMENT For the Year Ending December 31, 1914 Total Sales (for cash) $21,350.00 Inventory of Merchandise, Jan. 1, 1914 $ 4,220.18 Add Merchandise Purchases 10,000.00 $14,220.18 Deduct Inventory of Merchandise, Dee. 31, 1914. . 5,600.00 Cost of Goods Sold 8,620.18 Gross Profit $12,729.82 Deduct Expenses Salaries .$ 1,000.00 Interest on Mortgages 1,155.00 Office Expense 800.00 2,955.00 Net Profit (Transferred to Summary) $ 9,774.82 EXHIBIT C TRUSTEE'S SUMMARY STATEMENT Net Profit (from Exhibit B) $9,774.82 Loss on Eealization and Liquidation (from Exhibit A) 4,250.00 Amount Creditable to Partner's Capital Accounts $5,524.82 Special Forms of Statements 395 Whatever metho.d of solving such problems is used, the exhibit is not complete without a statement of the trustee's cash receipts and disbursements and a state- ment of the resources and liabilities at the time of his discharge. The preparation of these is a simple matter, since all the data are contained in the problem itself and all that is needed is a careful picking-out of the items. It will be noted that all these statements " support" one another, so that an error may not be made in one schedule without being caught by some of the others. It is always a good idea to present the final resources and liabilities in comparative form, although the ordinary account form would be proper. It is always of interest to compare the statements just before and just after the trusteeship, and the comparative form showing the in- creases and decreases of the various items would prove most illuminating. TEST QUESTIONS 1. (a) What is a statement of affairs? (b) What is its purpose? (c) For whom and by whom is it prepared? 2. (a) What is a deficiency account? (b) What relation does it bear to the statement of affairs? 3. (a) What is a statement of realization and liquidation? (b) What relation does it bear to the statement of affairs and the deficiency account?' (c) How is it constructed ? (d) For whom is it constructed? CHAPTER XIV THE HOLDING COMPANY AND THE CONSOLIDATED BALANCE SHEET During recent years a new form of organization has been developed, bringing with it accounting problems of importance. This organization is what is familiarly known as a "trust" or "holding company." Broadly speaking, there are two ways that a "trust" may be formed : 1. A new corporation may purchase all the assets of a number of other corporations engaged in the same general line of business. 2. A new corporation may exchange its stock for the stock of other corporations. The first case presents no accounting difficulties. The second method of organization deserves the very closest attention, because of the fact that the various units, i. e., subsidiary companies, retain their legal individuality. Each subsidiary corporation is linked direct to the parent corporation through capital stock control, but ordinarily there is no such relation between the various subsidiary companies, although there may be. Such combinations or holding companies are formed (1) for the purpose of acquiring control of the capital stock of operating companies and (2) for the purpose of receiving as their own income, incomes of the sub- 396 Holding Companies 397 sidiary organizations, which can probably be considerably increased because of 1. Reduced cost of operation. 2. Elimination of competition. 3. Cheaper financing. Holding corporations, strictly speaking, exercise nti function except that of holding the stock of other cor- porations, but there is no reason why a holding company may not, in fact, they do frequently, engage in certain operating activities. THE ACCOUNTING PROBLEMS In a discussion of the broad general accounting features of such holding companies and their subsidiaries, it must be borne in mind that there are two kinds of holdings : 1. A holding company may possess only a very small proportion of the total outstanding stock of the subsidiary. 