Cornell University Library The original of tiiis book is in tine Cornell University Library. There are no known copyright restrictions in the United States on the use of the text. http://www.archive.org/details/cu31924014055572 HF5625.H3T92l""'""""-"'"'^ "" llimnS™!;'.!;''"^' "® principles and s 3 1924 014 055 572 MODERN ACCOUNTING ITS PRINCIPLES AND SOME OF ITS PROBLEMS BY HENRY RAND HATFIELD, PH.D. PBOFEBSOB OF ACCOUNTINO UKIVES8ITY OF CALIFOBNIA NEW YORK AND LONDON D. APPLETON AND COMPANY 1921 PREFACE In the following treatise an attempt is made to present the principles of accounting. In doing so the details of technic, important though they are, are purposely omitted or treated with the scantest mention. The essence of ac- counting, from the author's view point, is the presentation, first, of a correct exhibit of the financial status of the con- cern at a given moment of time, and, secondly, a showing of the results obtained during a given period of time. The first is embodied in the Balance Sheet; the second in the Income or Profit and Loss statement. In the ordinary routine of the accountant's toil there is, indeed, another function; that of keeping account of claims and property, in order to secure the concern against the loss which might arise from forgetfulness, carelessness or dishonesty. This phase of accounting attains its acme in governmental accounting where the essential thing is to insure the proper handling of vast sums. But this seems a matter of much less scientific interest and is not treated in this work. The method of treatment, in general, has therefore been to consider how a given transaction is made manifest in the Balance Sheet, the goal which the accountant ever has in mind. The technical entries to be made in the journal or in other books of original entry are excluded. They are not of such importance for the forms in which such entries are made vary according to the needs of the office economy, V vi PEEFACE and still more because they are only the steps by which the Balance Sheet is formed. Keeping the latter constantly in mind, serves to make clear the logical significance of each transaction recorded. That being clear the technical entry to be made is an obvious matter. The presentation of a correct view of the concern's financial status and of its past profits involves many points of theoretical interest and of practical importance. To present an intelligible view it is essential to have a rather definitely crystallized terminology so that the terms used with a technical meaning shall be definitely under- stood with the exact connotation intended. Unfortunately, despite the advancement made in accounting practice, there is a most embarrassing confusion in terminology, so that one can never be sure of just what is meant by a given account. Amperes and ohms, miners inches and foot pounds, have definite meanings free from misunder- standing. But the current terms of accounting: Reserves, Depreciation Fund, Manufacturing Costs, even Profits, are loosely and divergently used. More serious still is the uncertainty as to the correct principle to follow in many cases, as for instance in the valuation of fixed assets and the method of estimating depreciation. In some cases it is possible to differentiate certain usages as bad, some methods as involving incorrect prin- ciples. But this is not always true and when in doubt there is no ultimate arbiter to whom appeal can confidently be made. In this dilemma it has, therefore, seemed advis- able to show the existing variations rather than to attempt to formulate rigid rules. The comparative study of ac- counting practice will, perhaps, be a greater service to PEEFACE vii accounting science than a more dogmatic treatise. Refer- ence has accordingly been frequently made to the pub- lished accounts of corporations which presumably exhibit current usage, and to the leading English and American texts. But in addition considerable recourse has been had to other less obvious sources of information. These include the decisions of English and American courts, the com- mercial codes of Germany, Prance and Austria and the commentaries of the leading jurists of these countries. The legal provisions of the Continental countries are, of course, not binding on American practice. But they are of considerable significance in discussing the principles of accounting, for they embody the carefully expressed opin- ion of experts on many difficult problems. Such attention to foreign authorities is all the more necessary since in this country far too little attention has been given to matters of principle. American accounting is famed for short cuts and practical efficiency. At the same time the accounts of American corporations, until Very recent years, have been replete with questionable practices, oftentimes vicious in principle and misleading in their results. While the work is mainly a discussion of the problems of practical accounting, it has seemed advisable to insert an introductory section on the theory of double entry book- keeping. Those who are familiar with the literature of the subject need not be told of the author's indebtedness to J. F. Schaer whose clear writings have done much to put bookkeeping on a more rational basis. Of especial value has been that writer's: " Versuch einer wissenschaftlichen Behandlung der Buchhaltung. " vui PREFACE The twofold classification of accounts herein adopted differs materially from the customary treatment in Ameri- can text-books. The conventional division of accounts into real, personal and fictitious, as Jones pointed out in 1841, " renders all theorizing impossible, and shuts up every avenue to the more general principles of the subject on "which the analysis of accoimts so immediately depends." So too there is a marked divergence in the treatment of the terms Debit and Credit, the mere rules of thumb so generally used being abandoned for what, it is hoped, is not only more rational but actually of greater practical value to the student wrestling with the problems of ele- mentary bookkeeping. Henry Eand Hatfield. CONTENTS CHAPTER I THE PRINCIPLES OF DOUBLE ENTRY BOOKKEEPING PAGES The Fundamental Equation of Bookkeeping — -Goods — Pro- prietorship — Exchange, Profit and Loss, and Mixed Trans- actions — ^The Development of a System of Accounts — The Classification of Goods Accounts— The Classification of Proprietorship Accounts — The Purpose of the Double Set of Accounts — ^Mixed Accounts — ^The Introduction of the Inventory — Debts or Negative Goods — Summary of Prin- ciples^ 1-15 CHAPTER II THE PRINCIPLES OF DOUBLE ENTRY BOOKKEEPING (CmUinueiO The Ledger — Debit and Credit — ^The Clearing of Mixed Accoimts — -Negative Accounts — The Balance of Accoimts — Imper- fections in Double Entry Bookkeeping — Bibliographical Note to Chapters I and II 16-34 CHAPTER III THE BALANCE SHEET The Trial Balance — ^The Formation of the Balance Sheet — ^The Two Sides of the Balance Sheet: (1) The English Inverted Order; (2) Variations in Headings — The Grouping and Marshaling of Items — ^The Double-Account Balance Sheet — ^Valuation Accounts in the Balance Sheet — The Balance Sheet in Relation to Profits — Accuracy in the Balance Sheet — Examples of the Balance Sheets of Corporations — Bibliographical Note . 35-69 X C0J5TTENTS CHAPTER IV ASSETS AND THE PRINCIPLES OF VALUATION PAGES The Difficulty in Distinguishing Assets from Expense Items — Revenue Expenditure and Capital Expenditure — The Problems of the Inventory: (1) What Items are to be In- cluded? (2) What is the Cost Price? (3) What is the Basis for Revaluation? — Undervaluation in the Inventory — ^BibUographical Note 70-85 CHAPTER V THE VALUATION OF PARTICULAR ASSETS Land: (1) Permanent Holdings Valued at Cost; (2) Land Held as Merch^dise — Buildings — 'Machinery, Tools, etc. — In- v^tments: (1) The Significance of Public Quotations; (2) The Market Price Logically Neghgible for Permanent In- vestments; (3) Legal Regulations Regarding Valuation; (4) Value as Affected by Time — Mercantile Credits — Mer- chandise: (1) Cost the Normal Basis for Appraisal ; (2) Prob- lems in Determining Cost — ^Bibliographical Note . . 86-106 CHAPTER VI IMMATERIAL ASSETS Goodwill: (1) Legitimacy of Including Goodwill Among Assets; (2) Value Limited to Actual Cost; (3) The Purchase of Fictitious Goodwill; (4) Factors Determining the Value of Goodwill; (5) The Rate of CapitaUzation; (6) The Writing-off of Goodwill — Deferred Assets: (1) Definition; (2) The Writing-off of Deferred Assets; (3) Losses Appear- ing among Deferred Assets — Bibliographical Note . . 107-120 CHAPTER VII DEPRECIATION The Economic Significance of Depreciation — Depreciation and Anticipation Accounts — Depreciation and Profits — De- preciation in the Courts — ^The Rulings of the Interstate Commerce Commission-7-Methods of Booking Deprecia- CONTENTS xi tion — Methods of Estimating Depreciation: (1) Percentage of Original Cost; (2) Percentage of Diminishing Value; (3) Annuity Method; (4) Comparison of Above Methods — De- preciation in Relation to the Total Cost of Production — Irregular Charges to Depreciation — Excessive Depreciation — Depreciation and Replacement — Depreciation for Other than Wear and Tear — Specific Rates Charged — Bibliograph- ical Note 121-143 CHAPTER VIII CAPITAL STOCK. I. ISSUED FOR CASH The Capital Account of Individual Traders — The Different Treatment of Capital in Corporation Accounts — Subscrip- tions to Capital Stock: (1) Subscription ImpUes Payment in Full; (2) Unsubscribed and Treasury Stock; (3) Uncalled Subscriptions; (4) Subscriptions at a Premium — The Sale of Capital Stock: (1) Discussion of Decision in Haudley v. Stutz; (2) Proper Booking of Stock Sold Below Pai^-The Reduction of Capital Stock 144-160 CHAPTER IX CAPITAL STOCK. II. ISSUED FOR PROPERTY. ETC. Distinction between Issues for Property and for Cash — Stock Issued for Less than Par: (1) The hegkl Distinction between Par and Market Value; (2) The Issue of Stock at "Market Value"; (3) The Proper Accounting for Such Issues; (4) Subterfuges Found in Accounts — Stock Watering — Stock Dividends — Donation of Stock to the Company — The Use of the Term "Working Capital" — Stock Issued to Combine Corporations — Bibliographical Note to Chapters VIII and IX 161-183 CHAPTER X LIABILITIES Liabilities as Negative Goods — Accounting Problems: (l)The Classification of Liabilities; (2) Interest Adjustments; (3) Un- issued Bonds; (4) Repurchased and Treasury Bonds; (5) Uncertain Liabilities — Bibliographical Note . . . 184-194 xii CONTENTS CHAPTER XI PROFITS PAGES The Profit and Loss Account: (1) Definition; (2) Purpose; (3) Relation to Other Accounts — Charging Losses to the Profit and Loss Account: (1) The Exploitation of "Wasting Assets"; (2) The Loss of "Fixed Capital"; (3) The Relation of Previous Losses to Current Profits; (4) Decisions in American Courts 195-213 CHAPTER XII PROFITS (.Continued) The Relation of Capital Losses to Dividends: (1) The Legality of Paying Dividends when there has been a Capital Loss; (2) The Business Policy of Such Dividends; (3) The Proper Booking of Capital Losses — The Credit Side of the Profit and Loss Account: (1) Premium on Stocks andBonds; (2) Appre- ciation of "Capital Assets"; (3) Unreahzed Profits; (4) The Doctrine that Profits Must Consist of Cash Receipts — Legal Decisions Concerning the Relation between Profits -and Un- paid Debts — The Payment of Dividends out of Borrowed Funds — Summary of the Attitude of the Courts in Regard to Profits — ^Bibliographical Note to Chapters XI and XII 214-232 CHAPTER XIII SURPLUS AND RESERVES The Nature of a Surplus — Surplus to be Distinguished from Valuation Accounts: Illustration and Definition of Terms Used — Purposes for which Surplus Established: (1) To Provide Additional Permanent Capital; (2) To Provide for Emergencies; (3) To Equalize Dividends — General and Special Reserves — Criticism of Claim that Reserves must be Specially Covered: (1) Confuses Two Sides of Balance Sheet;. (2) A Specially Covered Reserve no more Secure or Available; (3) Leads to False Financial Theories; (4) Cita- tion of Authorities^Reserves and Reserve Funds — Re- serves in Banking and in Insurance — Secret Reserves — The Application of a Reserve: (1) To Cover Losses, etc.; (2) To Make Extensions, etc. — Reserve for Insurance — Biblio- graphical Note 233-260 CONTENTS xiii CHAPTER XIV SINKING FUNDS PAGE3 Definition — ^The Four Methods of Booking a Sinking Fund — Sinking Fund Installments in Relation to Income — Interest on Sinking Fund Investments — ^The Payment of Bonds from the Sinking Fund — ^The Calculation of Amount Necessary for Sinking Fund — Sinking Funds and Depreciation — Bibliographical Npte . 261-273 CHAPTER XV TRADING. MANUFACTURING, AND INCX)ME ACCOUNTS The Purpose of Subdividing the Profit and Loss Account — ^Types of Such Accoimts: (1) The Trading Account; (2) The Manu- facturing Account; (3) The Income Account of Railroads — The General Principle Involved in the Form of Such Ac- counts — Problems Relating to Such Accounts: (1) The Valuation of Manufactured Goods; (2) The Items to be Included in the Trading Section; (3) The Determination of Selling Price; (4) The Treatment of Taxes; (5) Depreciation — Bibliographical Note 274-292 CHAPTER XVI COST ACCOUNTS The Purpose of Cost Accotmting — Different Conceptions of Cost — ^The Elements of Cost: (1) Direct or Prime Cost; (2) Indirect Factory Expenses; (3) Genera! Estabhshment Charges — General Problems in Applying Cost Accounting: (1) Expense of the System; (2) Accuracy to be Obtained; (3) The Use to be Made of Cost Estimates — ^The Technic of Cost Accounting— BibUographical Note 293-315 CHAPTER XVII PARTNERSHIP ACCOUNTS The Establishment of the Partnership: (1) The Amount Con- tributed; (2) A Share of the Profits and a Share in the Busi- ness; (3) Contributing a Share and Buying a Share — Inter- est on the Partners' Capital: (1) On Total Contribution; xiv CONTENTS PAGES (2) On Excess or Deficit — Liquidation: (1) The Appor- tioning of Assets in Liquidation; (2) Distribution of Assets in Installments — Bibliographical Note .... 316-334 CHAPTER XVIII THE STATEMENT OF AFFAIRS AND DEFICIENCY ACCOUNT The Use of the Statement of Affairs and Deficiency Account — Discussion of Variations in Forms — Bibliographical Note 335-340 CHAPTER XIX TECHNICAL IMPROVEMENTS IN ACCOUNTING PRACTICE Improvements in Relation between Chronological and Classified Records — Improvements in the Form of the Ledger: (1) Method of Ruling; (2) Abbreviation of Entries; (3) Cards and Loose Leaves — ^Mechanical Devices in Accounting: (1) Adding Machines; (2) Calculating Machines; (3) Tabulating Machines — Effect of Economic Changes on the Develop- ment of Accoimting: (1) The Factory System; (2) The Corporate Fonn of Industry — BibUographical Note . 341-357 INDEX 359 MODERN ACCOUNTING CHAPTER I THE THEORY OP DOUBLE ENTRY BOOKKEEPING Double entry bookkeeping, the basis of all modern accounting, was first made known to the world in a mathe- matical treatise published in 1494 by Luca Paeiolo. This work, the " Summa de Arithmetica, Geometria, Propor- tioni et Prop^rtionalita, " not only contained the first printed work on bookkeeping but also included the first European treatise on Algebra. Appropriate to this early connection with algebra, double entry bookkeeping starts out with an equation. The recording of all subsequent business transactions con- sists in altering the form of the equation without affecting the equality of the two members. This original equation, or Balance as it is called in the bookkeeper's technical lan- guage, when reduced to its simplest form is : The value of the various Goods one owns = The amount one is worth. Or, to use shorter terms : Goods = Proprietorship.^ Goods is here used in the technical economic sense of anything, material or otherwise, to which value attaches. The left-hand member of the equation therefore represents 1 The term Proprietorship, as a collective terra for all the accounts representing the "Amount one is wor'^h" is adopted from Charles E. Sprague's most valuable "Philosophy of Accounts.'' It is better than other terms which have been iiaed, as it is free from technical ambiguity. 1 2 MODERN ACCOUNTING a complete list or inventory of all valuable possessions ; the right-hand member expresses the total Proprietorship, that is, the capital or net present worth of the proprietor. This initial equation appears whenever a man first starts a set of books. It may be illustrated by a new busi- ness in which the proprietor starts with $5,000 cash on hand, the equation here being : Cash .$5,000 = Proprietorship $5,000. For the present, consideration of debts owed may be postponed, and the proprietor may be assumed to pay cash on all transactions and not to borrow any money. With this limitation it must be clear that all possible business transactions, or all possible operations, whether purchases or sales, the payment of expenses, the receipt of rent or interest, the loss of property by fire or theft, the taking of profits by the proprietor, additional contributions to or withdrawals from the original capital; all operations of any form whatever which come under the cognizance of the accountant may be reduced to the following: (a) Operations in which the kind of Goods owned is altered by exchange of Goods of one form for other Goods of equal value ; (6) Operations in which the amount (value) of Goods is either increased or decreased. Furthermore, it is to be noted that a business transac- tion may combine the two changes so that there is a third class : (c) Operations in which the kind of Goods owned is altered at the same time that the amount (value) owned is either increased or decreased. These three classes of operations may be respectively called: (a) Exchange or pure exchange transactions, (6) Transactions affecting Proprietorship (or Profit and Loss transactions) and (c) Mixed transactions. DOUBLE ENTRY BOOKKEEPING 3 Exchange transactions evidently do not alter the value of either member of the original equation. If the propri- etor buys 25 horses for $2,500 cash his books no longer show: Cash $5,000 = Proprietorship $5,000, but Cash $2,500 + Horses $2,500 — Proprietorship $5,000. So with any subsequent transactions which involve the exchange of goods of equal value, it is evident that there can be no change in total value. This may be expressed algebraically : If like values are both added to and subtracted from one member of an equation, the value of the equation is not altered. In this case the original equation takes the form Cash $5,000 + Horses $2,500 — Cash $2,500 = Proprietorship $5,000. Transactions which involve a pure exchange take place whenever goods are purchased or whenever they are sold at cost price : where cash is deposited in the bank or other- wise invested; and in debt transactions to be considered later. On the other hand, it is true that any transaction com- ing under 6, changing as it does the total value of the Goods owned, must be accompanied by an equivalent change in the value of the other member of the equation. For instance, if the proprietor in the case mentioned should lose ten horses by death, there would no longer be the «quation Cash $2,500 + Horses $2,500 = Capital $5,000 for the Goods now owned are Cash $2,500 -\- Horses $1,500 which do not equal the original Proprietorship of $5,000. In order to represent the correct position produced by the loss of the horses there must, therefore, be an equiva- lent change made in the member representing Proprietor- 4 MODERN ACCOTUSTTING ship. The disappearance of the horses was at the same time a diminishment of the amount the proprietor was worth. This may be expressed algebraically by subtract- ing from the original equation another equation represent- ing the loss of horses, thus : Cash $2,500 + Horses $2,500 = Proprietorship $5,000 Horses 1,000 = Proprietorship 1,000 Cash $2,500 -f Horses $1,500 = Proprietorship $4,000. On the other hand, if the proprietor rents his horses receiving therefor $100 in cash his statement will then show Cash $2,600 and $2,500 worth of horses. This will be correctly shown if to the original equation is added an. other equation representing the change produced by the rent transaction thus : Cash $2,500 + Horses $2,500 = Proprietorship $5,000 Cash 100. ' = Proprietorship 100. Cash $2,600 + Horses $2,500 = Proprietorship $5,100. Transactions which thus affect the total value of the goods owned, and necessitate a change in Proprietorship occur : (1) Whenever goods are surrendered without receiving an equivalent value in exchange. This occurs when there is a payment of expenses in distinction from a purchase of goods; when there is a loss, or when there is a withdrawal of cash or other property by the proprietor, and (2) Conversely whenever additional goods are obtained without a corresponding exchange, as when clear profits are received, or further contributions are made by the pro- prietor.^ ■ The purchase of goods on credit does not come xinder this head but is an exchange transaction. The obligation to pay the debt, given to the vendor is a Good given in exchange. At present, however, only rash transactions are considered, debts being discussed later. DOUBLE ENTET BOOKKEEPING All the principles of double entry bookkeeping can be^ observed in an extremely simple set of accounts. This may be illustrated by a set in which only the most rudimentary differentiation is made in the Goods, Cash being placed in one account in contradistinction to all other goods which are included in another account. In such a system the accounting of a trader who (1) starts in business with $5,000 cash, (2) buys 25 horses for $2,500 and a farm for $2,000, (3) loses 5 horses by death, (4) rents his horses for $100, and (5) sells the remaining 20 horses for $3,000 will appear as follows: Form 1. Transaction, Cash Account. Miscellaneous Assets Account. Proprietorship Account. Starts business vrith cash Buys horses and farm + $5,000 - 4,500 + 100 + 3,000 + $2,500 (Horses) + 2,000 (Farm) - 500 (Horses) - 2,000 (Horses) = +$5,000 = - 500 Rents horses for cash . . . 20 horses sold = + 100 = + 1,000 Closing condition $3,600 + $2,000 (Farm) = +$5,600 The differentiation here made, between cash and all' other goods is an important one because Cash is, in many respects, the most important form of Goods and also (or therefore) most likely to be stolen unless carefully ac- counted for. But in any practical set of books there is of course further classification of the Goods. "Where sales are not all for cash the account, perhaps, even more important than the Cash account is one indi- cating the amounts due from customers. This is especially necessary where the bill is merely charged up against the customer's account, there being no other evidence of the debt than that furnished by the trader's books. A primi- 6 MODEEN ACCOUNTriSrG tive form of such an account is the slate on which the vil- lage tapster " chalks up the P's and Q's " consumed by his regular patrons. But in any systematic business, ac- counts must be kept showing claims of all kinds, both the charge accounts and those evidenced by notes given by the customer. These latter can again be divided into se- cured and unsecured, foreign and domestic, time and de- mand, or any other classification appropriate to the char- acter of the business transaction. Thus the differentiation is continued, real property separated from personal, mer- chandise distinguished from plant, and still further sub- divided into different classes as for instance, dry goods and groceries, each of these divided into groups such as: silk goods, linens, notions ; flour, tea and coffee, sugar, and thus indefinitely according to the nature of the business, the taste of the proprietor and the particular purpose for which the accounts are kept. No rule can be laid down as to the degree to which ramifications may be made, as each additional subdivision gives to the proprietor additional information valuable in the conduct of the business. The only limit is that at some point, varying with the particu^ lar business, the expense of getting the additional infor- mation, requiring as it does more books and more clerks, is greater than the value of the information thus gained. Somewhat before this point the process should stop. In certain incomplete systems of accounts not only is a differentiation made of particular assets, but these selected assets are alone considered, all other Goods being altogether excluded from the account books. Thus in that bane of domestic peace, the household expense book, as it is gener- ally kept. Cash is practically the only asset considered. No difference is made between a diminution of Cash which represents an actual loss, as when it is dropped on the street, given in charity, or paid for taxes, and one which is an exchange as when paid for a permanent asset, for in- DOUBLE ENTEY BOOKKEEPING stance a diamond. Cash only is considered; other assets, so far as the account book is concerned are nonexistent. Another stage is in the accounts frequently kept by small traders by so-called single entry, in which the only assets shown are Cash, and the claims against persons. Other assets are entirely excluded from the books. But in sys- tematic accounting while differentiation of assets may be carried to any extent, everything owned must be shown in the books and must balance with the items representing Proprietorship. The line of differentiation of Goods accounts inay be represented as follows: f Class A B C Goods Positive (Assets) Mer- chan- dise 1 " L etc. - [- In Till CashJ Funds I In Bank J. B ■ Ic Invest- J g ments | p Credits Nega- tive (Liabil- ities) Plant Funded . Current- A B Bonds-^ B Ic Mortgages^ B Accounts Payable Bills Payable Demand Loans, r Accounts Com- J Receivable mercial I Bills ["Time L Receivable ■< De- [ mand 8 MODEEISr ACCOirerTING This scheme is merely illustrative, and is not univer- sally applicable. Not only do different enterprises, say a bank and a railroad, require different systems of classifi- cation, but the individual establishments in a given trade, say two dry-goods stores, also need, each its own system, adapted to its particular organization and business meth- ods. For the sake of completeness the above scheme sub- divides Goods into Positive and Negative Goods. The latter term has not yet been used in the text, but the subject is discussed at some length on page 13. On the other side a similar division of the Proprietor- ship account appears. The first and most obvious division is between the capital at the beginning of the business and subsequent additions and subtractions, or between the Capital and Profit and Loss: This distinction is of funda- mental importance as it indicates the degree to which the enterprise is successful. As the measure of success is ex- pressed in the percentage which the profits gained in a single year bear to the initial capital, the Profit and Loss Account is ordinarily a temporary one. At the end of each fiscal period it is added to the main Proprietorship account, or otherwise cleared from the books. During the fiscal period the Profit and Loss account may be further subdi- vided into accounts representing items which decrease the net wealth and those which cause an increase, that is, into accounts which show expenses, or losses, and those which show earnings. Thus there may be a general expense account, or this may be divided into Wages, Rent, Interest, Light, Fuel and so forth. Each of these may be subdivided to correspond with subdivisions of the business. Profit, too, is divided into its various elements, such as Interest, Profit on sale of Dry Goods, Profit on sale of Groceries, and so on ad libitum. Such a division of the elemental Proprietorship account is indicated in the following diagram : DOUBLE ENTRY BOOKKEEPING Proprietor- ship {f Contributed by A OriginaH " " B L " " C Surplus Reserve for A Reserve for B etc. Profit & . Loss Current Accretions, (Profits) Deductions (Losses) fDept.A On Sales -{ Dept.B L Dept. C Interest Other gains General Expense Business Losses, etc. It should be noted that there are two distinct types of differentiation of accounts. In one class a subdivision is made into several coordinate groups, as when a Merchan- dise account is divided into Groceries, Dry Goods, Hard- ware, etc. In the other the subdivision of an account is such that all negative items are placed in one account, all positive items in another. This is done where a gen- eral Profit and Loss Account is temporarily split up into two accounts, one showing Losses and the other Gains. The division of accounts into two distinct groups, one representing Goods and the other Proprietorship, consti- tutes the very essence of double entry bookkeeping. Yet the clear enunciation of this principle seems not to have been made until about 1830 when it was set forth by Thomas Jones, an American accountant, in lectures deliv- ered in New York. He showed plainly the two sets of ac- counts and pointed out that they are distinct in both content and purpose. The Goods accounts make record of 10 MODEEN ACCOUNTING the various items of wealth positive and negative, showing all the details of assets and liabilities. But the other set, consisting of the original Proprietorship and the Profit and Loss accounts, serve to exhibit the amount of capital in- vested at the beginning of the period and the gain or loss accruing during that period. By means of the various sub- divisions, as shown in ttie above diagram, the second set of accounts shows not merely the total net profits or loss, but as well the various sources of profit, the different lines of expense. These two distinct sets of accounts must, how- ever, agree in their results. Evidently the original capital plus the net profits, which is the showing of the Proprie- torship accounts, must at all times agree with the net assets, which are shown by the Goods accounts. It is this agree- ment between the Proprietorship and Goods accounts which serves as an evidence of accuracy, and constitutes the characteristic merit of double entry bookkeeping. Books might be kept containing only one or the other of these two opposed sets of accounts. Single entry book- keeping contains certain Goods accounts but omits all Profit and Loss items. On the other hand, the bookkeeping of governments and of charitable organizations have for their main, if not their sole purpose, the exhibition of income and expenses, that is, of certain Proprietorship accounts. But in systematic commercial bookkeeping a double record is kept, both Goods and Proprietorship are shown in full, and the two sets of accounts by agreeing serve to verify the results. The accounts presented have thus far been either pure Goods accounts or pure Proprietorship accounts. Each account showed either unmixed Assets or unmixed Proprie- torship. But in business practice many transactions are Mixed Transactions falling under class c, page 2, where there is both an exchange of goods and an element of profit. To illustrate: A purchase of goods is a pure exchange DOUBLE ENTRY BOOKKEEPING 11 transaction, for the value of the goods is uniformly taken as equaling the cash paid therefor, say one hundred dol- lars. A receipt of interest is a pure profit transaction, for the lender still holding his right to the principal in undiminished value receives an additional Good, that is, ten dollars cash paid him as interest. But the sale of merchandise should be a mixed transaction, for the mer- chant exchanges merchandise costing him only $100 for cash amounting to $110.^ The mixed transaction can be correctly portrayed by the use of unmixed accounts as was done in the accounts on page 5. Here the $3,000 cash received is in fact divided into two constituent pacts: return of cost price of horses $2,000 and additional cash received as profit $1,000. The " Miscellaneous Assets " account therefore represented that horses worth $2,000 were parted with, the cash ac- count showed the receipt of $3,000 and Proprietorship was at once credited with $1,000 Profit. The tendency to keep the Goods accounts thus unmixed, is increasing in business practice, but it is by no means universal, nor even preponderant. When goods are sold it is frequently impos- sible, and generally difScult, to determine how much the sold goods cost and how much of the selling price repre- sents profits. The salesman knows definitely the price called for by the bill of sale, but it would often take much complicated reckoning to determine the actual cost of the ' Theoretically it may be held, that the profit transaction preceded the exchange, that just before the sale the merchandise appreciated to the extent of ten dollars, and the increased value of the goods must be balanced by taking recognition of the profits. After this there is a pure exchange; merchandise worth $110 being exchanged for an equal value in cash. But such a conception is at variance with ordinary com^ mercial expression, and is thoroughly opposed to what is a cherished precept of accounting practice (even though it is not a principle of accounting theory) namely: that it is dangerous to recognize apprecia- tion of goods in the owner's hands. 12 MODERN ACCOUNTING miscellaneous assortment of merchandise sold. Conse- quently the custom in ordinary mercantile establishments is to treat the Mixed Transaction as if it were a pure Ex- change Transaction, and in the accounts to represent it as though the goods parted with were of the same value as the cash received, neither profit nor loss being shown at the time. Thus a merchant having capital of $2,500 all in- vested in merchandise, and selling for $110 a bill of goods which cost him only $100 would, if his account were kept unmixed, show. Form 2. Transaction. Merchandise. Cash. Capital. Profits. Starts in business with Sells Mdse. at profit + $2,500 - 100 + $110 = +$2,500 + $10 Closing condition + $2,400 + $110 = +$2,500 + $10 But in ordinary practice the accounts would appear thus: Form 3. TKANSACnON. Merchandise. Cash. Capital. Profits. Starts in business with Sells merchandise + $2,500 - 110 + $110 = +$2,500 + $2,390 + $110 = +$2,500 The Capital account here stays unchanged at $2,500 and no entry at all is made in the Profits account. The correct equation is really Merchandise $2,400 + Cash $110 = Capital $2,500 -{- Profits $10. The equation shown by the book is : Merchandise $2,390 -f Cash $110 = Capital $2,500 + Profit 0. DOUBLE ENTRY BOOKKEEPING 13 which is incorrect ia two particulars. It shows merchandise worth $2,390 instead of $2,400, and the total proprietor- ship, that is, Capital + Profits, as $2,505 instead of $2,510. It is only for convenience' sake that this confessedly incorrect statement is made. It is necessary at some later time to correct the errors. This is ordinarily done by ' ' taking stock, ' ' that is, ascertaining the amount and value of the merchandise actually on hand and making an entry in the books to correct the wrong showing of the merchan- dise account. This, of course, necessitates another entry at the same time in the Profits account in order to main- tain the proper equation, or balance of the books. In the example given above, inspection of the cash drawer shows $110 as called for by the Cash account. But an inventory of the merchandise on the shelves shows so many yards and so many pounds all which at cost are worth $2,400. But the Merchandise Account in the books shows $2,390, a misstatement which must be corrected by increasing the sum $10. Here the book value of the assets is increased by $10. Clearly there is no exchange. Nothing else is diminished, and an increase in the total book value of all the good accounts must, if the equation is to be maintained, be accompanied by a corresponding increase in one of the Proprietorship accounts, in this case evidently in the Prof- its account. The significance to bookkeeping of thus rely- ing on an inventory to secure correct results is extremely great, and the principles of making such an inventory are discussed at length in Chapter IV. So far the discussion has been based on the assumption that the merchant does business entirely on his own capi- tal, that he has not borrowed money, nor incurred any other obligation. In actual business this is seldom true, and it is accordingly necessary to see how liabilities of the proprietor are treated in accounting. If one has a stock of merchandise on hand, worth $10,000, half of which was 14 MODERN ACCOUNTING paid for in cash and the other half bought on credit, the equation cannot stand: Goods on hand $10,000 = Proprietorship $5,000. It is however perfectly correct to make the statement : Total goods on hand $10,000 — Amount due to creditor $5,000 = Proprietorship $5,000. Proprietorship represents the net wealth, not the gross assets of the proprietor. It is true that legally the goods bought on credit or with borrowed money are the property of the purchaser, belonging absolutely to him. But eco- nomically there is a divided ownership and the credit in- strument is merely a form of title to an undivided half of a certain mass of valuable goods. Liabilities, — that is, debts of any kind,— may therefore be considered as Nega- tive Goods, the assets being Positive Goods. While the pro- prietor holds and legally owns $10,000 worth of assets he also has $5,000 worth of Negative Goods which must be subtracted from the Positive Goods to determine the net proprietorship. But just as in algebraic equations a nega- tive term in one member may be transferred to the other member thereby becoming positive, so in the bookkeeping equation the form is ordinarily Goods $10,000 = Proprietorship $5,000 -f- Debts $5,000. This simple conception of negative items is of great impor- tance to bookkeeping, applying not alone to the relation- ship of debts, but to other subtractions which are made for technical purposes. In accounting, it is always legiti- mate, whenever a sum is to be subtracted from an amount appearing on one side of the equation, to place it instead as a positive item on the other side. It is entirely imma- terial whether one writes a — b^c or a = c + b. DOUBLE ENTRY BOOKKEEPnfG 15 On these few principles rests the whole structure of double entry bookkeeping. Summing up : 1. There is an initial equation made between Goods possessed and Pi'oprietorship. 2. Either side of this equation may be ramified indefi- nitely to suit the needs of the individual business. 3. Negative items appear, which instead of being im- mediately subtracted may be placed as positive items on the other side of the equation. Thus— e. g., items repre- senting IS'egative Goods or debts are not subtracted from the Positive Goods (assets), but are transferred to the other side of the equation and added to the items repre- senting Proprietorship. 