2. It may own all or practically all the outstanding capital stock and thus exercise complete control. In the first case the stock holdings are considered merely as investments or, possibly, as a lever for influ- ence, and no special points of interest are involved; but in the second case where a sufficient amount of the stock is owned to carry control, some of the most difficult problems of accounting are to be noted. In a discussion of holding companies and their sub- sidiaries, it is likewise well to get in mind the fact that from the operating standpoint (disregarding for a moment the legal point of view) the entire organization may be considered as nothing more than a series of 398 Principles of Accounting separate establishments or plants under the same man- agement and ownership. When looked upon in this light, certain accounting principles, it can be clearly seen, will apply that would not be appropriate if each subsidiary were to be considered as a separate self-contained and independent unit. If the various subsidiaries are considered merely as separate elements in the same organization, it is clear that any transactions between two such subsidiaries will have no effect upon the status of the organization con- sidered as a whole. In illustration of this point we can do no better than quote the very apropos illustration which is to be found in Esquerre's Applied Theory of Accounts. If a father had intrusted the management of $300,000.00 of personal property to three of his sons, in equal amount, they to enjoy the income of the trust estate, it might be that, at the end of a given period, the marshaling of the units of the principal of the trust fund might show that John had loaned $50,000.00 to James, who in turn had loaned $25,000.00 to Charles. But the balance sheets submitted by the three trustees would not in the aggregate reveal anything of great importance to the father, since the fund remains intact. If James repaid John the $50,000.00 which he owes him and, in turn, Charles repaid to James the $25,000.00 loaned by the latter, John's balance sheet would be richer in liquid assets, while that of James and Charles would be poorer in liquid assets and richer in reduction of lia- bilities; but the father would not have one cent more. If, then, the components of a holding company, as represented by the stock which the latter controls, have been financed one by the other, all the debts of an individual member (one such subsidiary), which are the assets of another must be omitted from a statement endeavoring to show the exact status of the assets controlled by the parent company. Holding Companies 399 TRUE BALANCE SHEET The true balance sheet of a holding company is or- dinarily not very illuminating. On the asset side it contains practically nothing but securities owned, and on the liability side very little but its own capital stock outstanding. Nor are the balance sheets of the subsidiary companies as informative as they should be. From a study of them it is difficult, if not impossible, to get that adequate survey of the business as a whole which would be desired by the stockholder of the holding company. Such a stockholder feels that so far as true ownership is concerned all the phases of the business are simply phases of a single enterprise and that he is, therefore, entitled to obtain his information from that standpoint. CONSOLIDATED BALANCE SHEET It is clear that some special form of exhibit or statement must be prepared in order to satisfy the wishes of the holding company's own stockholders. Such a statement cannot be a balance sheet, in the strict sense of the word, but custom has sanctioned its use in this particular in- stance, since the term " consolidated balance sheet " has a distinct meaning peculiar to itself. It may be well to say at the outset of the discussion that the consolidated balance sheet probably has no legal standing at the present time, but it is almost universally employed by every large holding company. The consolidated balance sheet is made up by properly combining, according to the certain fundamental accounting principles, the several balance sheets of the various corporations making up the organization. The consolidated balance sheet shows the assets of the subsidiary companies as the assets of the holding company, thus for balance sheet purposes 400 Principles of Accounting eliminating and disregarding the legal distinct individu- ality of the subsidiary corporations. ELIMINATION OF INTEKRELATIONS In order to form this consolidated showing, it is necessary to eliminate all the