4. In all subsequent transactions it is necessary to pre- serve the equation as follows: (a) An addition to one of the Goods account may be offset by a subtraction from another Goods account. (&) An addition to, or subtraction from one Goods ac- count may be offset by a similar addition to, or subtraction from a Proprietorship account. (c) Addition and subtraction are here used in the algebraic sense, a subtraction from a negative account be- ing equivalent to addition. CHAPTER II THE THEORY OP DOUBLE ENTRY BOOKKEEPING {continued} The discussion has thus far been in most general terms and with no reference to the details of bookkeeping tech- nic. This has been done advisedly, in order that the prin- ciples might be presented unrelated to conventional prac- tice. In just what form the equation described is to be written, how the books are to be ruled and paged, how items are to be gathered together for adding, whethar columns are to be run perpendicularly or horizontally, whether items are to be entered directly into a particular book or to be transferred to it from another book of origi- nal entry ; all these and many other details may be impor- tant in securing efficient bookkeeping. They may affect the ease with which the record of business operations is made and transcribed, or the readiness with which certain facts are ascertained from an inspection of the books ; they may aid in preventing error and detecting fraud. But after all, these are variations in technic, not matters of princi- ple. The essential thing in any form of double entry book- keeping is that there is somewhere a number of items rep- resenting what are here called Goods accounts, and some- where in the books another set of items which are here called Proprietorship accounts. The sum of these Goods items, taking in account the Negative Goods, or debts, must equal the algebraic sum of the Proprietorship items. Nevertheless the points of more general acceptance in bookkeeping convention should not be neglected, although it must be remembered that even the most deepseated con- 16 DOUBLE ENTRY BOOKKEEPING 17 ventions in bookkeeping could all be violated without, in the least, affecting the essentials of the system. In whatever form the first record of the transaction is made, it is customary to have the items of similar nature gathered together on a page of a book (which may indeed be loosely bound, or even consist of unbound sheets or cards) which is called the Ledger. Although legally the ledger is treated as an inferior book, its validity in court being less than that of the books fr'om which the ledger entries are ordinarily transferred, it is in bookkeeping the most important, the essential book, as is indicated by the names which have been given it in other tongues, Libro Maestro, Grand Livre, Hauptbuch. It is possible to use the ledger alone. This was customary among the earlier Venetian accountants and even to-day it is the method oc- casionally employed, with correct results, for keepipg sim- ple accounts. But in a large business the use of a ledger alone is clearly impossible, and even in a small establishment such a system, while possible, is unsatisfactory. The chief trou- ble is the difficulty of detecting errors. The use therefore of some chronological record of transactions, in contradis- tinction to the ledger where entries are classified, while multiplying the writing to be done is really an economy. It is easier to make the original entries in such a book; the entries are less liable to error ; an error once made can more easily be detected. In each of the ledger accounts there will be certain items to be added, certain other items to be subtracted. In early bookkeeping these items were all listed in a single column, addition or subtraction being indicated. This is the form which has thus far been used in the pages of this treatise ; it is in some cases still used in modern bookkeep- ing practice where the items to be subtracted are generally differentiated by being written in a different colored ink. 18 MODERN ACCOUNTnsrG But it is apparent that with a single column there is a great danger that the bookkeeper will make the mistake of adding where he should subtract or of subtracting where he should add. It was therefore a very valuable, though a simple device, to separate the items to be added from those to be subtracted. Thus the cash account given on page 5 instead of appearing as it does there in the form: Form 4. Cash Account. Amount with which business started +$5,000 Paid for Horses - 2,500 Paid for Farm - 2,000 Received for Rental + 100 Received for Horses + 3,000 Amount on hand +$3,600 is presented with positive and negative items separated thus: Form 5. Cash Account. + Amount with which started business $5,000 Received for Rental 100 Received for Horses 3,000 Total $8,100 Paid for Horses $2,500 Paid for Farm 2,000 $4,500 Balance 3,600 $8,100 Balance $3,600 The word " Balance " as here used signifies merely the difference between the sum of the positive and the sum of the negative items, or the algebraic sum of all the items. It is customary, but by no means necessary to add the " Balance " to the smaller of the two sides so as to produce the same total at the foot of each column. This is less rigidly done in recent years than formerly, as in many ledgers special column rulings (described in Chapter XIX) render the formal balancing of the accounts unnecessary. DOUBLE ENTRY BOOKKEEPING 19 Certain of the accounts thus presented in double col- umn will represent positive Goods or Assets. It is a con- vention well-nigh unbroken, although its violation in no way affects the results to be gained by double entry book- keeping, to list the items representing Goods on hand, or subsequently acquired, in the first or left hand column, the subtractions therefrom in the second, or right hand col- umn. In all Assets accounts the left hand column is there- fore the positive column, the right hand column containing the negative entries. It is a further convention applicable to all accounts to call the left hand column ' ' Debit ' ' and the entries therein Debit entries. The act of making a Debit entry is called Debiting or charging an account. The right hand column is called ' ' Credit, ' ' the entries therein Credit entries, and the act of making such an entry Crediting an account. Furthermore the normal condition of all Asset accounts is to have positive— that is, a Debit excess of values. As- sets, things which one possesses evidently are positive. One may lose them all, or pay them all away but normally the limit is zero. Fire may burn all but not more than all of the merchandise; one may pay out all the Cash in the drawer, but it is difScult to squeeze it so as to make it pay out more than was put in. Thus, while in rather technical bookkeeping entries an asset account may show an excess on the credit side, such is not the normal condition, and always requires interpretation.'^ Another class of accounts will represent the Proprietor- ship accounts and these too will be divided into two col- umns. The Proprietorship account presented on page 5 ' A good illustration is where the cash account is kept so as to include not merely cash in the till, but also cash deposited in the bank. Now, while the till cannot give out an excess, it is sometimes possible to pay out by check in excess of the amount on deposit. In such a case the Cash account, normally the highest type of a pure positive Goods (Assets) account may show a negative balance. 20 MODERN ACCOUNTING Form 6. Proprietorship Account. Original capital +S5,000 Loss by death — 500 Profit by rental + 108 Profit by sale + 1,000 Net proprietorship +$5,600 becomes Dr.(-) Form 7. Proprietorship Account. Cr. (+) Loss by death $500 Balance 5,600 Total $6,100 Original capital $5,000 Profit by rental 100 Profit by sales 1,000 Total $6,100 Balance $5,600 A striking contrast between the aeeonnt showing an asset and one indicating Proprietorship is to be noted. In the former the positive items appear in the left hand col- umn and are hence Debits; in the Proprietorship accounts the positive items appear in the right hand column and are hence Credits. In one class of accounts therefore Debits are positive and in the other class they are negative. This confusing use of the terms Debit and Credit has been one of the most perplexing points in accounting practice. Undoubtedly the terms were originally used in their strict sense of indicating a Debtor or a Creditor and in accounts showing such relationships they still maintain their original meaning in full force. If an advance of $100 is made to A it constitutes him a Debtor to that amount, and this is shown by charging or Debiting hiu account, which is conventionally done by an entry in the left hand side. Should A repay the $100 it of course can- cels the Charge, which is shown by entering $100 in the DOUBLE ENTRY BOOKKEEPING 21 right hand column. If he in turn advances more than the $100 it transforms him from a Debtor to a Creditor, so that it is not unnatural that with Debits on the left hand the right hand column should be called Credit. This orig- inal meaning of Debit and Credit is still preserved in per- sonal accounts. But the application of Debit and Credit to other classes of accounts is more difficult of explanation. It may not be unreasonable for the merchant having become accustomed to list that most important class of assets, claims against customers, as Debits, to treat other assets in the same manner. Most writers have gone fur- ther in attempting an explanation and have assumed that Debit and Credit in all accounts, whether representing debt relations, or other Assets, or even Proprietorship, show a relationship of Debtor and Creditor. This is ac- complished by a rather forced system of personification. Thus for instance Cash, or Merchandise is personified as being a Cashier or a Store Keeper, who is in turn indebted to the business for all values which have gone into his hands. On the other hand the Proprietor, contrary to the legal fact, is assumed to be a Creditor of the business. These are perhaps not so bad, but when the same theory of personification is carried to such accounts as Expense, Profit and Loss, etc., it becomes difficult of application and of less than doubtful value. The better theory rejects all this personification and, as is done in this book, treats the two sets of accounts as representing two different concep- tions, each of which has its own value and meaning, and in which Debit and Credit are used conventionally with dif- fering signification. Thomas Jones, writing about seventy years ago, said: " All debits are net sums owing to us, nor are all credits sums we owe. Some debit items are owing to us, others (Stock) are sums withdrawn by us; some (Merchandise) are sums paid, others (Cash) are sums received; and the 22 MODERN ACCOUNTING eredit items also stand for equally dissimilar facts. Prom which it must be evident that these terms are used arbi- trarily, and any attempt to exhibit them in one uniform relation of indebtedness must necessarily oblige us either to use language of corresponding ambiguity, or resort to the personification of things which not only have no exist- ence but the indebtedness of which cannot possibly have any apparent influence on the end we aim to accomplish. As names, enabling us to designate which side of any ac- count we may refer to or speak of, they answer our pur- pose ; and so would the terms blue column and red column, equally well, if custom permitted their use. In personal accounts they bear a literal meaning ; and by analogy they have been extended to all other accounts ; but the relations which constitute that analogy are too obscure to be of use as a guide to the student, and are more calculated to mys- tify than explain the subject. ' ' ^ And Colonel Charles E. Sprague in his ' ' Philosophy of Accounts " says that those who make such a personification of the business have been " misled by the lazy habit of bookkeepers in calling all Credit balances liabilities al- though they know that some of those balances are not lia- bilities. Even admitting that there is a fictitious entity it owes nothing to the real owners " (p. 33). "While it is true that most of the intervening authors present unquestioningly the naive personalistic theory, it is interesting to note that Jones who was the first, and Sprague the latest and most penetrating American theoret- ical writer are thus in accord. And on their side are found many of the leading Eutopean authorities, among whom may be mentioned Hiigli and Schaer. Eeference has been made to the confusion caused by Mixed Accounts,— that is, accounts in which the element • Principles and Practice of Bookkeeping, p. 21. DOUBLE ENTRY BOOKKEEPING 23 of Profit is entered without separation from the exchange element. Thus where merchandise is purchased for $100 the Merchandise account is debited with that amount. If half the Merchandise is sold for $75 the account is ordi- narily credited with that entire sum, instead of crediting Merchandise with $50 and Profit and Loss with $25. This results in a balance in the Merchandise account which does not show the value of the unsold stock, but that sum less the profits on the goods sold. Mixed accounts are cleared at intervals by crediting the account with the in- ventory value of goods on hand, leaving a difference be- tween the total debits- and the total credits of the account, corresponding to the profits realized. The inventory being brought down as the balance on the new Merchandise ac- count, that again starts out as a pure Goods account. This may be illustrated algebraically as follows : The cost price of the merchandise (C) = Cost of Merchan- dise sold (Sj) + Inventory (I). Amount received for sales (S) = Cost of Merchandise sold (SJ + Profit (P). Therefore C — S = I — P. But C — S is the Balance (B) shown in the Merchandise Account before the introduction of the Inventory. Hence I — B = P. The crediting of the Inventory is equivalent to subtracting the outstanding balance, so that the remainder indicates the amount of Profits. The reversal of the positive sides in the two classes of accounts (Goods accounts and Proprietorship accounts) is of considerable importance in the technic of bookkeeping. It has already been shown that the fundamental equation running through all accounting is one in which Goods, or, ignoring debts. Assets equal Proprietorship. But assets are conventionally listed in the left hand column and hen >s 24 MODERN ACCOUNTING show Debit excesses or balances. Proprietorship is con- ventionally listed in the right hand column and hence the balances are Credits. Consequently the fundamental equa- tion is one in which Assets (Debits) = Proprietorship (Credits) so that there is an equivalence not merely between Assets and Proprietorship but also between Debits and Credits. The significance of this is discussed on a following page. In addition to the two classes of accounts just men- tioned—namely, accounts showing Assets and normally having debit excesses, and Proprietorship accounts with a normal credit excess, the scheme of accounts contains two other groups referred to on page 13. These are Negative Goods accounts, of which Debts Payable may be taken as a type, and Negative Proprietorship accounts, tj^pified by the Expense account. Considering first the Negative Goods accounts it is seen that they are items which might logic- ally have been entered to the credit of some asset account. To illustrate: If a piece of real estate is purchased for $20,000, of which $15,000 is paid in cash and the balance is still due, it would not be illogical (although the prac- tice is condemned by accountants, and in cases, is even considered fraudulent misrepresentation) to record the transaicStion thus: ' ' !! FOHM 8. Br. (+) Real Estate. (.-) Cr. Land and buildings $20,000 Due on purchase price $5,006 in which the debt appears as an immediate subtraction from the total value of the property. But for the sake of clearly showing the exact status, it is much better to sepa- rate these two items, thus : DOUBLE ENTRY BOOKKEEPING 25 Dr. (+) Form 9. Real Estate. (-)Cr. Land and buildings- $20,000 -Dr.(+) Form 10. Debts Payable. (-) Cr. Due on real estate $5,000 This not only shows the present situation more clearly, but also allows for further details, for the Credit column of the Real Estate account can now show other deduc- tions from the value of the Real Estate quite different from the unpaid portion of the purchase price. Thus if fire damages the building to the extent of $1,000 the Real Estate account will show: Dr. (+) Form 11. Real Estate. (-)Cr. Land and building $20,000 Damage by fire $1,000 The Debit column of the Debts Payable account can be used to show payments on account thus : Dr. (+) Form 12. Debts Payable (-)Cr. Paid on account $1,000 Due on real estate. $5,000 The showing thus made is much more explicit than if all four items were lumped together thus: 26 MODEKN ACCOUNTING Dr.(+) Form 13. Real Estate. (-)Cr. Land and building $20,000 Paid on account 1,000 Due on purchase price $5,000 Loss by fire 1,000 although in both methods the net assets must be the same $15,000. In so far as debts are considered as subtractions from assets they must appear in a credit column, for it is in that column that any deductions from assets appear. But a cleavage takes place, and a separate account is estab- lished to represent debts. The mortgage shown in Form 8 no longer appears in the credit column of the Real Estate account but in the credit column of a separate Debts Pay- able account. Every new debt incurred or every addition to outstanding debts necessarily appears in a similar col- umn, while any debt paid, or otherwise canceled is placed among the debits, for here as elsewhere in accounting the two sides of any account are opposed one to the other and tend one to cancel the other. A statement of the Goods would therefore show : Real Estate $20,000 + (— Debts $5,000) = $15,000 for by the simplest algebraic principle the effect of adding a negative is the same as subtracting. But subtraction is at best a clumsy process, and again by ordinary algebraic principles it is customary to trans- fer all such negative items to the other member of the equation with an accompanying change of sign, so that the equation becomes Real Estate Form 14. Proprietorship Dr. {+) $20,000 + Debts Payable Cr. (-) Dr. (-) It follows therefore that in all accounts indicating Cr.(+) Dr.(-) Cr.(+) 815,000 $5,000 DOUBLE ENTEY BOOKKEEPING 27 debts the balance is normally on tlie Credit side. And while it is true that a credit in a debt account indicates a subtraction from the total assets of the proprietor, yet in itself the Credit side, of the Debt account may be consid- ered the positive side. This is true in the sense that an existing debt appears on that side, and that the cancela- tion of a debt is performed by making an entry among the Debits. In form therefore the Debt or Liability accounts, as they are ordinarily called, agree with the Proprietor- ship accounts, in having normally a credit balance. Agree- ing thus with the Proprietorship accounts they necessarily differ from the Asset accounts which normally have a Debit balance. "While this may be a little confusing at first to the student it is in perfect accord with algebraic principles and should offer no permanent difficulty. The uses of Debit and Credit in the various classes of accounts may be represented schematically thus: Assets. Proprietorship. Debts. Debit + -1- Credit + All that has b^en said regarding the Negative Goods accounts can be said, mutatis mutandis, of the Negative Proprietorship accounts, of which expense is taken as type. An expense being an outlay of goods (e. g., cash) without the receipt of some other equivalent Good ^ it can only sig- > From the econdmic viewpoint even an expense involves the ex- change of equivalents, but this is for convenience' sake, disregarded by the accountant. For instance the wages paid to a watchman is treated as an expense, for the services which he gives in return, are not considered as a "Good" to be taken into account. Even when there is a tangible equivalent received in return for the payment the account- ant may at times disregard it in his accounts, as for instance, the cost of repainting a house is treated as an expense, although for part of the money expended there was received an equivalent value of white lead. 28 MODEEN ACCOUNTING nify that the total Proprietorship has been lessened. ' A diminution of the Proprietor's capital can be indicated by debiting the Capital account thus: Form 15. Dr. ( — ) Proprietor's Capital. {+) Cr. Expenses paid $500 |{ Original capital $15,000 but it is more satisfactory temporarily to segregate such Expense items, putting them into- a separate account, and transferring this account, which must normally have a Debit excess, to the left hand member of the equation. Here it can conveniently be added to the Asset accounts which similarly have a Debit excess. Thus all Negative Proprietorship accounts. Expense, Profit and Loss (where there is a deficiency), and other similar accounts have the Debits in excess. In this respect they resemble the Asset accounts, and consequently are in contrast to the Capital account and to those showing Debts. The equation of accounts, first given Goods accounts (Debit) = Proprietorship account (Credit) becomes : Assets (Debit) — Debts (Credit) = Capital account (Credit) + Profits (Credit) — Negative Proprietor- ship accounts (Debit) and by transposition : Assets (Debit) + Negative Proprietorship accounts (Debit) = Capital account (Credit) -|- Profits (Cred- it) -f Debts (Credit) or finally as values are expressed in figures, and can more conveniently be added vertically than horizontally, the equation becomes: DOUBLE Debit ENTRY Form BOOKKEEPING 16. Credit 29 Assets Expenses Loss, etc. Capital Profits Debts, etc Total Debits Total Credits In any set of books therefore the total debits should equal the total credits and this is true whether the total of all debits is compared with the total of all credits, or whether the comparison is made between the sum of debit balances and the Bum of credit balances. In the routine of bookkeeping this is of great service, furnishing the most frequently used criterion as to the correctness of the books. Without inquiring further as to the nature of the accounts, or the significance of the various outstanding balances, the bookkeeper ascertains at regular or frequent intervals whether the Debits and the Credits in his ledger are equal. If this is the case the ledger is said to balance. For ordi- nary purposes such a balancing is taken as evidence, in- conclusive though it may be, that there are no errors in the bookkeeper's work. Certainly a ledger is incorrect so long as it fails to bal- ance, but the evidence from balancing is not conclusive. It does show that there has been a Credit for every Debit. But it does not show whether a transaction which should have been entered is altogether omitted; it does ribt indi- cate transpositions which may have been made, nor errors of equal amount made in both the Debit and Credit post- ing. It does not show that an item has not been entered in Merchandise which should have gone into Real Estate which would make a wrong showing of the kind of assets held. More unfortunately it does not show whether item An example of such a procedure is found in the reports of the C. & N. W. R. Co. which in the fiscal year 1898-9 deducted an even $5,000,000 from the cost of the road charging the same to the income account. While such conservative action is highly praised by financial critics, it must be admitted either that it is a direct violation of book- keeping principles, or that, even in one of the best managed roads, the accounting system broke down and had to be patched. 