relations of constituent companies with each other. Assume that Company "A" is a holding corporation owning the entire capital stock of Corporation "B," Corporation "C," and Corporation "D." To get a consolidated balance sheet it would be necessary to merge the balance sheets of these four cor- porations, and if a true showing is to be desired, all intercompany relations must be eliminated. Company "B" may owe Company "C" $50,000.00, yet from the standpoint of the enterprise as a whole this fact is im- material. From the standpoint of an individual, it does not make any difference which pocket his money is in, but if an account is to be kept with a certain pocket, the matter of transference of funds from one pocket to the other is of importance. We may, therefore, lay down the rule that in the con- struction of a consolidated balance sheet the balance sheets of all the companies forming a complete whole are to be merged into one, but that all intercompany relations are to be eliminated in the process. In the formation of a consolidated balance sheet all the items of cash owned by each of the companies will be added together, their sum representing the total cash on hand. In a similar way all the items of merchandise on hand will be deter- mined and the total used in the consolidated balance sheet. The item of accounts receivable, however, would not necessarily be treated in this way. It would be necessary for the accountant to scrutinize these various items care- Holding Companies 401 fully to find out whether an account receivable of one company was not offset by an account payable of another. If this were found to be true, it would be necessary to eliminate them both, showing only as accounts receivable the total amount due all the companies from outside sources. WOEKING FORM As an aid to making up consolidated balance sheets, it is customary to use a working form as follows : Elimination Accounts Company -A" Company Company "C" of Inter- Total relations The form is self-explanatory, simply providing a con- venient means of making the required elimination. The principal points to be noted in the preparation of consolidated balance sheets are in connection with good- will, surplus, and the minority interests. GOODWILL The goodwill item which appears on the consolidated balance sheet is the algebraic sum of the several items of goodwill purchased by the holding company from the several subsidiary companies. If the price, whether in cash or in capital stock, which is paid for the stock of another company should be greater than the sum of the par value of such stock and its proportion of surplus, the difference is the amount which is properly chargeable to the Goodwill Account on the consolidated balance sheet. 402 Principles of Accounting This principle has for its basis merely ordinary common sense. If the purchase price is greater than the total net worth, as exhibited in the balance sheet of the pur- chased company, it is assumed that the assets of that company have been stated at a figure which is really under their true value. It cannot be held that the pur- chasing company is guilty of the folly of knowingly paying more for the stock than it is worth. The excess price which is paid is, therefore, held to be for the purchase of goodwill. If, on the other hand, the purchase price is less than the market value of the stock, as shown by the balance sheet, it may be assumed that the balance sheet figures are inflated, and such a discount would ordinarily be credited to the Goodwill Account on the consolidated balance sheet. It might happen that the total credits to Goodwill were in excess of its total charges, although this would be unusual. In such a case at least one authority recom- mends that the excess credit balance be credited to the Capital Surplus Account. It would be equally proper to credit it to a valuation account, since it merely serves as an offset to inflated asset values. Whatever title is used, it should clearly label the amount as being unavailable for dividends. In addition to the various goodwill components- ob- tained by charging the excess of purchase price over book value of capital stock of the purchased companies, there must also appear as additional charges to that account the various items of goodwill which appeared on the balance sheets of the underlying companies at the time they were taken over. Such previous goodwill items are frequently merged with other items under the head of property. As an illustration of the goodwill treatment, we may Holding Companies 403 assume that Corporation "A" has purchased all the outstanding capital stock of Corporations "B," "C," and "D." Disregarding other elements appearing in their balance sheets, we find that Corporation "B" shows goodwill of $10,000.00, that its outstanding capital stock is $50,000.00, and that its total surplus, both appropriated and free, is $7,000.00. Corporation "C" has a capital stock of $25,000.00, and a surplus of $8,000.00, and Cor- poration "D" has goodwill of $5,000.00, capital stock of $15,000.00, and a surplus of $2,000.00. Corporation " A " paid $60,000.00 for the total stock of Company "B," $31,000.00 for Company "C," and $20,000.00 for Com- pany "B." Com- pany B C D Goodwill Capital Stock Surplus $10,000.00 None 5,000.00 $50,000.00 25,000.00 15,000.00 $7,000.00 8,000.00 2,000.00 Price Paid by Company A $60,000.00 31,000.00 20,000.00 EXCESS OB DEFICIT Excess Deficit $3,000.00 $2,000.00 3,000.00 From the foregoing facts it is required to determine what the item of goodwill on the consolidated balance sheet would be. Charges to Goodwill Co. B $10,000.00 " B 3,000.00 " D 5,000.00 " D 3,000.00 $21,000.00 Balance $19,000.00 Credits to Goodwill Co. C $ 2,000.00 Balance 19,000.00 $21,000.00 From the calculation as shown it is plain that the goodwill item appearing on the consolidated balance sheet will be $19,000.00. This item of goodwill, which has just been determined, would not actually appear anywhere 404 Principles of Accounting Chart illustrating condition before stock transfer Stockholder* Stockholder* HOLDING CORPORATION (owns majority stock in 3 subsidia- ries.) Chart illustrating condition after the stockholders in Company "A," Com- pany "B," and Company "C" exchange their stock for stock of the new holding corporation. P! G . 74. Charts Illustrating Lines of Stock Control of a Holding Company Holding Companies 405 on the books of account either of the holding company or of any of these subsidiary companies. Ten thousand dollars of it would appear in the Ledger of Company B as an asset and $5,000.00 of it in the Ledger of Company D as an asset, but the remainder could nowhere be found as a book item. The reason is that the stock holdings of the parent company are shown at their cost price, while the general books of the subsidiary companies will Stockholder, in Pn Company HOLDING CORPORATION (owns majority stock in 3 subsidia- ries.) Chart illustrating condition if parent company is able to buy only controlling interest in Company "A," Company "B," and Company "C." A consolidated balance sheet must not overlook the legal rights of stockholders marked "x," "y," and "z" FIG. 74. Continued show no changes. The only effect so far as their books are concerned is the change in stockholders, which will be registered in the stock ledger entry. In the foregoing discussion it has been assumed that the holding company has purchased all the stock of its subsidiaries, but in practice this rarely, if ever, obtains. 406 Principles of Accounting MINORITY INTERESTS Usually the holding company is unable to purchase all outstanding shares, although it usually can obtain enough to exercise a controlling interest. (See charts in Figure 74.) The minority stockholders, i. e., those who have not exchanged their holdings for stock in the parent company, must not be ignored in the consolidated balance sheet. Not only must the stock belonging to outsiders be set up as a separate item on the consolidated balance sheet, but also the amount of surplus which belongs to those stockholders. This is a matter of simple arith- metical calculation. The amount of surplus to be appor- tioned to minority stockholders is the same percentage of the total surplus of the subsidiary company as the minority stockholders' interest is of the total outstanding stock of the subsidiary. There are at least three ways of exhibiting the facts on the Consolidated Balance Sheet. First Method CONSOLIDATED BALANCE SHEET Assets $ Liabilities $ Capital Stock of holding c o m - pany $ Proportion o Surplus Minority Stock- holders ' Interest Capital stock Proportion of Surplus Assets Holding Companies Second Method CONSOLIDATED BALANCE SHEET $ Liabilities Capital Stock Capital Stock of holding company . . . . \ Subsidiaries ' Stock Out- standing .... Surplus Majority In- terest . Minority In- terest . 