2 See model form given on page 66. DOUBLE ENTEY BOOKKEEPING 33 erate statement of Rehm that the " principle of truthful- ness in accounting is only relative and limited." BIBLIOGRAPHICAL NOTE TO CHAPTERS I AND II Caslill, J. A. Principles of Bookkeeping. London, 1896. Cayley, a. The Principles of Bookkeeping. Cambridge, 1894. Dyer, S. A Common Sense Method of Double Entry Bookkeeping on First Principles as Suggested by De Morgan. Part I. Theoretical. London, 1897. Foster, B. F. Double Entry Elucidated. Boston, 1852. HtJGLi, F. Buchhaltungsstudien. Bern, 1900. Jones, Thomas. The Principles and Practice of Bookkeeping. New York, 1841. Lisle, George. Accounting in Theory and Practice. Edinburgh, 1906.' [This is perhaps the best single volume treating the entire subject which has appeared in English.] ScHAER, J. F. Versuch einer wissenschaftlichen Behandlung der Buchhaltung. Basel, 1890. [In this treatise is presented the theory of bookkeeping on which Chapter I is based.] Sprague, C. E. The Philosophy of Accounts. New York, 1908. [The most important theoretical work which has appeared in Enghsh.] TiPSON, F. S. The Theory of Accounts. New York, 1902. [Con- tains answers to the questions on Theory of Accounts given in the New York examinations for Certified Public Accountants.] The following reference works are also valuable : The American Business and Accounting Encyclopaedia. Detroit. Third Edition, 1901. [A comprehensive work of somewhat mixed character.] Dawson, S. S. Accountant's Compendium. Third Edition. London, 1908. [A valuable reference work in dictionary form.] Encyclopedia of Accounting. Edited by George Lisle. 8 vols. Edinburgh, 1903-8. [A most valuable work of highest scien- tific standard.] 34 MODERN ACCOUNTING Stern, R. Buchhaltungs Lexikon. Wien, 1904. [The repre- sentative German work, but less comprehensive in its charac- ter.] Useful text-books of bookkeeping without especial reference to theory are: Bogle, A. M. Comprehensive Bookkeeping. New York, 1905. [An admirable little work giving good exercises free from ex- cessive arithmetical detail.] DiCKSEE, L. R. Bookkeeping for Accountant Students. Fifth Edition. London, 1906. Advanced Accounting. Third Edition. London, 1908. [The above two works form a comprehensive treatise. The latter contains an admirable collection of bookkeeping problems.] On the History of Bookkeeping, with an extensive bibliography of the subject, see : Brown, R. A History of Accounting and Accountants. Edin- burgh, 1905. CHAPTER III THE BALANCE SHEET A LEDGER kept according to the principles of double entry bookkeeping will at any time show various accounts in each of which may appear sundry Debit and Credit items. A list of the totals of the items shown in each ac- count gives such a Trial Balance of footings as is shown in column (6) below: Form 17. (o) Title of Account. (6) Footinga. T)T. Cr. Balances. Dr Cr. Cash $9,000 22,000 15,000 2,000 150 l',SOO 10 550 $8,000 21,000 3,000 7,000 100 110 11,000 $1,000 1,000 12,000 150 1,400 , Bills Receivable Bills Payable $5,000 Rent Commissions ICO Proprietor's Account 10,450 $50,210 $50,210 $15,550 $15,550 The characteristic feature here is that the total Debits of necessity equal the total Credits. Such a balance of footings is chiefly valuable as furnishing strong, though not conclusive evidence that entries have been correctly posted. As an exhibit of the status of the concern it is made more lucid if, instead of the total footings, only the excesses of one side over the other are listed, thus forming a Trial Balance of Balances, as column (c) is somewhat loosely termed. In this, too, the total Debits necesisarily 4 35 36 MODEElSr ACCOUNTING equal the total Credits as the smaller of each pair of items has been subtracted from each column, and the sum of $34,660 being thus taken from equals leaves equal remain- ders. Such a Balance must exist at any time in books which are free from errors. But as books are kept, though they miist at any time thus balance, the statement which is made by the Trial Balance would ordinarily be incorrect in matter and incomplete in form. Incorrect in matter hecause of the presence of mixed accouhts, such as the merchandise account, which give the excess of Credits over Debits but do not indicate the value of merchandise on hand, nor exhibit the profit on goods sold. Assuming in the case given that an inventory shows the merchandise to "be worth $4,000 there is an error of $3,000 which must be adjusted both in the Merchandise and in some Proprietor- ship account, normally by crediting Profit and Loss. There may also be further inaccuracies because other ac- counts show only the amount of expenses paid or' profits received and not the total incurred or accrued. Thus the amount of interest or rent appearing in the books does not, ■except by chance, indicate the charges actually incurred during the period covered by the accounts, but merely the amount which has been paid, which may be either greater or less than the amount properly chargeable to Profit and Loss. In the case given it may be assumed that the rent item of $150 was for six months; but that at the time of balancing three months more have elapsed on which rent is accrued but not yet paid, so that there is altogether $225 Tent chargeable against the profits of the period. This simple illustration is, of course, capable of the widest ex- . tension, for in a large concern the unadjusted accounts are frequently of decided importance. The Trial Balance is incomplete in form becaUse it shows several items indicating profit or loss, and these havff THE BALANCE SHEET 37 not been combined into a single account, so as to present the facts in a way easily to be undterstood. A Trial BaU ance fails to concentrate the various temporary; subsidiary accounts which indicate changes in Proprietorship. This must be done by closing these accounts into the Profit and Loss Account which then shows : Dr. Form 18. Profit and Loss. Cr. General Expenses $1,400 On Merchandise Sales. . . Commissions Balance . . $3,000 .. 100 Rent Balance .... 225 .... 1,475 $3,100 $3,100 $1,475 If the changes here indicated are made in the ledger there then results a true Balance Sheet which may be pre- sented in the following form : Form 19. Dr. Balance Sheet. Cr. Cash .isi nnn Bills Pavable . . $5,000 Merchandise 4.000 Rent Due . . 75 Bills Receivable 12,000 $17,000 Proprietor's Account.. . . . . 11,925 $17,000 The Balance Sheet then differs from a mere Trial Bal- ance in that correct figures have been introduced through the inventory and the subsidiary, temporary accounts have all been gathered together and combined with the more permanent Proprietorship account. In the instance given here all is combined in one Proprietor's account, as is customary in the accounts of private traders. Where a corporation is concerned the net profits are not added to 38 MODEKN ACCOUNTING the Capital account, but may be stated in a single credit to Profit and Loss, oi* perhaps by credits to Surplus, Re- serve, etc., as shown in later chapters. The gathering together of aU the changes in net wealth and their condensation into one account presumably takes place in the ledger itself as weU as in the statement known as the Balance Sheet. It is done by transferring the bal- ance formerly standing to the debit of Expense to Profit and Loss; — that is, by Debiting the latter and Crediting the former account. Similarly with the other accounts concerned, and finally the balance showing in Profit and Loss is itself transferred by an identical process to the Proprietor's account. When this is done a trial balance taken from the ledger corresponds exactly with the Bal- ance Sheet given above. There are no longer any balances standing to temporary accounts; there are no longer any incorrect balances due to the inclusion of mixed accounts. But this condition is but momentary and as soon as trans- actions are again recorded the Trial Balance no longer presents a statement at once correct and condensed. But it is, of course, possible to prepare a Balance Sheet from the data obtained from the ledger, supplemented with an inventory or other estimate of values, without making the changes in the ledger accoimts. The condensation and combination shown in the Balance Sheet given above applied only to Proprietorship accounts. A somewhat similar grouping of the accounts representing Goods, both positive and negative, may be performed for the purpose of making the showing of the Balance Sheet more perspicacious. Thus the ledger may contain a num- ber of different accounts of individuals who are debtors. It were foolish to list these individually in the Balance Sheet and so they may be subsumed under the title Ac- counts Receivable, although in the ledger each debtor has a separate account. Or a bank, while caref^Uy distin- THE BALANCE SHEET 39 guishing in its own books between the amounts deposited with each of its several correspondents, in its Balance Sheet may not only combine these but may write them with the actual cash on hand under the single title " Cash on hand and on deposit." The Balance Sheet then not only shows a statement condensed to correspond to the ledger after that has been altered by the changes periodically in- troduced, but may go further in, the process of condensa- tion combining accounts which ^re kept separate in the ledger. To sum up : A ledger as kept from day to day shows both Debits and Credits in both permanent, and temporary accounts, and contains incorrect amounts in the mixed ac- counts, and unadjusted accounts such as "Interest Pay- able. ' ' A trial balance of these footings, or of the balances would indicate whether the book as a whole balanced, but would give a poor survey of the condition of the concern. To make a clearer exhibit there should be a consolidation of accounts, a correction of the mixed accounts by the in- troduction of the inventory, an adjustment of accruing expenses and income, a closing of the subsidiary accounts into the general Profit and Loss account. A list of the ledger balances after this has been done would be a Bal- ance Sheet. But in the approved form still greater sim- plicity may be secured by grouping together similar items, and the cancellation of certain positive and negative items even where these processes are not performed in the ledger. In the preceding chapter was sketched the development of a scheme of accounts from an ideally simple, but un- serviceable set of three accounts, to one which by the division and subdivision of different classes, and the sepa- ration of the Debit and Credit sides of a single account into independent accounts, secures a mass of detail neces- sary to the thorough understanding of the business oper- ations. The formation of the Balance Sheet is the reverse 40 MODEEN ACOOUNTmG process. From a mass of details in which the forest is hidden by the trees, there is prepared by synthesis and simplification a statement in which the main facts are pre- sented succinctly and intelligibly. The process of differ- entiation and integration has no fixed limit. It is carried on so long as it proves economically justifiable. The re- verse process involved in the preparation of a Balance Sheet, similarly has no absolute limit. For its daily rou- tine, a bank, for instanco, needs to have accounts showing the amount due to each individual; for other purposes it may desire to show separately its " Savings deposits," its " Time Certificates," its " Checking Accounts," etc., for still others a single item " Amount due Depositors " suf- fices. The purpose for which the Balance Sheet is prepared determines the extent to which condensation is to be car- ried and the form in which it is to be presented. The advantages of the Balance Sheet being obvious, it seems strange that its use was so long delayed. In the earliest treatises the taking of even a trial balance of foot- ings was not suggested as a means of verifying the correct- ness of postings. That was done by carefully checking each Debit entry with its corresponding Credit and when everything cheeked off the ledger was assumed to be cor- rect. Nor were the ledgers balanced at regular or frequent intervals. Of early account books still extant one was not balanced at all in nine years, another not until the end of twenty-seven years. Early trading being largely of the nature of separate ventures, the sending of a caravan to one place or a ship to another, profits were reckoned sepa- rately on each completed venture. But those still uncom- pleted, the ships not yet come in, were left out of account. Hence it was not necessary to balance the ledger as a whole, and the practice recommended by Paeiolo of bal- ancing only when a new book was opened seems to have been generally followed by trading companies. The Brit- THE BALANCE SHEET 41 ish East India Company prepared a general balance in 1665, but not again until 1685. The French ordonnance of 1673, however, required an inventory and Balance Sheet each two years and in a treatise by Sehurtz in 1695 a quar- terly balancing of the ledger is inculcated. In recent times the preparation of an annual Balance Sheet is nearly universal. It is required by law in Eng- land, France, Germany, and other countries of all corpo- rations. And while in the United States there are few legal requirements in regard to the form of accounts, yet certain classes of corporations which are regulated by law,, such as banks, insurance companies, and public utility companies, frequently are required to submit statements including Balance Sheets to state or federal officials. The Interstate Commerce Commission, under authority of the amended law of 1906, has prepared a form for the Balance Sheet to which all railroads under their supervision must conform. A Balance Sheet in this form is given on page 59, The Massachusetts business corporation law of 1903 also provides a form of Balance Sheet to be annually prepared by all corporations within the State. ■^ A Balance Sheet being a summary of the ledger must contain two groups of figures, showing respectively Debit and Credit balances. Usually these two groups are ar- ranged in parallel columns, similar to the conventional arrangement of a ledger account. Indeed in earlier days, and even to-day in continental countries, the Balance Sheet is in fact a ledger account, all of the accounts being actu- ally closed out and their balances transferred to a " Bal- ance Account " which, of course, itself balances. When this is done the ledger is actually closed, no outstanding balances any longer appearing to the Debit or Credit of any account. English and American bookkeepers long ago tired of the useless work of actually closing the accounts in the ledger, necessitating as it does the immediate re- 42 MODERN ACCOUNTING entering of the items in new accounts. The Balance Sheet is now prepared as an outside abstract of the ledger rather than as an actual ledger account. Some confusion is, however, caused by divergence in practice in regard to the relative position of the column containing " Asset " items and " Capital and Liabilities " items respectively. The general custom throughout the world is to place the asset items in the left hand column. But in England the reverse is customary, and asset items appear in the right hand column. Much discussion has taken place on this point. The chief argument against the English custom is that it is at variance with the practice of the rest of the world, even Scottish accountants not follow- ing the English model, and it seems also to be at variance with common sense, that a summary of the ledger should reverse the accounts from the position which they hold in the ledger itself. On the other hand it is urged in sup- port of the English practice that the Balance Sheet is not in itself a summary of the ledger but an account sub- mitted by the company or by the directors to the stock holders, for which purpose it is, of course, actually pre pared. As such it is logical to charge the directors with the capital and other funds furnished to the company and to take credit for the assets on hand, which at the time of the report are constructively tendered to the stockholders in satisfaction of the account. The extended debate on the subject seems largely a logomachy, and doubtless no one ever was misled by the divergence in practice. Uniformity is however desirable, and even among British accountants there is much opposi- tion to this national idiosyncrasy. " The custom seems to have arisen, ' ' says Lisle, ' ' through the influence of the forms given in Acts of Parliament, chiefly the Companies Act, 1862, which must have been prepared by those unac- quainted with the theory of accounts. The Profit and Loss THE BALANCE SHEET 43 Account is taken from the Ledger, and the sides are not transposed, and there is no logical reason why the sides in the Balance Sheet should be reversed when the items in it are supposed to be the balances remaining in the Ledger, after certain balances have been taken to the Profit and Loss Account. ... It is certainly most desirable that the form of Balance Sheet with the assets on the left side which is founded on correct principles, should become universal, conforming to the best traditions and the accepted practice of the rest of the world. ' ' Technically expressed the difference is that the British Balance Sheet is the opening balance account, while the rest of the world uses the ' ' closing balance ' ' account. As shown above, in the formal method of balancing, all ac- counts are closed into a balance account on the debit side of which appear the debit balances of the various ledger accounts. But in this system the accounts must imme- diately be reopened, which is also done by means of a Bal- ance Account, the " Opening Balance." The new asset accounts, " Cash," " Merchandise," etc., being debited with the outstanding balances, a corresponding credit is made in the Balance Account, which evidently is identical, save that the sides are reversed, with the " Closing Bal- ance ' ' account.. But it is difficult to find any logical pref- erence for the account showing the opening of the new year over that showing the momentarily antecedent closing of the old year. Still further divergence exists ill regard to the title to be given the two sides of the balance sheet. That contain- ing the assets is frequently headed " Assets " or " Re- sources." The other side has perhaps most frequently been entitled " Liabilities." To this much criticism has been made on the ground that the Capital or Proprietor- ship accounts, which in many cases are the most important are, strictly speaking, not liabilities of the company, still 44 MODERN ACCOUNTING less of the individual proprietor. To avoid this difficulty the title " Capital and Liabilities " is often used. Other accountants prefer to head the two sides Debit and Credit, as an ordinary ledger account or account cur- rent is headed. But the application of the terms Debit and Credit offers an additional difficulty where the Eng- lish form of Balance Sheet is adopted. It is a well-nigh inviolate convention— (but only a convention and not, as claimed by many writers, a principle) —of double entry bookkeeping, that the left hand column is called " debit." But another sacred convention is that assets are " debits." When he finds the assets in the right hand column the ac- countant is indeed perplexed. Shall the right hand column be called Credit because of its position or Debit because of its content ? Practice, for here as elsewhere in account- ing there is no absolute authority, varies. Thus the head- ings and position of the two columns of this most impor- tant accounting form, show, in good usage, the following variations : Assets Liabilities Resources Liabilities Liabilities Resources Liabilities Assets Debit (Assets) Credit (Liabilities) Debit (Liabilities) Credit (Assets) Credit (Liabilities) Debit (Assets) Active Passive. It thus appears that there is not merely divergent usage as to the position of the asset items, but that these assets are sometimes called Debits and sometimes, as for instance in the Balance Sheet of the Bank of France, Credits, and sometimes the first column not only contains the liabilities but is labeled Credit. The headings " Active " and " Passive " deserve far- THE BALAISrCE SHEET 45 ther mention. They are given to the two sides of the Bal- ance Sheet by practically all the world except the English speaking peoples. Reason as well as custom gives prefer- ence to them over the other simple descriptive titles, for the one side of the Balance Sheet sometimes contains items which are not assets or resources while the other side always contains items which are not liabilities, and fre- quently includes those that are neither liabilities nor capital. Debit and Credit too are undesirable as being technical but not significant. English and American ac- countants have nevertheless been loath to adopt this better nomenclature. It is recommended by Sprague in his val- uable treatise " The Accountancy of Investment," but it is practically unknown in balance sheets published in the United States. A slight variation in the forms given above consists in using the phrase " Capital and Liabilities " in place of the single word Liabilities to designate one side of the Balance Sheet. By many accountants this is considered an important improvement. It certainly has the advan- tage of more completely describing the contents of the column, and removes the confusion which arises from treating the proprietors' capital as though it were legally a liability. As the Balance Sheet is designed to give an intelligent synopsis of the business it is evidently advantageous not only to consolidate ledger accounts of an identical nature into a single collective account, as the sums due from vari- ous customers are subsumed ander the title " Accounts Receivable " but also to group the various items, which while differing enough to be kept separate, have certain similar characteristics. Thus while Accounts Payable and Bills Payable are separately shown it adds to clearness to have them appear near each other in the Balance Sheet. Subheads are frequently introduced into Balance 46 ]\IODERN ACCOUNTING Sheets to make more clear the grouping of items. The particular terms thus used vary according to the taste of the accountant and the nature of the corporation. In a grouping coming into considerable use the headings are: Capital Assets, Current Assets, and Deferred Assets, with a similar division of liabilities. By Capital Assets is here meant the permanent plant of the corporation, presumably purchased with the proceeds of the Capital Liabilities — that is, the stock and bonds. Current Assets are cash, realizable securities and accounts, or merchandise or mate- rial to be currently consumed. On the other hand Current Liabilities axe those that are not permanent or funded. Deferred assets generally represent expenses paid in ad- vance. Their inclusion among assets is discussed in Chap- ter V. This classification is used for instance by the Chicago and Alton Railway. The grouping of similar items leads to the marshaling of the entire list in some systematic order. This is espe- cially the case in regard to the assets, where the system generally used is based on the degree of ease with which they may be converted into cash; or, in ether words, the assets are ranked according to tlieir liquidity. At one end of the scale is cash in which liquidity is perfect, on the other end those assets which cannot be realized at all while the business continues its existence, as perhaps the roadbed of a railroad or the good will of a factory. But disagreements appear as to whether the proper order is from liquid assets to fixed, or from fixed to liquid. Stated concretely the question is whether the list of assets should begin or end with cash. The argument in favor of showing Cash first among the assets is perhaps a little forced, for it rests on the false assumption that cash is in all cases the most impor- tant item. It is true that in some institutions, for instance a commercial bank, cash on hand is the most significant of THE BALANCE SHEET 47 the assets, showing the ability of the bank to meet a sud- den run. It may even be true that cash is generally more important than any other item of similar amount, but it seems a gross perversion to say that in a railroad the rela- tively small amount of cash is more important than the great fixed plant. Even an insurance company must surely attach more importance to its many millions of investments than to its cash, for unlike a bank the demands made upon an insurance company are such as to give time for realization of assets. Foreign accounting practice seems to recognize the varying importance of cash in dif- ferent classes of institutions. Thus in Austria and Ger- many the Balance Sheets of banks very generally give cash as the first of the assets while in those of industrial corporations cash appears farther down the list. In the United States and England, m the contrary, it is very unusual ta find cash listed farst either by banks or other corporations. Strict consistency compels a marshaling of the liabil- ities similar to that of the assets. Convenience of inspec- tion certainly demands that ' similar assets and liabilities appear opposite each other. Cash is naturally compared with the liabilities on which immediate payment may be demanded. Yet strangely some accountants who place cash at the beginning of the assets do not change the con- ventional order of the items on the other side but head the list with the permanent item Capital. This results in the juxtaposition of Cash and Capital Stock, items which in a growing concern have the least possible connection with each other. One may, perhaps, not insist on cash coming first. Even in a bank statement, one is habituated to look at the last item as the most significant of the assets. But certainly strong objection is to be made to having a different order of arrangement on the two sides of the balance sheet. Occasionally consistency in this respect is 48 MODERN ACCOHNTriSrG found in Balance Sheets. That of the American District Telegraph Company of New Jersey may be mentioned, in which the assets run from Cash to Plant, and the liabilities begin with BiUs Payable and end with Capital and Sur- plus. Another variation in the form of the balance sheet is that prescribed for the so-called parliamentary companies of England, and known as the Double-Account Balance Sheet. An example is as follows: Dr. Form 20. Capital Account. Cr. Cost of property ....j£195,000 6,000 ;g200,000 Share capital /l 00.000 Balance Debentures 100,000 £200,000 General Balance Sheet. Liabilities Assets Capital account, balance. . £5,000 Bills payable 10,000 Profit and loss 3,000 £18,000 Materials, etc £4,000 Cash 6,000 Accounts receivable 8,000 £18,000 It is to be noticed that the Balance Sheet proper does not contaia the entire outstanding capital but merely the portion of the capital receipts, including receipts from funded debts, which have not been expended in acquiring the company's plant. Nor does the Balance Sheet itself include the plant in the asset column. Information on these points is gained from the accompanying capital ac- count, the balance of which is brought down as a liability in the General Balance Sheet. The origin of this peculiar arrangement is that the law THE BALAlSrCE SHEET 49 governing such companies provides that the money re- ceived on capital account,— that is, from subscription to shares or from sales of debentures, etc.— may be used solely for investment in the plant of the company, and the Double Account Balance Sheet is designed to show how far this requirement has been fulfilled. This form is rarely used in American practice but it has practically' been adopted in the reports of the Atchison, Topeka and Santa Fe Railway, as shown on page 60. The Balance Sheet of the company given above, if pre- sented in the ordinary English form, would be : Capital and Liabilities Form 21. Balance Sheet. Assets Share capital ;£100,000 Debentures 100,000 Bills payable 10,000 Profit and loss 3,000 £213,000 Cost of property. £195,000 Materials, etc 4,000 Accounts receivable 8,000 Cash 6,000 £213,000 In discussing the subject of the shrinkage in value of plant in reference to profits it wiU be shown that the double account form of Balance Sheet has had a consider- able and perhaps baleful influence on the legal interpreta- tion of accounts. It has indeed been argued that the placing of the capital in a separate account involves the principle that changes therein cannot affect the Profit and Loss account appearing in the Balance Sheet. While the validity of this inference may be questioned it is true that the isolation of " capital assets " and " capital liabil- ities ' ' in the capital account has a tendency to cause them to be considered as isolated in fact, and has led to some far-reaching conclusions which might otherwise never have been reached. 60 MODEEN ACCOUNTING Another question relating to the form of the Balance Sheet, — namely, whether certain items are better shown as additions on one side or as subtractions on the other side is of considerable practical importance. This can best be considered after a discussion of the nature of the various classes of accounts found on either side of the balance sheet. On the Debit side are found the following : 1. Assets, of whatever kind and including whatever subdivisions such as capital assets, circulating assets, im- material assets, etc. 2. Loss — when the business shows a net deficiency. 3. Debit Valuation Accounts. On the Credit Side : 4. Capital — in the strict sense of the contributions made by stockholders or proprietors. 5. Profits— in the broad sense of the accumulations or accretions to the original capital, which may be divided into various subheads, such as Surplus, Reserve, Undivided Profits, etc. 6. Liabilities in the strict sense of debts due by the business. 7. Credit Valuation Accounts. Of the above groups, (1) and (6) are easily identified as " Goods " accounts, positive and negative respectively,, while (4), (5) and (2) are Proprietorship accounts, the last named negative, the others positive. These are already familiar, but the remaining groups, (3) and (7) require further description. The^e accounts may be called Valuation Accounts, adopting the German nomenclature (Bewertungskonten) as there is no well es- tablished English term. They may be defined as accounts introduced for the technical purpose of indicating that a sum is to be subtracted from some other account. Alge- braically they correspond to a negative item transferred THE BALANCE SHEET St to the other memher of the equation with a transformation of sign. Thus in the equation : t 4x — 2x = 5y — I7 the terms 2x and 4y are evidently to be subtracted from 4x and 5y respectively. But the equation is still correct if it is presented in the form 4x + 4y == 5y + 2x in which 4y and 2x would correspond to a Debit and a 'Credit Valuation account, respectively. They represent, therefore, not independent values but merely that a sum is to be subtracted from another item purposely overstated on the other side of the equation. This is quite in consonance with practice already ex- plained. It has been seen that expense is logically a sub- traction to be made ultimately from the proprietor 's Cap- ital account, or immediately from Profit and Loss. But instead of entering every expense item at once to the debit of Profit and Loss, it is placed temporarily in a spe- cial Expense Account. But these negative Proprietorship accounts are Ordinarily temporary. Before the prepara- tion of the final Balance Sheet they disappear by being included with other items in the general Profit and Loss account. But so long as a balance stands to the debit of Expense, it indicates that to that extent the showing made in the Profit and Loss or in the Proprietor's account is incorrect, that it is overstated because a necessary subtrac- tion has not yet been made. Valuation accounts are sim- ilar in origin and purpose but differ in being more perma- nent in character. The simplest and best type of a Valuation account is the Depreciation account. At the beginning of the year a concern buys machinery for $10,000. This is properly debited to the Machinery account, and is listed among the 52 MODEEN ACCOUNTING assets. But during the year the value of the machinery declines because of wear and tear. The machinery in- stead of being worth $10,000 as shown by the account is worth onljr $9,000. Correct accounting demands that this change be shown just as much as that a payment of $1,000 out of the cash balance of $10,000 be shown. The simplest and most direct, but not necessarily the best way of show- ing this decline is to enter the $1,000 depreciation in the Credit side of the Machinery account thus reducing the effective balance to $9,000. But it is also permissible to do here what was done in regard to Expense — that is, to indi- cate the required deduction not by immediate entry in the minuend account but by establishing an independent ac- count for the subtrahend. In this case instead of showing the account thus : Form 22. Dr. Machinery Account. Cr. Cost price down. . $10,000 Depreciation Ba ance 81,000 9,000 810,000 810,000 Balance broixght . 89,000 the ledger shows the following two accounts: Dr. Form 23. Machinery Account. Cr. Cost price 810,000 Dr. Depreciation Account. Cr. On machinery $1,000 THE bala:noe sheet 53 The resemblance of such accounts to the Expense and other Negative Proprietorship accounts is clear. But while the Expense account disappears from the ledger at the end of the year, when it is closed into Profit and Loss, the Valuation accounts continue beyond the period for closing the ledger. It is not for years, and perhaps never, closed into the account from which it indicates a subtraction. As a balance showing on the ledger it must therefore be considered when the formal Balance Sheet is prepared. Debit Valuation Accounts are similar in their nature, but of course, indicate a subtraction to be made from some item standing on the Liabilities side of the Balance Sheet. An item representing unissued stock or bonds, or showing a discount on the issue of capital stock, will serve as an ex- ample of such an account. The question of form to which reference was made above, concerns the treatment of these Valuation Ac- counts. The point at issue is whether Valuation Accounts should appear in the Balance Sheet as independent items, or whether the subtraction which they are designed to indicate should more clearly be shown. In the illustration already used it is desirable that the ledger should contain the two accounts, instead of having the depreciation of the machinery credited at once to the Machinery Account. But that does not decide the form in which the Balance Sheet is to appear and it remains debatable which of the two forms given below is preferable -. Form 24. Dr. Balance Sheet. Ct. $10,000 $19,000 Other assets 10,000 Depreciation 1,000 $20,000 $20,000 54 MODERN ACCOUNTING Form 25. Dr. Balance Sheet. Cr. Machinery $19,000 Cost price $10,000 Less depreciation 1,000 9,000 Other assets 10,000 $19,000 $19,000 While practice is by no means uniform, it is better, where an account is clearly of the nature of a Valuation Account, to allow the subtraction to appear in the Balance Sheet, somewhat in the manner just indicated. This avoids any danger of its being mistaken for some other class of accounts, which might lead to an entire misapprehension of the status of the company. Depreciation and Discount on Capital Stock are cited here as typical Valuation Ac- counts ; there are numerous other accounts, however, which come under the same category. The purposes of the Balance Sheet are twofold. Pri- marily it shows the financial status of the concern, giving information as to its solvency, and in a less degree it ex- hibits profits which have been made. The first purpose is on the face the most evident one. The Balance Sheet shows a cross section of the business, it presents the status at a given moment of time ; it is ostensibly a showing of Assets and Liabilities, not of Income and Expenses. Yet the Bal- ance Sheet is not without value as an exhibit of profits. Prepared, as it ordinarily is, at annual intervals it serves, at least by comparison, to show the flow of income during the period, as well as the financial status at the moment of its preparation. Indeed some writers, noticeabh'^ Rehm, maintain that the prime function of the Balance Sheet is to show the profits of the year and serve as a basis for the declaration of dividends. It may even be presented in THE BALANCE SHEET 55 such form as not only to show the profits of the past year, but also to indicate the proposed distribution of sueli profits. This may be done perhaps in the method shown in the German Balance Sheet on" page 65. A somewhat similar treatment is found in the Balance Sheet of many English companies— as e. g., that of J. & P. Coats, Lim. For whichever use the Balance Sheet is designed it is evident that it must give, as far as possible, a correct show- ing of the facts. High standards have been set in this re- spect by the statutes. Thus the English Companies Act provides that the Balance Sheet shall be " drawn up so as to exhibit a true and correct view of the state of the company's affairs"; and the German Commercial Code prescribes severe penalties for ' ' untruthfulness or unclear- ness ' ' of the Balance Sheet. Nevertheless accountants gen- erally deny the possibility of strict accuracy in the Balance Sheet. Thus Dicksee says: " A Balance Sheet is not a statement of facts, but rather an expression of opinion," and another writer has said: " Not more than ten per cent of the items in any average Balance Sheet are, or can possibly be facts that are capable of being absolutely tested." Unclearness and consequent misunderstanding of Bal- ance Sheets may be due to several different causes, the principal ones being: (1) The nature of accounting itself, which being at basis an estimate can never be absolute or free from error. (2) The vagueness of the terminology used and the liability that technical words will be misun- derstood, even when used in good faith. (3) The purpose- ful misrepresentation of the condition of the company on the part of the directors or officers. 1. The uncertainty of all accounting can never be alto- gether avoided. It appears principally in connection with the valuation of assets. In many cases there is no outside criterion of value and no way of insuring against a wrong 56 MODEEN ACCOUNTING estimate. This subject is discussed in the chapters dealing with assets and their valuation. 2. The vagueness of terminology adds to the difficulty of presenting a lucid statement. Technical terms such as Reserve, Reserve Fund, Treasury Stock, Adjustment Ac- count, and others are used with entirely different mean- ings by different companies and are given most divergent definitions by the courts and by the various text-book writers. Unfortunately there is at present no accepted authority to whom appeal can be made. The likelihood of a serious misunderstanding is in- creased because of the fact that items so widely divergent in character stand together in the columns of the Balance Sheet. On the Debit side items representing losses or ex- penses may be confused with assets. On the other hand, the Credit column contains such antipodal items as Profits and Depreciation— that is, those showing that there has been an increase in the value of the assets, and those indi- cating that the value of some of the assets has declined. Exactly the same term may be used to indicate these two categories, for both are frequently covered by what is called Reserve. Much good will be accomplished by the action of the Interstate Commerce Commission in prescrib- ing certain uniformities in railroad accounting. It would be well for the public accountants of the country to take even wider action in securing definite and uniform account- ing terminology. 