407 Assets Third Method CONSOLIDATED BALANCE SHEET $ Liabilities $ . Capital Stock of holding company Subsidiaries ' Stock Out- standing Surplus This latter arrangement does not apportion the sur- plus; hence one of the other two methods is to be preferred. INTERCOMPANY SALES Another interesting accounting feature occurs in con- nection with intercompany transactions where there is a minority stock interest. If we regard the holding com- pany and all its subsidiaries as being one undertaking r then it is evident that the sales from one subsidiary to 408 Principles of Accounting another should contain no element of profit. If this principle is not closely observed, anticipation of profits would result and inventories would be inflated from the viewpoint of the enterprise as a whole. On the other hand, the minority stockholders may not be interested in the enterprise as a whole, if only stockholders in a particu- lar subsidiary. So far as they are concerned sales must be made to other subsidiaries at a fair profit; otherwise they feel that they have been defrauded. The system of handling intercompany sales, in order to meet both these points of view, must necessarily be very elaborate. It implies carrying all sales, both at the cost and at the selling price. This enables the con- struction of consolidated balance sheets, showing all inventories at actual cost of production, and it also permits the preparation of subsidiary companies' state- ments and balance sheets, showing intercompany trans- actions on the basis of profitable selling prices. Material may be passed from one subsidiary to another, and in a large organization there may be eight or ten transactions before the ultimate finished product is eventually sold to outsiders. Not until this has actually been done may the various intercompany profits be actually shown as " realized " from the holding company viewpoint. Another point of interest in the same connection occurs when one subsidiary sells material to another for con- struction purposes. In previous chapters we have seen that from the standpoint of the undertaking as a whole, all charges for new construction should be strictly on a cost basis, including no element of profit. This same principle holds true in situations similar to the one now in discussion, and the price at which materials are charged to the construction account of Corporation B must be their actual cost of production, although Cor- Holding Companies 409 poration B paid for the materials on the basis of cost plus profit to another subsidiary. The whole scheme of holding company accounting is so vast that we cannot do more than lay down a few general principles which apply. The very size of most of our modern trusts necessitates intricate and elaborate accounts. Complicated as these may appear, they have no terrors for the man who is thoroughly versed in accounting science, for they are based on the simple unchangeable accounting principles. TEST ^QUESTIONS 1. (a) What is a "trust" in the popular sense? (b) In what two ways may a "trust" be formed? 2. What are the advantages of consolidation? 3. What is the difference between the accounting and the legal point of view as regards holding companies ? 4. (a) What is a consolidated balance sheet? (b) What is its legal standing? (c) How does it differ from a true balance sheet? 5. What are the components of "goodwill" on a consolidated balance sheet? 6. Illustrate three ways of exhibiting proprietary interest on a consolidated balance sheet. 7. What is the accounting rule as to inter-company sales? INDEX Acceptances, 167 Accountancy, definition of, 21 Accounting period, 36-38, 131-34 Accounts analysis of, 26-32 assets. See Assets. balance sheet. S'ee Balance sheet. bases of. 21-52 controlling. See Controlling accounts. corporation. 210-21. 295-344, 372-409 definition of, 19, 21 depreciation. See Depreciation. double entry, 3-19. 