3. Purposeful misrepresentation in the Balance Sheet is secured in part by insidiously taking advantage of the inherent difficulties just referred to, in part by more pal- pable untruth. Of the latter little need be said. Evidently if a company deliberately states it has $100,000 cash on hand when it really has only $10,000 no knowledge of the principles of accounting will disclose the facts. More in- sidious are the less open misrepresentations. Sometimes a THE BALANCE SHEET 57 purposeful grouping together of certain items will conceal the real condition. Thus a company owning $100 govern- ment bonds and $100,000 bonds of some wildcat company lists them under the heading " Government and other Bonds. " Or it lists bonds and stocks together as ' ' Bonds and Other Investments." More flagrant is the case where liabilities have been subtracted from the assets, as for instance where the Bal- ance Sheet does not show both Bills Receivable and Bills Payable, but merely the excess of the former over the lat- ter; or again shows only the equity in Real Estate instead of both the cost price and the purchase-money mortgage given in part payment. Even the improper division of an account may be resorted to in order to hide the fact that a company is too largely involved in a single line of invest- ment. A striking example of this came up in connection with the disastrous failure of the Leipziger Bank, which divided up among various different accounts the advances which it had made to an industrial company, hoping thereby to conceal the extent to which the bank was in- volved in that ruinous enterprise. Against the positive misstatements in the Balance Sheets the outsider is of course defenseless. But assum- ing that amounts are correctly given and that there is no gross overstatement, he still needs to be on guard against a misunderstanding. He should be sure that the ambigu- ous titles are rightly understood, and that he does not con- fuse accounts of opposite nature. A most important aid in this matter is the careful indication of Valuation Ac- counts in the manner suggested. Further examination of the Balance Sheet and of the other statements which should accompany it is then possible. The diiScult points, in the- ory and practice, relate to substance rather than to form and are discussed in the various chapters following. Reference has here been made to incorrectness in the 58 MODERN ACCOUNTING Balance Sheet as being an admitted fault, or even a fraud. Attention should be called to the fact that many account- ants and jurists draw a marked line between the incor- rectness of statement which places the company in a more favorable light and one which understates its financial strength or minimizes its profits. To some the former is fraudulent, the latter almost a virtue. It suffices here to call attention to this point, which is discussed at some length in connection with the subject of Secret Keserves. To illustrate the variations in form found in account- ing practice, there are given below a number of Balance Sheets of different corporations. Descriptive notes on the forms given are to be found on pages 67-68. THE BALANCE SHEET 59 U3«0 00 0-* o §g i OON CO tb'oo >oo6 5" lOO t~ oTg gg T-l T— 1 e© o o H 13 o to to 1 Form 27. THE ATCHISON, TOPEKA & SANlA GENERAL. BALANCE Balances June 30, 1901. ASSETS. Balances 'June 30, 1902. "412,361,783.19 $1,887,595.14 460,611.34 1,028,172.40 Railroads, Franchises, AND Other Property, in- cluding Stocks, Bonds, etc (Exhibit A) $2,723,775.51 656,172.99 7,226,772.68 $418,982,696.40 Expenditures for Con- struction AND Equip- ment DURING Current Fiscal Year (Exhibit B) 3,376,378.88 3,803,278.10 189,669.86 Investments in other Co.'s (Exhibit 0) 10,606,721. 1& 10,321,617 73 $2,898,496.26 677,126.51 $2,896,896.26 357,066.66 New York Security and Trust Co. , Trustee : Cash and Securities in Balance carried down Balance from Capital Ac- count S.07S,804.67 $419,731,110.03 $444,984,840.00 $4,495,870.03 Securities on Hand (Ex- hibit D) : Company's Securities (esti- Other Securities (estimated 3,475,622.77 2,293,276.35 32,156.03 Material and Supplies Prepaid Insurance Pre- mium $3,252,962.92 3,403,026.86 32 019 98 $1,387,659.94 380,822.09 503,125.97 3,270,427.68 $1,457,105.87 372,429.30 409,899.80 4,524,173.36 242,958.00 257,447.24 Union Trust Co. op New York, Trustee: Cash deposit under Article 5 of Gen'l Mtge Guaranty Trust Co. of New York : Cash deposit for Fuel Re- 252,975.50 548,032.72 AccoijNTS Receivable: Traffic Balances Agents and Conductors U. S. Government 5,542,035.68 5,739.54 Prior Accounts in Liquid- ation 6,763,608.33 1,276.06 20,544,405.62 9,484,200.69 Cash: On Hand and in Bank $25,829,306.33 $34,798,307.99 FE RAILWAY COMPANY— SYSTEM. SHEET, JUNE 30, 1903. Balances June 30, 1901. LIABILITIES. Balances June 30, 1902. sio2,ooo,ooo:oo 114,199,530.00 199,035,710.00 4495,870.03 $138,727,500.00 51,728,000.00 1,500,000.00 250,000.00 6,000,000.00 830,210.00 S419 731.110.03 $1,239,309.18 582,747.39 321,860.83 59,412.56 257,447.24 844,290,70 3,308,935.00 5,863,946.96 268,616.06 13,082,740.41 $239,386.58 18,060.66 $3,115,305.00 193,630.00 $1 807,310.16 2,428,257.98 1,488,466.91 139,911.83 825,829,306.33 Capital Stock: Common Preferred Less amount in Special Trust: Foracqui- sition of Auxilia- ry Lines.$l(),800,000.00 For Im- prove- ments, Ex t en- sions.etc. 6,486,470.00 Funded Debt: General Mtge 4% Bonds.. Adjustment Mtge. Bonds. Serial Deben. 4% Bonds. . . Chicago & St. Louis Ry. 1st Mtge. 6% Bonds. .. Equipment Tr. 5% Bonds The San Francisco & San Joaquin Valley Ry. Co, 1st Mtge. 5% Bonds Miscellaneous Bonds Balance carried down Balance from Capital Ac- count Special Betterment Fund . Rolling Stock Replace- ment Fund Rail Renewal Fund Tie Renewal Fund Fuel Reserve Fund : The Atchison,- Topeka & Saota Fe Ry. Co Cherokee & Pittsburg C. & M. Co Accrued Taxes not yet due Interest on Funded Debt : Accrued, not due Coupons, not presented.. . . Accounts Payable : Pay Rolls Audited Vouchers Traffic Balances Miscellaneous Prior Accounts in Liquida- tion Profit and Loss : Surplus. . . $131,486,000.00 $102,000,000.00 17,286,470.00 114,199,530.00 138 51, 30 .728,500.00 ,728,000.00 ,000,000.00 1,500,000.00 i,000,000.00 828,810.00 228,785,310.00 $444,984,840.00 $489,834.90 58,197.82 $3,512,275.00 201.160.00 $1 ,954,254.70 3,637,781.11 1,452,391.22 272,162.34 $5,073,804.67 367,079.52 211,687.57 366,781.16 548,032,72 953,103.64 3,713,435.00 7,316,589.37 220,379.11 16,027,415.23 $34,798,307.99 SI 62 MODEEN ACCOUNTING ■aooo «rt CD tC IN CD COt-T o tn O CO c» Oi o (N m 00 n T— 1 O o § U5 00 CO" o 00 IN S3 CO o 00 IN 00 nO 00 t; O O to 3t3^ be c.;5 °^-S - • HH r/l JJ n r/; K I :s CO p 1-5 •3 o „ a-^ S -» •a IS Sgcrt o Q OPQfflffl ii mg § > ^ s o o 2 ■3 ^ O to t, ' oS 2 iO 25 ; J. : i O T3 . a :§ • S : c9 ?3 S : e •s : § fi-S : o iS||S.|§, ffl o E=} O IS S (S - -^ +3 COS 5> cs B a« ^ n I Fori Condensed General BALANi ASSETS PROPERTY ACCOUNT Fropekties Owned and Operated by trb Several Coupanies Balance of this account as .of December 31, 1906 $l 1378,185,605. 07 Additions during igo? to foregoing balance (see page 28) I 614,723. (Sq Tennessee Coal, Iron & R. R. Co.'s Properties, viz. 'Cost of Fixed Property as acquired at November i, 1907. $4B^i,3cS^ Expended for Construction in November and December.... 984,886.74 '"**' ' 4!}i!M6i095 ■ 57 Expended for Additional Property and Construction in igo7 other than by or for account T. C.,' I. & R. R. Co 65,996,365.72 «. ^ « ,. , „ ■ $1,49*742788.99 Less, Charged oit to the' following accounts, viz: : To Bond Sinking Funds. ..' $572,500.00 To Depreciation, Extinguishment and Replacement Fnnds 4^80,421.03 To Funds provided from Surplus Net Income for pay mentof capital expenditures (see page 12) 53^49.799-46 S9,202j3O.49 $l<43S.S40,o68.5o . Expenditures, fdr Stripping and Development at Mines, and In- vestment in Structural Erection and LogEj^ng Plants, viz. : Balance at December 31,. 1906 '. ^ $^,722,340. 61 Net Increase during the year 1907 4.575i04i .26 10,297,381 .87 81,44ff,SS7,4fi0.37 DEFERRED CHARGES TO OPERATIONS Payments for Advanced Mining Royalties, 'Exploration expenses and Miscel- laneous charges, chargeable to future operations of the properties $6,204,733.85 Less: Fund reserved from Surplus to cover possible failure to Real- ize Advanced Mining Royahies,., 2.500,000.00 3,704,733.85 INVESTMENTS Outside Real Estate and Other Property 1,717,119.»7 SINKING AND RESERVE FUND ASSETS Cash resources held by Trustees account of Bond Sinking Funds $444,200.88 ($31,559,000 par value of Redeemed Bonds held by Trustees, not treated as an asset) Contingent Fund and Miscellaneous Assets.....-..., 1,215,522.85 Insurance Fund Assets (at market value).: 4,120,158.63 Depreciation and Extinguishment Fund Assets (at market value) . . . .' 10,741,977. 19 Investments (at market value) for Spedat Construction Fund for Gary Plant.. 151920,542.14 ' — 32,442,401.69 CURRENT ASSETS Inventories* $136,188,874.28 Accounts Receivable , 58,398,454.36 Bills Recdvable, Customers' and Guaranteed Loans : 10,193,706.91 Agents' Balances ; ", 835,269.33 Sundry Marketable Bonds and Stocks , -. 8331,154.32 Loans on Collateral , 6,000,000.00 Cash, viz. : In hand and on deposit with Banks) Bankers and Trust Companies subject (o cheque $51,222^95.07 Deposits loaned on call , 2,741,453.81 53^66,848.88 274,411,308.08 * Invcnlory TBluationi ineluBe proGti accrued to luliiidiary cotupuuei on flialniili aad prodncu lold (o otbn subsidliTy campimiEi and uadUpcncd of by die laller — tee conua ipecific lurplui account for tbeie profiU. The tolil of all Invenloriet ii, bat/cvcr, below the vcruil current market price*. We have audited the above Balance Sheet, and certify that in Our opinion it is properly drawn up so as to show the true finan- cial position of the United States Steel Corporation and Subsidi- ary Companies .on December 31, 1907 PRICE, WATERHOUSE & CO., Auditors. New York, Marcb 7, 1908. «1 ,7flS,113,0I.3.Se HEET. December 31, 1907. LIABILITIES CAPITAL STOCK OF U. S. STEEL CORPORATION Common ^ $508,302,500.00 Preferred .^ 3fio,28i,ioo.oo CAPITAL STOCKS OF SUBSIDIARY COMPANIES NOT HELD BY U. S. STEEL CORPORATION {Par Toiuc) 8868^83,600.00 761,SlO.OO BONDED AND DEBENTURE DEBT United States Steel Corporation 50 Year 5% Bonds 1303,957,000.00 United States Steel Corporation 10-60 Year 5% Bonds 300,000,000.00 $503557.000.00 23,758,000.00 Less, Redeemed and held by Trustees of Sinking Funds. . Balance outstanding , , $48o,-i{g,0OO.BO Subsidiary Cos." Bds. (Guaranteed by U S. Steel Corp'n) $4S/>36,O90.oo Subsidiary Cos.' Bds. (Not guaranteed by U. S. Steel Corp'n). 79,716,904.13 $127,752,904-13 Less, Redeemed and- held by Trustees of Sinking Tun ds. . 7,801,003,00 ojtstanding , Debenture Scrip, Illinois Steel Company. CAPITAL OBLIGATIONS AUTHORIZED OR CREATED FOR CAPITAL " EXPENDITURES MADE (beld in the treasury sudject to sale, hut HOT INCLUDED IN ASSETS— See page I's). Subsidiary Companies' Bonds, not included in this Balance Sheet as either a Liability or an Asset MORTGAGES- AND PURCHASE MONEY OBLIGATIONS OF SUBSIDIARY COMPANIES Mortgages Purchase Money Obllgalions CURRENT LL\B1LITIES Current Accounts Payable and Pay Rolls , Bills Payable (of Tenn. Coal, Iron & R. R. Co.) Special Deposits or Loans due employes and others Accrued Taxes not yet due. Accrued Interest and Unprcscnted Coupons Preferred Stock Dividend No. 27, Payable February 29, 19A Common Stock Dividend No. 17, Payable March 30, 1908. . $2,135,240.38 3,258,700.65 $22^06,488.45 1,052,747.59 1*57.495.58 3736.747-80 7.863,913 -57 6^04519.25 3^1.512.50 000,185,270.79 5,393,941.03 4fi.06S.824.74 Total'Capital and Current Liabilities J. $1^19,988,446.56 SINKING AND RESERVE FUNDS Sinking, Depreciation and Replacement Funds, per table on page 10 $41,360,655.19 General Construction Fund for authorized appropriations (seepage 12).. Special Construction Fund for account Gary, Ind., Plant (see page 12).. Contingent and Miscellaneous Operating Funds Insurance Funds 3*13314.96 26^51,242.62 7fl9i,27S-89 4,648.358.57 BOND SINKING FUNDS WITH ACCRETIONS , , - Represented by Cash (and by redeemed bonds not treated as assets— See Contra). UNDIVIDED SURPLUS OF U. S. STEEL CORPORATION AND SUB- SIDIARY COMPANIES Capital Surplus provided in organization $25,000^0.00 3alance of Surplus accumulated by all companies from April 1, 1901, to Decem- ber 31, 1907, per table on page 34 69,736,490.77 Total Surplus exclusive of Subsidiary Companies' Inter-Company Profits in Inventories $94.736490-77 Undivided Surplus of Subsidiary Companies, representing Profits accrued on sale of materials and products to other subsidiary companies and on hand in la Iter's. Inventories ,..., 27,908,752.85 83,976.347.23 31^03,976.45 122,645,243.68 81.758,118,013.86 THE BALANCE SHEET 63 <§ .2 I d « S U Q 0^ oo « OO "* do d' oo o TOO O ®*d" rt 0-* o CO t>.-!t< OOrH ■*_ doo^ ^H i-H T|H CD lo (NO-* rt OOrH i-Hco'd' 0-* CO •a '3 a, ■2^ « gem S s s ,.g « o g? ^=3 O STora.S t)Q|2;pqi-j Q «: o H COOiOQCO r-lOOOCO-* 1-1 O C35 ^H O OO rtOlOO TfOIN Ot)< C-fd'Tl''''*!^ 00 "5 (N001> COIN KICO (N (N OS(N OOOO O WOOOOOO NMOOOJt; O O (N O (N »H ^ O ■*t^_ino3_e<3(N o r-T C-; t> '-H 33 H t-l IN M i-H 05 .1* 00 t^t^ lO CD wi# OOt^t^'-i^OOCO^ o 00*0 05" cfo »0 IN W ro rH CO ■*ININ . o •s :§ if I • >''& ID^g.cS o ca « ^1 agb-s . =tl •r3 — ^ 0) CL,° M a 3 :a -2 3 0_H 3 s o 2 !; S m o— 0_, ■a a is ti » wi|^ 1^5 8 & agio's S^g-g ^5 g H) f-^ fcJ3+=» 15 c3 O f-. 03 to Qj MJ3 t-. •• S G .2 02 ;^.S " ^ d3 O ^ GJ IS £".£> ^ ^ 9 fe o cS *+-< m^ T3 o-e O Clj2 O-rt 3 ■l2 O OT3 .2 a S a S o o o tj " o o a -t-s •a bO -a o §11 :q ° a. <» ^:S CD e ia oj2'g el ■s-a et-< .3 -s-g g .■XI s Hs o fig.? ^1 ^ K S to H OB P*l-r( ■^ So t: •a s 02 O bO ■H a ° ^ O P* m c3 ••■§ MB S 3 •fe 3 0) a) '43 b i> « a2Hr-< 1"^- ■3 N M 3 5 » 03 P^ °3 '3 5 0) **-< w H EQ'Ci o is as J 2 8°^ a s .-.aj-d 3 al ^ S^"3 § fe: " ?i a ro.^ a o 5^ « » s » S g '3 a o ft _2^ ■ -9 2_e-5 o S mi 2 n.S ■S o a o c3 !« 3 o a H S3 ^ a o 3 THE BALANCE SHEET 67 Notes on the Forms of Balance Sheets Form 26. — This form divides the Assets into four, the Liabilities into seven groups. Some of the items listed under Unadjusted Debits are similar to those generally called Deferred Assets. The title, Deferred Lia,bilities as here used, is somewhat meaningless. The separate item, Govern- mental Grants, is a distinct innovation. It represents a contribution which does not come from the stockholders, yet is not a debt. The treatment of Corporate Surplus and of Depreciation is particularly to be noted. Form 27.— This Balance Sheet is in the Double Account form, although the two portions are not separately headed as is customary in the statements of Parliamentary com- panies. Attention is also called to introduction of the fig- ures of the preceding year's Balance Sheet for the sake of comparison. Form 28. — This Balance Sheet of the London and West- minster Bank not only arranges the assets with the most liquid form coming first, but logically observes a similar arrangement of the liabilities. Other features of interest are : The treatment of unpaid capital, the showing of liabil- ities for endorsement, etc., and the divergent methods used in showing Depreciation of Government Securities and the amount written off of Bank Premises. Form 29.— This Balance Sheet has many points of in- terest among which are : The consolidation in one state- ment of the assets and liabilities of the subsidiary compa- nies as well as those of the Steel Corporation, the treatment of Depreciation, the differentiation of the various Reserves and of their corresponding assets, and the treatment of the Bond Sinking Fund'; Forms 30-31.— These two Balance Sheets represent the condition of the Chemical National Bank of New York. 68 MODEEN ACCOUNTING The first is in the form furnished the Comptroller of the Currency and by him published in the annual report. The second, is a condensed form used as an advertisement ap- pearing in the Commercial and Financial Chronicle. The difference in the figures is due to leaving the overdrafts out of the condensed form and showing only the net sum due depositors. Strictly this is incorrect. It involves the cancelation of assets against liabilities, which is opposed to the general principle that both must be shown in full. The small amount involved however furnishes sufficient justification for the omission. Form 32. — This form (taken from Kehm's, " Die Bilan- zen ") is a typical German Balance Sheet. Points of spe- cial interest are : The arrangement of assets from fixed to liquid, the inclusion of unrealizable assets at a nominal value of 1 mark (such items b^ing technically called " memoriter accounts "), and the inclusion of many of the details of the Profit and Loss Account in the Balance Sheet. Item 17 " Delkredere Account " is a term seldom used in English accounting literature although occasion- ally found. It signifies about the same as " Reserve for Doubtful Debts " or for some similar uncertain asset. Form 33. — This form has doubtless had a great effect on English practice as its use was for many years obliga- tory for all companies which did not specifically adopt other articles. The British custom of placing the assets on the left hand side has been due largely to this legal form. Under the modification of Table A made in 1906 the use of this particular form is, however, no longer prescribed. Other points of interest are: The minute details regard- ing the issue and payment of shares, the addition of con- tingent liabilities as a supplement to the Balance Sheet proper, the classification of items in seven heads, and th© arrangement of assets with cash last. THE BALANCE SHEET 69 BIBLIOGRAPHICAL NOTE TO CHAPTER III Broaker & Chapman. The American Accountants' Manual. I, pp. 83-lOS. New York, 1897. Charpentier, J. Etude juridique sur le bilan dans les societes par actions. Paris, 1906. [A good presentation of French law and custom, containing also a bibliography.] A Chartered Accountant. How to Understand the Balance Sheet. London, 1903. GouGH, T. H. Balance Sheets and How to Read Them. London, 1906. Keen, F. N. The Balance Sheet of a Limited Company. Ac- countant, XXIV, p. 399. Lisle, G. Balance Sheets. Article in Encyclopaedia of Account- ing. I, p. 203. Accounting in Theory and Practice, pp. 69-82. Edin- burgh, 1903. PixLEY, F. W. How to Read a Balance Sheet. Accountant, XXXV, p. 511. [A valuable article by the former president of the Institute of Chartered Accountants.] Rehm, H. Die Bilanzen der Aktiengesellschaften. Munich, 1903. [The most comprehensive work on the subject, dealing how- ever with the details of German law.] Simon, H. V. Die Bilanzen dei- Aktiengesellschaften. • 3te Aufi. Berhn, 1899. [A work similar to Rehm's. Although less comprehensive it is perhaps more valuable to the general student of accounting. While dealing with Gernjan law the discussion of theoretical matters is of general interest.] ViGEON, H. Balance Sheets. Accountant, XXV, p. 29. An interesting collection of various forms of Balance Sheets with critical comments is found in Encyclopaedia of Accounting, VIII, pp. 249-326. CHAPTER IV ASSETS AND THE PRINCIPLES OF THEIR VALUATION In the preceding chapter it was shown that where the ledger is properly closed so as to eliminate expense and other loss items, the left side of the Balance Sheet con- tains only two classes of items: (1) those indicating assets, and (2) those indicating Valuation Accounts— that is, technical accounts whose object is to indicate a subtrac- tion to be made from items listed on the other side of the Balance Sheet. But this latter class of accounts is always small in number, and in the more approved Balance Sheet the Valuation Accounts, too, are eliminated from the left side by being listed in an interior column of the right side, the exterior column showing the remainder after de- ducting the indicated amount. The left column of the Balance Sheet containing, then, in most cases, nothing but asset iteflis, and in any event having few accounts other than these, that column has generally been called by its characteristic feature, and is labeled " Assets " or " Re- sources. ' ' But while negative items, whether representing actual losses, or mere technical Valuation Accounts, appear infre- quently in a properly prepared Balance Sheet, the impor- tance of distinguishing all such items from asset items proper cannot be overemphasized. A failure to do so causes most of the misrepresentations or misunderstand- ings of corporation accounts. Thus, with a given sum, say $50,000 worth of unquestioned assets, there may appear in the Balance Sheet another item of $10,000 of indeterminate 70 ASSETS AND THEIR VALUATION 71 character. If it proves to represent Goods the concern then is possessed of $60,000 gross assets with which to secure its creditors and indemnify its stockholders. But if the $10,000 item is merely a Valuation Account, or one representing a loss, it is a serious error to add it to the real assets, for the false estimate of this additional prop- erty may mislead the creditor or