21, 43-45 holding companies, 396-409 Insolvency. 372-95 inventories. See Inventories. journals. See Journals. liabilities. See Liabilities: Insol- vency. manufacturing statement, 233-37 mixed, 35-36. 116-18 nominal and real. 33. See also Proprietor's account. partnership. 217-19. 275-94, 317-21 payable. 42-44, 63-64. See also Lia- bilities. posting. 40-41, 101-4 preliminary survey of, 1-19 private ledger, 79-84 profit and loss. See Profit and loss account. proprietor's. See Proprietor's ac- count. railroad. 253-58, 271. 343 receivable, 42-44. 62. See also Assets. reserves. 221, 301-2. 329-44, 377 single entry, 44-45. 152-53 subsidiary. See Subsidiary accounts. surplus. See Surplus account., symbolized, 2-19 the ledger, 21-23. tee also Ledger. trial balance. See Trial balance. two principal objects of. 38 Accrual. 118. 133-34. 198-99. 325 Adjusting entries. 110-12. 118-39, 146- 54 Affairs, statement of, 372-78 Allocation account, profit and loss, 214 Amortisation definition of, 180 of land. 183-84 of mines, 323-24 Analysis of accounts. 26-32 Apportionment accounts, 265-66 Appreciation. 179-82, 349 Articles of partnership, 275-77 Assets acceptances, 167 and their valuation. 155-96 bad debts. 162-64, 251-52 bills receivable, 167 buildings. See Real estate. classification of. 157, 178-79 consist of property and claims, 155- 56 current, 157-58, 160-67. 178 debts receivable. 6-8. 162-65 deferred. 48, 132-34, 158. 191, 348 depreciation of. See Depreciation, equipment. See fixed, expressed in terms of money. 156-57 fixed. 157. 178-96 fluctuation in value of. 168-69, 177- 83, 348-49 franchises and patents, 195 goodwill, 192-95. 401-5 investments, 188-91 intangible, 179, 191-96 land. See Real estate, leaseholds. 186-87 machinery. 148-52. 187-88, 354-56 merchandise, 3-19. 27-28. 33-36. 108. 167. 178 notes receivable. 165-66, 200-203 of partnerships. 275-94 organization. 196 real estate, 26-27. 178-87 symbolized. 3-19 utility in. 158-60 valuation account, 151, 163-64, 329- 30 valuation of basis of, 160 current assets. 160-67, 178 fixed assets, 147-52. 178-96, 323-24 working assets. 167-78 working, 158, 167-78 See also Accounts ; Insolvency. Bad debts. 162-64. 251-52 Balance, trial. See Trial balance. Balance sheet adjusting entries, 110-12, 118-39. 146-54 closing entries. See Closing entries. consolidated, 899-407 construction of. 144-47 definition of, 37-38, 113. 141-42 depreciation in. 147-52. S'ee also Depreciation. effect of reserves on interpretation of. 332-37 form of, 113-14, 142-46 limitations of. 115-16, 147-52 receiver's, 372-73 showing of bond discounts and pre- miums, 205-10 who interested in. 114-15 working. 116-39, 145-47 Bases of accounting, 21-52 Bills receivable. 167 Bonds. 184. 188-91, 203-11, 337-41 Bookkeeping, definition of, 21. See also Accounts. "Boston ledger," 88-89 Buildings. See Real estate. 411 412 Index Capital of a corporation, 220-21 of a partnership, 275-94 See also Capital stock. Capital stock. 220-21. 295-328. See also Holding companies. Capital surplus account, 303, 309-13 Cash as a current asset, 158, 161-62 how handled in columnar .lournal. 55-61 in realization and liquidation state- ment. 387 journal, 65-75 private, 83 statement of receipts and disburse- ments, 253 See also Accounts. Cash book, 46 Checks, 161 Clearing accounts. 267-74 Closing entries, 110-12, 118-20, 125, 139-40, 147, 153-54, 252-55 Columnar journal, 55-61 Columnar ledger, 88-89 Consolidated balance sheet, 399-407 Contingent liabilities, 200-203, 331, 335-36, 352-53 Controlling accounts definition of, 43, 65 examples of, 43-44, 62-63, 263-66 relation to special journals, 77-78 Corporations capital stock in, 295-328. See also Holding companies. corporate books. 297-300, 397-409 definition of, 219-20, 295-96 depreciation in, 324-25. See also Depreciation. discount on stock of. 303 dividends of. 297, 300-302, 321-28 donated stock of, 310-13 holding companies, 396-409 insolvency in. 372-95 mining companies, 323-24 opening entries of, 305-10 partnership changed to, 317-21 premium on stock of, 302-3 proprietorship account of, 220-21, 300-328. See also Holding com- panies. reserves of, 301-2, 329-44, 377 surplus of, 301-3, 309-13 treasury stock of, 303-5, 310-13 unissued stock of, 303-5, 316-17 Cross-indexing, 104 Current assets, 157-67 bills receivable, 166 debts receivable, 162-65 merchandise, 166 money and checks, 160-62 notes receivable, 165-66 Current liabilities, 197-99 Cycle, economic, 158-60 Debit. 