investor. Frequently Loss items are thus carried in the Balance Sheet with some colorless or misleading title, and a gross misconception of the actual status of the concern is the result. Thus a man- ufacturing concern engaged in making harvesters, carried in its Balance Sheet the following items: Moving account. Fair machines account, Material and labor expended on self-binder. Bindery account. In each of these instances the court decided that the item represented an expense and not an asset, and the confusion in this case amounted to a positive fraud on the creditors of the company. To one interpreting a Balance Sheet, or to one charged with the duty of preparing it, the first duty is to distinguish properly between assets and the negative items which ap- pear in the ledger, and which if not correctly treated will appear on the debit side of the Balance Sheet, in the goodly company of the assets. The better rule is to eliminate such altogether from the asset side of the Balance Sheet, but where for some reason this is not done, it is indis- pensable that they be so labeled and distinguished that there may be no uncertainty as to their real nature. The difficulty in making proper discrimination is greater because the ledger itself, of which the Balance Sheet is an abstract- and epitome, does not immediately serve as a guide. The original transaction was a payment of cash for services rendered or material supplied. Cash being diminished, the cash account was properly credited and some other special account, " Bindery account " in the instance cited, was debited. But exactly the same 72 MODEKN ACCOUNTESTG booking might legitimately be made whether the payment was a loss transaction, or an exchange ; whether the amount standing to the debit of ' ' Bindery ' ' represents an expense or an asset. Nor can the proper determination be based on the crude fact of whether or not there was an actual purchase of material. For convenience in accounting it is customary to treat some purchases, such as stationery, fuel, oil, or material or equipment needed for replacements as an immediate expense ; and on the other hand certain pay- ments such as wages, and interest, for which nothing tangi- ble is received in exeliange, are at times legitimately treated as representing the cost price of some tangible or intangible asset. Wliether a given payment is an expense (Loss or " Negative Proprietorship " transaction) or whether it is the means of securing an equivalent asset (Exchange transaction) is a fundamental problem, but one sometimes difficult of determination. In either case it first appears upon the books as a Debit entry in some account, and may, therefore, ultimately be found among. the items which appear on the Debit side of the Balance Sheet. Confusion may result either from purposeful deception, or from the misunderstanding of ambiguous or doubtful titles. The difficulty of distinguishing between these two classes of transactions has been made prominent in railway accounting. To use the technical terms, it is an ever-recur- ring problem whether a given expenditure is a Revenue Expenditure or a Capital Expenditure, whether it goes into Operating Expenses or into Construction Account. If regarded as a Revenue Expenditure it works as a charge against earnings and so reduces the net profits. If a Cap- ital Expenditure, the Construction Account, that is, the account representing the cost of the road, is debited and the equivalent of the money expended is therefore carried among the assets in the Balance Sheet. ASSETS AND THEIE VALUATION 73 No less than three theories exist as to the proper divi- sion of expenditures between capital expenditures and charges against revenue. (1) The most commonly accepted is that in so far as the transaction results in an addition of substantial and permanent character which increases the value of the plant such increase should be made to the construction account. (Mackintosh v. Flint & Pere Marquette Ry. 34. Fed. Rep. 609). Or as it is clearly expressed in Hubbard v. Weare : '• Money paid out should not be reckoned as an asset. If paid for property that is on hand, the property is an asset. If expended in a way that has enhanced the value of the general assets it is included in its valuation. If so expended as to have brought no property, and no enhance- ment of that on hand then it is a loss, and should not be counted as an asset." (79 la. 678.) (2) A more extreme view is that expressed, for in- stance, by T. F. "Woodlock: " An addition which does not increase revenue or diminish expenditure is not a proper capital charge according to the best modern practice in railroads. That which simply tends to hold business and not to increase business is a proper charge against operat- ing expenses." ^ (3) At the other extreme is the view, presented in the decision by Lord Kyllachy in Cox v. Edinburgh and Dis- trict Tramways Company, Lim. (6 S. L. T. 63, [1898] ) that where an improvement is made in the plant, even though it be in the nature of the substitution of new plant for old, the entire cost of the new plant, and not merely the excess in value of the new over the old may be charged to Construction account. Of these three views the first is not only the most gen- erally accepted but seems to comport best with account- ing principles. It has furthermore been-^ authoritatively ' Engineering Magazine, xi, 241. 74 MODEEK ACCOUNTING adopted for railway accounting by the Interstate Com- merce Commission. The second view, while praised for its conservatism seems to imply that there must be a constant rate of normal interest or profits, a condition denied by economic history. If a general decline in profits occurs an improvement which, in a given enterprise, prevents the fall and maintains the old rate of profits is clearly a source of additional value, and would be capitalized in the money market. The third view is rarely justified by accountants, but the principle involved is not dissimilar to that con- cerned in the question of the loss of capital discusred fully in Chapter XII. Assuming (a) that it has been possible to differentiate all expense items and (6) that all expense accounts have been closed into Profit and Loss, and further (c) that all mere Valuation Accounts are deducted from the appro- priate account, the Balance Sheet, in its best form, con- tains on the Debit side a list of all the assets belonging to the concern and nothing else. In other words it is a com- plete inventory, and in its preparation enter all the prob- lems connected with taking an inventory of goods on hand. The problems of the inventory are three: (1) What items are to be included in it? (2) What expenditures are to be considered as entering into their cost price? (3) In subsequent revaluations are the assets to be continued at the original valuation or are their values to be estimated on some new basis ? These three problems are not entirely distinct. They may all be implied in the last One, that of the current re- valuation of assets ; for it evidently matters not whether an object, say a worn-out machine, be excluded from the list of assets or be valued at zero ; it matters not what was the original value of an asset if at each new inventory it must be independently revalued. But in practical ae- ASSETS AND THEIR VALFATION 75 counting the questions are likely to arise somewhat in the form and order given above. 1. What items are to be included in the inventory? , The underlying principle is that all valuable goods are to be included. Goods is here used in the proper most inclusive sense of all desirable things and does not in any sense imply a discrediting of immaterial or intangible property. Whether the property be material, consisting of land, or permanent plant, or of merchandise; whether it be less tangible credits such as securities, customers' notes, or merely non-negotiable book-accounts; or whether it be that most elusive form of property. Goodwill; — in any event, all goods are alike to be included in the inventory. • While Goodwill and the allied immaterial goods such as patent rights, and trade names are forms of property to which legal rights adhere, it may even be correct to in- clude among assets items representing the cost of some good to one who has no real property right therein. For instance, the money paid by a railroad company to im- prove a street giving access to its station, or the contribu- tion which it has made to the cost of a tunnelare cited as items which may legitimately be reckoned among the assets of a company although it has acquired no legal property. 2. What is the cost price ? At the time of acquiring a new asset it is normally listed at its cost, even though the purchaser thinks he has bought it at a great bargain. But oftentimes it is not easy to determine just which expenditures entered into the cost of the particular asset. This may well be illus- trated by- the case of a railroad where its principal asset is the roadway, which in accounting frequently appears under the title Construction Account. The cost of right of way, the purchase price of rails and ties, the labor of engineers, superintendents and laborers are all clearly part of the cost of acquiring the road, and are to be charged to 76 MODEEN ACCOUNTING the Construction Account. But a more debatable question arises concerning payments not made in the form of a direct purchase of property or payment for productive labor but which may perhaps be construed as the cost price of acquiring the property. In this class come what are known as Organization Expenses. For instance, a cor- poration is started with $100,000 capital, all of which is paid in cash. In the process of organizing the corporation, expenses must be incurred for stationery and printing, for engraving certificates of stock, for fees paid to the state, and to attorneys. These may amount, say, to $2,500. Is this sum merely an expense, or does it represent part of the cost? If an expense, the corporation is in the position of having encroached on its capital, for with a capital stock of $100,000 it has no assets whatever except cash, and of that it has only $97,500. Interest charges are normally an unquestioned expense, but even interest may at times be construed as capital ex- penditure. Thus a railroad borrows money with which to construct the road, an undertaking which will require sev- eral years. ' During the period of construction interest must be paid while no revenue is accruing. It is not un- reasonable to say that the asset which the company is acquiring is a finished road ready for operation. To secure such a plant there must be paid not merely the cost of material and equipment, the salary of engineers and the wages of laborers, but equally essential is the payment of interest to the bondholder. Without this latter pay ment the finished road could not be acquired. To include it among the costs of construction is, therefore, not illog- ical, and the custom of so doing is gaining increasing legal sanction. In an early American case (Gratz v. Redd. 4. B. Mon. (Ky.) 178) the court held that interest on bonds is not to be charged to construction, but the present practice permits the interest paid during the period of construction ASSETS AND THEIR VALUATION 77 to be added to the cost of the road. In England the similar early opposition on the part of the courts has been re- moved by the Companies Act of 1907 which virtually makes, not merely interest on bonds, but even dividends on capital paid in lieu of interest during construction, a part of the construction costs. And in Germany, where the statutory regulation of accounting practice is generally much more specific than in either England or America, both interest and dividends thus paid are chargeable to " Construction Account." Some have argued that the discount on bonds sold should also be charged to the cost of the road. But so far as the bonds'run longer than the period of construction, the justification of such a practice rests on an illogical distinction between discount paid in advance, and current interest installments. As is shown in the ChaiDter on Liabilities, discount on bonds is prepaid interest for the entire life of the loan, and it is only inter- est during construction, not for the later period that can legitimately be construed as part of the cost of construc- tion. The Interstate Commerce Commission has ruled that discount on securities is not properly included in the cost of property. A similar problem arises in connection with the ex- penses incurred in making experiments in search of new inventions, now a recognized part of many industrial plants. This may be treated as a part of general expense but there is colorable argument on the other side. An im- provement might be secured by purchasing a patent right from an outside inventor. The alternative plan is to hire the inventor to work for the company, in which case the salary and other expenses incurred seem to be the cost of the secured invention just as truly as the price paid for the patent right. If this is so, may not expenses be counted as part of the prospective cost even though the goal has not been quite reached? 78 MODERN" ACCOUNTUSTG From the foregoing it is seen that it is by no imsans easy to lay down a rule by which to determine whether certain charges are to be treated as expense or whether they are to be held in the Balance Sheet as representing the cost of assets. From a purely theoretical view point it seems that any expenses necessarily involved in organiz- ing a going concern are properly assets of that concern, as much as are the real estate, the machinery, or the stock in trade. To the stockholder or proprietor it is part of the investment from which profit is to come and is hence capital expenditure. Being necessary to the establish- ment of such a concern rivals cannot spring up, unless they too provide capital for such a payment, and actuarially figured a concern fully established is worth to new oper- ators a premium equal to the cost of organization. Fur- thermore, as was most clearly brought out by Justice North in Abstainers and General Insurance Company ( [1891] , 2 Ch. 125) any other treatment of such payments would have the absurd result, already alluded to, of mak- ing necessary an initial inroad into capital except where a company started with a nominal surplus. The effect is similar whether the payment of organiza- tion and other similar expenses is charged directly to the Construction Account or is carried along as an inde- pendent item. The significant fact is that both in theory and practice the sums so paid are held to represent assets. Whether it is better to show them in increased cost of plant or as an independent item is debatable. German legislation allows only the former, the idea being that it is dangerous to allow the appearance of " fictitious " ac- counts among the assets. It also attempts to discriminate between the preliminary costs of construction which are to be charged to the plant, and the costs of organizing the corporation itself, which are not to be counted as an asset at all. In order to provide for these latter it is customary ASSETS AND THEIR VALUATION 79 in Germany to issue the original capital at a premium suf- ficient to cover the preliminary expenses. But in America the preferred practice seems rather to favor listing Or- ganization expenses and similar itemt as a separate item, for attention is thus called to their somewhat intangible character. This custom also furthers the conservative practice of annually charging off a considerable portion of such items, so that in a few years they disappear from the inventory altogether. But the Interstate Commerce Com- mission provides in its rules for classification of expendi- tures for road and equipment that organization expenses shall be charged to the construction or equipment account. In the problems thus far discussed the question has been whether a payment of a definite sum should be con- sidered the cost of an equivalent asset, or merely the pay- ment of an expense. Another problem arises in connec- tion with the purchase of property with -stock or bonds instead of with cash. Here the difficulty turns not on whether an asset has been acquired, but on the uncertain value of that which has been given in exchange therefor. In actual practice it is all too customary to treat the cost of such property as being equal to the par of the stock issued therefor. Even accountants of the highest standing justify such a procedure. Evidently this is but one as- pect of the much-debated question of stock watering. To assume that the value of the property acquired equals the face of the stock issued is to assume that stock never is, and never can be issued in excess ; that there can be no stock watering. It argues in a vicious circle, for it makes the value of the property dependent upon the amount of stock issued, while capital is to the accountant properly an expression of the value of the net assets owned,— a sum representing the net wealth of the proprietary interests. If carried to the logical extreme, this principle would re- quire that where stock is sold at a discount the cash re- 80 MODEEN ACCOUNTING ceived should be treated as equal to the full face value of the stock, though it is in fact only a fraction of that sum. It is true that there are difficulties in determining the real value of the property purchased with stock, and stat- utes and courts have doubtless been wise in refusing to interfere with valuations placed on property; but because the courts cannot detect the error is no excuse for a willful misstatement of the value of the property acquired. The Connecticut law of 1903, while recognizing that the valu- ation of the property is a function of the directors and not of the courts, sets a high standard in requiring that where stock is issued for anything except cash the " directors shall make and sign upon the record book of the corpora- tion a statement showing particularly of what the prop- erty received in payment for stock subscriptions consists, and that it has an actual value equal to the amount for which it is received." The judgment of the directors is properly made final, but they are liable for fraud in over- valuation. Less complete is the provision made in other statutes that the accounts of the company shall clearly show that certain property was acquired in exchange for stock but without implying an equivalence in actual value. This subject is discussed more fully in Chapter IX. 3. What is the basis of revaluation ? Having accepted the principle that the original valua- tion of assets should not exceed the cost price, and having noticed the practical and theoretical difficulty in deter- mining the exact cost price, there remains the more impor- tant question as to subsequent revaluations -of assets. Shall they be put down at the original acquisition price or at some other valuation? If at some other value, shall it be the current market price, the present value to the concern, or the price they would bring in liquidation ? The general principle which, with various applications, is now universally accepted, is: The inventory should be on the ASSETS AND THEIR VALUATION 81 basis of the value of the assets to the present holders as a " going concern." The proper value is that which they have to the holding concern, and not that which they might have to other persons, whether these persons are ordinary customers, or those who might bid in the assets at a liqui- dation sale. The value is that which they have to the company as then existing and not to a company in the hands of a receiver, or one closing up its accounts and going out of business. It is true that in the case of cor- poration this represents the interests of the stockholders rather than those of the creditors. Yet it is little exag- geration to say that if all assets were listed at the value which they would realize at forced liquidation, no Balance Sheet would show solvency. Valuation on such a basis would, therefore, be absurd, and the general principle must be adopted that the basis of inventory values is the present value of the asset to the holders as a " going con- cern." To this rule there may be exceptions or modifica- tions, mostly introduced for the sake of preventing a self- deceiving exaggeration of values. This leads to another distinction of great importance, that between " fixed " and " circulating " assets. It is impossible to draw a sharp and absolute line between these two classes, but in general the differentiation is easily made. By fixed assets are meant those which are bought for permanent or long-continued use, by circulating assets those whose use is relatively short or which are purchased for resale as merchandise. There is coming to be recog- nized a difference in the basis of valuation of these two classes of assets, which permits much greater latitude in regard to fixed assets than is allowed concerning circidat- ing assets. In general it is considered legitimate to con- tinue fixed assets at their cost despite a subsequent decline in their value. But in valuing circulating assets regard must be had to current values, although there is some 82 MODERN ACCOUNTING question as to whether the market value, even of circulat- ing assets can be accepted where that exceeds the original cost.