21. See also Accounts. deferred, 48, 132-34, 158, 191, 348 Debts payable. See Liabilities. Debts receivable bad, 162-64, 251-52 symbolized, 6-8 valuation of. 162-65 Deferred assets, debits, or charges, 48, 132-34, 158. 191, 348 liabilities. 133-34. 199-200 Deficiency account. 378-83 Departments. 30-31. 266 apportioning expenses among, 267-74 Depreciation. 115. 147-52. 179-87. 323- 24. 330-35, 340-71 and fluctuation. 348-49 as a cost, 247-48. 347-48 causes of, 349-52 contingent. 352-53 in rnilroads. 370-71 methods. 149-52. 358-69 plant ledger. 353-56 rate of, 356-58 replacements, 353, 369-70 Disbursements. See Cash. Discounts in valuation of working assets, 169- 70 journal record of, 71-75 on bonds, 205-7 on stock, 303 symbolized, 5-8 treatment of, in profit and loss state- ment, 248-50 Distribution of expenses, 267-74 Dividends, 184, 199, 297, 300-302, 321- 28 Donated stock, 310-13 Double entry confined to General Ledger, 43 defined, 21 illustrated, 3-19 incomplete, 44-45, 152-53 Economic cycle, 158-60 Entry double. See Double entry. single. 44-45, 152-53 Errors, treatment of. US, 242-43 Expenses, 224-27, 259-74 clearing accounts for, 267-74 Factory profits, 246-47 Fixed assets, 157, 178-96 buildings. 184-87. See also Real estate. deferred. 48, 132-34, 158, 191, 348 franchises and patents, 195 goodwill, 192-95 intangible, 191-96 investments, 188-91 land, 182-84. See also Real estate. machinery, 148-52, 187-88, 354-56 organization expense, 196 See also Depreciation. Fluctuation and depreciation, 348-49 in value of fixed assets. 179-83 in value of working assets, 168-69, 177-78 Forwarding the balance, 28 Franchises and patents, 195 Goodwill, 192-95, 401-5 Holding companies accounting problems of, 397-4 consolidated balance sheet. 399-4 Index 413 formation of, 396-97 goodwill, 401-5 minority interests in, 405-9 Incomplete double entry, 44-45, 152-53 Insolvency deficiency account, 378-83 statement of affairs. 372-78 statement of realization and liquida- tion, 383-95 Insurance, 46-48, 132-33, 251 Intangible fixed assets, 179, 191-96 Intercompany sales, 407-9 Inventories asset. 46-48, 132-34 liability, 49-50, 133-34 perpetual, 172, 243-46 physical, 34-36, 167-78 positive and negative, 46-50 Investment as an asset, 188-91 shown in proprietor's account, 213-14 symbolized, 3-19 Journals cash, 65-75 columnar, 55-61 definition of. 39-40. 53-55, 101 kinds of, 41, 53-105 notes and bills, 75-77 posting, 40-41. 78. 101-4 purchase, 62-64, 89 record of discounts, 71-75 sales, 62-64 special, 41 development of, 53-105 relation of, to control accounts, 77-78 status of, 97-101 Junior partners, 277-78 Kinds of journals, 41, 53-105 Land. See Real estate. Leaseholds, 186-87 Ledger balance sheet made from, 106-54 "Boston," 88-89 columnar, 88-89 definition of, 21-23. 78 form of accounts, 84-87 general, 78-79, 84 plant, 353-56 posting in. from journal, 53-61, 101-4 private, 79-84 stock, 171-78 See also Accounts. Liabilities accrued. 133, 198-99 bonds. 203-11, 337-41 classification of. 197 contingent, 200-203, 331, 335-36, 352-53 current, 197-99 deferred, 133-34. 199-200 dividends, 184, 199, 327 inventories, 49-50, 133-34 mortgages, 203-11 statement of. under single entry, 45 symbolized, 3-19 wages. 198-99 See also Accounts; Insolvency. Limitations of balance sheet 115-16, 147-52 of trial balance, 25, 107-9 Liquid assets, 157-58. See also Assets. Liquidation, statement of realization and. 383-95 Liquidation of partnership, 284-94 Loss arrived at by inventory, 33-35 kinds of, 215-16 symbolized, 8-19 See also Profit and loss account. Machinery, 148-52. 187-88, 354-56 Manufacturing statement, 233-37 Materials in process. 170-71. See also Working assets. Memoranda of entries in ledger. See journals. Merchandise account, development of, 33-36 as an asset, 167, 178 how entered, 27-28 symbolized, 3-19 Mining companies, 323-24 Minority interests, 405-7 Mixed accounts, 35-36, 116-18 Models, as illustrating the function of accounts, 1-2 Money checks, 161 nature of, 156-57 paper. 161 See also Cash. Mortgages, 203-11 Necessity of accounts, 1 Nominal accounts, 33. See also Pro- prietor's account. Notes and bills journal. 75-77 Notes payable, 198 Notes receivable, 165-66, 200-203 Obligations, secured, unsecured, and partly secured, 373 Organization expense, 196 Overhead, 246 Partnership accounting, difficulties of, 275 articles of, 275-77 capital in, 275-94 changed to corporation, 317-21 definition of, 217-19 formation of, 278-81 interest on capital. 281-84 junior partners. 277-78 liquidation of, 284-94 profit and loss in, 275-81, 284-94 Period, accounting, 36-38, 131-34 Perpetual inventory. 172, 243-46 Plant ledger, 353-56 Posting definition of, 40-41 technique of, 101-4 Preferred obligations, 373 Preferred stock, 297 Preliminary survey of accounting, 1-19 Premium on bonds, 189-90 on stocks, 302-3 414 Index Prime cost, 246 Private cash, 83 Private Journal. 82-83 Private ledger, 79-84 Profit arrived at through inventory, 33-35 definition of, 160 factory, 246-47 gross and net. 222-23 in intercompany sales, 408 of corporations, 322-25 of partnerships, 275-94 symbolized, 4-19 undivided, 221 Bee also Profit and loss account. Profit and loss account allocation, 214 definition of, 50 functional idea in, 238-39 in corporations, 322-23 use of. 110-12, 125, 147, 212-17 Profit and loss statement, 37-38, 213- 15, 228-33. 237-40, 243-74 Proprietor's account analysis of, 29-33, 153-54, 212-15, 222-29 classes of proprietorship, 217-21 consolidating, 50, 110-12, 125, 153-54 corporation. 219-21, 300-328 definition of, 29, 212 effect of typical transactions on, 126-34 entries in, 215-16 expenses, 224-27, 259-74 holding companies, 396-409 in insolvency, 376 manufacturing statement, 233-37 partnership, 217-19, 275-94 railroad income statement, 253-58 reserves, 221, 301-2, 329-44 sole proprietorship, 217 subsidiary, 30-33, 216-17 surplus account. See Surplus ac- count. symbolized, 5-6 trading statement. 222-23, 240-42 See also Closing entries; Profit and loss account. Purchases entered, 23, 35-36, 171 purchase journal, 62-64, 89 symbolized, 3-19 voucher register, 89-101 Railroad depreciation, 370-71 expense apportionment, 271 income statement, 253-58 secret reserve, 343 Real accounts, 33, 212 Real estate account, 26-27 as an asset, 178-87 Realization and liquidation, statement of/383-95 Receipts. See Cash. Receiver. See Insolvency. Register, voucher, 89-101 Replacements, 353, 369-70 Requisitions, recapitulation of, 174 Reserves definition of, 221, 301-2 effect of, on balance-sheet interpre- tation, 332-37 in insolvency, 377 reserve funds, 335-37 secret, 342-43 sinking funds, 337-41 surplus, 330-32 valuation accounts, 329-30 Resources, statement of, under single entry, 45, 153 Sales entered, 35-36 sales journal, 62-64 symbolized, 3-19 Scales, as a symbol, 2-18 Scrip dividends, 326-28 Secret reserves, 342-44 Single entry. 44-45, 152-53 Sinking funds, 337-41 Sprague, Charles E.. The Accountancy of Investment, 210 Statement deficiency account, 378-83 manufacturing, 233-37 of affairs, 372-78 of profit and loss. See Profit and loss statement. of realization and liquidation, 383-95 of receipts and disbursements, 253 of resources and liabilities, 45, 153 trading, 222-23. 240-42 Stock ledger, 171-78 Stocks, 184, 188-8a, 295-97. See also Capital stock. Subsidiary accounts payable, 42-44, 62-63 proprietor's, 30-33, 216-17, 263-66 receivable, 42-44, 62 Surplus account, 221, 242-43, 301-3, 330-32 Survey, preliminary, 1-19 Symbols, use of, 1-19 Taxes, 251 Trading statement. 222-23, 240-42 Treasury bonds, 210-11 Treasury stock, 303-5, 310-13 Trial balance and the balance sheet, 106-13, 121- 47 definition of, 24-25 of general and private ledgers, 80 of private ledger, 83 Trust. See Holding companies. Unissued bonds, 211 Unissued stock, 303-5, 316-17 Utility, 158-60 - Index 415 Valuation of assets Wages, 198-99. See also Expenses, basis of. 160 Wasting assets, 183-84, 323-24 current assets, 160-67, 178 Working asspfs 1^8 1R778 fixed assets, 147-52, 178-96, 323-24 Work hflancP sheet 1 16 W 14^ 47 valuation account, 163-64, 329-30 Working balance sheet, 116 d9, 1 working assets, 167-78 See also Depreciation ; Insolvency. Young men admitted to firm as junior Voucher register, 89-101 partners, 277-78 YC 39248