^ Here again the governing principle is that of the " going concern." A piece of land, for instUnce, is pur- chased at a fair price for the purpose of erecting a fac- tory. Its services are presumably perpetual and undi- miuishing; the value to the company was, in the first in- stance, represented by its fuU cost price ; its services, and hence its value to the going concern, are the same as before. It is therefore proper to continue in the inventory the cost price of the land quite irrespective of changes in its market value whether that be greater or less than the cost. The market price, evidently, can never be realized so long as the land is still used as a factory site, the abandonment of the factory means ordinarily that the enterprise ceases to be a going concern. To be sure the factory site might con- ceivably be sold and a less expensive one be bought in its stead, but this implies recognition of a double set of un- realized conditions and is too vague for embodiment in formal accounts. Changes in the market value of an abso- lutely fixed asset, such as land, railroad bed, or water rights, may be ignored on the principle that such changes do not affect the value of the going concern. This is most clearly seen in the case of land, but it is equally applica- ble to any form of fixed asset provided, of course, that allowance is made for its necessary maintenance and re- newal. A corollary of the foregoing is that mere fluctuations in value in contradistinctions to permanent change of value, may be ignored. This is theoretically correct, for fluctuations so transitory as to be included within the period during which the company holds the given asset are analogous to changes in the value of a fixed asset. If raw material is bought in July and the finished goods are to be > See Chapter V, ASSETS AJS'D THEIR VAI^UATIOISr 83 marketed during the following June, the oscillations of price within that period need have no effect on the value of the material in the manufacturer's hands. To take account of a temporary rise or fall in a December in- ventory in such a case would perhaps be erroneous; cer- tainly so if it were known that the normal price would again appear before the year's end. But in practice the principle is difficult of application, because of the impos- sibility of determining which changes in price are mere temporary fluctuations and which are more permanent alterations in value. It is, however, of importance in application to the fl.uctuation in the market price of invest- ments, although here, as is shown in the next chapter, con- servative practice justifies a less logical treatment. Another corollary needs mentioning. If changes in the market value of an unchanging asset need not be reck- oned the converse is true. Actual changes in the use value of a fixed asset, a machine for instance, must be reckoned, even though to the eye the machine remains unchanged. In technical terms, while fluctuations in fixed assets may be ignored, depreciation must always be considered. This is true whether there is actual physical deterioration or, as in the case of a patent right or a terminable leasehold, the decline is due to the approach of the time when the present asset will cease to have value. The three rules of appraisal of general application are therefore: (1) The value to be taken in the inventory is not the liquidation value, but that to a going concern; (2) Changes in market value of fixed assets may be ignored; (3) Depreciation must always be taken into account. In all the foregoing discussion it has been assumed that the purpose of accounting is to present the facts fully and without reservation; but argument is sometimes made' that the statement set forth in the Balance Sheet does not even profess to be true ; indeed, that a Tariation from the truth. 84 MODERN ACCOUNTriSrG provided only that it understates the wealth of the con- cern, is really a merit rather than a fault. This view has formally been set forth in a recent 'English case where the court stated that " The purpose of the Balance Sheet is primarily to show that the financial position of the com- pany is at least as good as there stated, not to show that it is not or may not be better." ^ This view is frequently supported by theoretical writers and has the further sanction which comes from the prece- dent set by conservative corporations in all lands. Thus it has been argued that an undervaluation improves the economic position of the corporation, that it prevents the danger of fictitious dividends, and that " absolute truth in the Balance Sheet is not only not demanded by law but is in itself undesirable. ' ' For precedents may be cited the Bank of England which omits from its statement its land and building, which are certainly worth many millions; the practice common among German companies of listing their real estate and sometimes their other fixed plant at the nominal sum of one mark; and the tendency among American railways to mark down the valuation placed on the road whenever large earnings make that possible. In so far as the undervaluation of certain assets is merely an attempt to secure a more truthful conspectus of the entire situation, the action may be justified. An argument that however truthful one's intentions may be, he is almost sure to overestimate the value of his own pos- sessions, and therefore after having determined what he really thinks they are worth, his results will be more accu- rate if he arbitrarily writes off certain sums, is not without force. But to state that an absolute understatement is praiseworthy neglects the fact that fraud may surely be perpetrated in that manner ; and while the reaction against overvaluation is but natural and in general healthful, it ■ Newton v. Birmingham Small Arms Co. [1906] 2 Ch. 378. ASSETS AND THEIE VALUATION 85 seems a mistake to overlook the value of accuracy and to cease to hold it up as the goal of accounting. Time was, and that not long since, when even the Supreme Court of the United States stated that there is but little danger that any board of directors will ever understate the value of the assets, thereby also underestimating the profit, the temptation being in the opposite direetion."^ But certain notorious bear operations in the stock exchanges show that the unforeseen has frequently happened, and the under- valuation of assets, with its accompanying understatement of profits and establishment of a secret reserve, if the lesser of two evils, nevertheless falls far short of the ideal stand- ard of accounting. BIBLIOGRAPHICAL NOTE TO CHAPTER IV DiCKSEE, L. R. Auditing. American edition, edited by R. H. Montgomery, pp. 160 ff. New York, 1905. Here, J. P. The Appreciation of Assets. When is it legitimate? Journal of Accountancy, III, p. 1. PiXLEY, F. W. Auditors, their Duties and Responsibilities. I, Chapter XL Ninth edition. London, 1906. Rehm, H. Die Bilanzen der Aktiengesellschaften. pp. 693-790. Munich, 1903. Simon, H. V. Die Bilanzen der Aktiengesellschaften. pp. 289-322. Berlin, 1899. For arguments in favor of valuing assets at their liquidation value, see: Aknold, H. L. The Complete Cost-keeper, pp. 358-359. New York, 1900. NoRRis, H. M. Machine-tool Depreciation as an Element of Manufacturing Cost. Engineering Magazine, XVI, pp. 958- 959. ' Union Pacific R. R. Co. v. U. S. 99 U. S. 402. CHAPTER V THE VALUATION OF PARTICULAB ASSETS In the light of the norms laid down in the preceding chapter the problem of the proper valuation of various kinds of assets may be considered. These may conven- iently be grouped into certain classes: Land, Buildings, Machinery, Investments, Mercantile Credits, and Merchan- dise. Land What has been previously said in regard to fixed assets generally, applies preeminently to land where that is held for the uses of the company. The rule here is that land for permanent holding may be held at its cost despite a decline or rise in its market value. Legal authority for this view is given in Bolton v. Natal Land and Coloniza- tion Co., Lim. ([1892], 2 Ch. 124) where the court held not only that a company need not bring into its accounts the increase or decrease in the value of its lands but that, at least so far as it afiEects the showing of profits, it is not right so to do. Occasionally, however, a question may arise as to what is the cost of the land. Difference of opinion arises as to the treatment of legal fees connected with the examination and recording of title. Practice seems to favor adding these to the price paid in determining the cost, but the high authority of Pixley is against such a practice. The arguments previously given regarding organization ex- penses support the current practice. Where a purchase mortgage has been given in partial 86 VALTJATION OF PARTICULAE ASSETS 87 payment of land it is sometimes the custom to add inter- est paid on the mortgage to the value of the land ; but this is unjustifiable for the interest is not a part of the cost of acquisition nor does it represent any additional value ac- quired, and even though it were parallel to an accretion in value (an assumption far from true), appreciation of a fixed asset is not to be booked. Property acquired not for permanent use but for resale is analogous to merchandise bought by a trader. Where the land requires improvement, as vehere a large tract is purchased to be provided with sewers, streets, gas and water pipes, sidewalks and other improvements, with the expectation of subdividing and selling it in small parcels; it is in almost the same category as raw material bought by a manufacturer to be used in producing his finished commodity. In such cases the principles applying to the valuation of merchandise and of partly finished manufac- tures respectively are to be applied to the valuation of the land. The expenditures actually incurred in acquir- ing the land, including those incident to bringing it into the desired form for sale, may properly be considered as entering into the value at any time during the process; but it is incorrect to add any sum representing an esti- mated appreciation. By some authorities interest actu- ally paid on a purchase mortgage during the improve- ment period may be added to the value of the land, but interest at a rate which it is estimated would normally have accrued on a similar sum loaned out, may not be added. This makes the treatment of interest payments on land where the land is being worked up into a market- able commodity similar to that of interest paid during construction of a railroad. But the better practice is against such a marking up of the value of land designed for sale. That there is no absolute criterion universally adopted is shown by the fact that in Germany the laws 88 MODEKN ACCOUNTING permit interest paid to be added to the value of real estate held by a company with limited liability (Gesellsehaft m. b. H.) but does not allow this to be done where the owner is an ordinary corporation. (Aktiengesellschaft.) "While the improvement of a large tract of land is analogous to the manufacture of commodities, the fact that the various small parcels of land differ widely in value makes the estimation of the value of the unsold portion of a tract of land a little more difficult than the appraisal of the unsold portion of the stock of identical commodities. A tract may have been purchased and divided into say one hundred lots, half of which are sold. The presumption is, however, not at all that the remaining half represents one half of the original cost. The proper basis is to appraise the value of each separate parcel at the market price, and to assign to it as the inventory value that proportion of the total cost which its appraised value bears to the total appraisal. Thus if a block of land is bought and divided into one hundred lots at a cost including improvements of $150,000, the sum of the appraised value of the one hun- dred lots after improvements have been completed may be $200,000, the appraised value of lot A because of its superior location, being $4,000; but the value to be as- signed to A in the inventory (some of the lots having been sold) is not $1,500, nor $4,000, but 4,000 X $150,000 or $3,000. , 200,000 BmLDINGS The principle here is not different from that applica- ble to land although there are differences in detail. These arise from the difference in the cost of maintenance, and the certainty that in most cases even after liberal re- newals the buildings will some time be worn out or an- tiquated. To continue the original cost it must be certain VALUATION OF PAETICULAE ASSETS 89 that all necessary repairs have been charged to expense. This is more difficult because during a course of years it is likely that additions and improvements, as well as nor- mal repairs, will be made. "Where an improvement, say the introduction of an electric lighting plant, or an addi- tion to the building has been made, it is difficult to deter- mine how much of the money thus expended is to be con- sidered as the cost of an additional amount of building and how much is a mere repair or restoration of part of the old building. Th6 ever difficult task of distinguishing between so-called " capital and revenue expenditures" must be accomplished; and, after all that is done, allow- ance must be made for the inevitable progress toward the time when the building will no longer be serviceable for the purposes of the company. Machinery, Tools, etc. Valuation at cost price, with proper aUowanee for depreciation is evidently the correct basis. But it should be borne in mind that much of the equipment of the fac- tory is of very temporary use, and a valuation near the cost would be far from correct. Such articles as patterns, in a short time may have practically no value. Lasts in a shoe factory are a very large item and accumulate with changes in fashion at an appalling rate. Much care must be exercised if the Balance Sheet is to escape being over- loaded with what represents a real cost but is no longer a real asset. "Where the machinery used is not purchased but made within the factory itself, as is very often the case, the value is of course not the price which that machinery would bring in the open market but the actual manufacturing cost. The inventory value of machinery may properly include its cost of installation in the factory. (Whittaker v. 90 MODERN ACCOUNTING AmweU Nat. Bank. 52 N. J. Eq. 400. (1894)). This is in harmony with the general principle that the inventory has to do with the value to the going concern. Investments In the foregoing pages there has been only one objective criterion of value, cost price, and that is confessedly faulty for it refers to an earlier and not to the present day val- uation. But for investments that are quoted in a stock exchange there is a definite objective determination of to-day's value. The objection to making an independent valuation of one's lands or houses is that there may be an unconscious overvaluation, or that an intentional, and per- haps fraudulent, overvaluation cannot easily be detected. But where there is a definitely ascertainable market price, known to the public and fixed by outside interests, the objections just urged do not apply and it would seem that it might be safe and justifiable to ignore altogether the cost price, and alter the book value with every fluctuation in the market price. But if the securities are real investments, and not the stock in trade of a banker the objection at once arises that there can be no availing of the market price so long as the securities are thus held. For instance a National Bank buys government bonds at par, the holding of a minimum amount of such bonds being a prerequisite to the bank doing any business. The bonds bought at par may rise to 110 per cent., or conceivably fall below par, but. it is evidently impossible for the bank to realize this increase in value, nor can it suffer a loss while it continues as a going concern. To list the bonds at more or less than cost price would, for the ordinary purposes of the bank, be futile. It is true that if the bank went into liquidation the variation would be realized, but to take account of VALUATIQN 01" PARTICULAK ASSETS 91 that possibility is counter to the generally accepted rule that assets are to be inventoried at their valu^ to the going concern. The bank may furthermore buy other bonds to serve as the basis for additional circulation. These bonds, above the minimum required in any event, may be sold but only where the covered circulation is withdrawn. The impossibility of realizing an appreciation of these addi- tional bonds is less absolute than in the ease of the re- quired minimum holding, but here again the principle of the going concern applies. The bank cannot continue the note-issuing function and at the same time realize on the bond premium. So here too the variation in market price seems to be of no import. The same conditions exist in regard to holdings of stock acquired by a railroad to give it control in the management of another road or of some allied enterprise. The market price of this stock may vary, but such changes in value cannot be realized by the pur- chasing company while it still continues to exercise the function for which it acquired the stock— that is, to con- trol the other road. In many cases, however, there is no such indissoluble connection between holding some given security and the maintenance of the business. Securities are held not be- cause required by some provision of liaw, not for the sake of controlling business nor even for the sake of income alone. It is desirable to hold some funds as an available reserve against emergencies and a low-rate marketable security is somewhat less expensive and almost as service- able a reserve as the bare cash. The sale of such securities at the market price would not at all interfere with tho business of the concern ; and the appreciation, as shown by the market price, indicates merely that the reserve to-day really contains more than the sum that was originally invested. May not the inventory here rely solely on the 92 MODERN ACCOUNTING market quotation? Strict consistency would seem to give an affirmative answer. On the other hand the present price is only one point in a fluctuating scale of market prices and there is no ground for assuming that it will be realized. If it has risen there is at least a possibility that it will fall. The emergency that will call for the sale of the securities is likely to be at the time of a monetary stringency and hence of low prices, so that a high valua- tion would be purely illusory. The attitude of statute law and of the courts on this point is that where the secur- ities are permanent holdings, disregard of market prices is proper whether these prices are above or below cost. This is clearly set forth by the English courts in Verner v. The General and Commercial Investment Trust Limited. ([1894] 2 Ch. 239) where the distinction is made between securities held as investments for the sake of the income, and those carried as the stock in trade of a dealer in invest- ments. In Prance, too, the Bank of France holds all gov- ernment securities which were bought for permanent hold- ing at cost price irrespective of market quotations. In Germany, however, the law provides that the market price is to be taken except where it is highei* than cost price, which is equivalent to saying that of the two prices, cost and quoted market price, the lower is always to be taken as the basis of the inventory. This provision of the Com- mercial Code leads therefore toward conservatism at the expense of logical consistency. In Austrian law the quoted market price is always to be taken whether higher or lower than the cost. The general practice of conservative American accountants, especially in banks, insurance com- panies and other fiduciary institutions, is in line with German law, and favors marking down the investments when the market price is below the cost price, but opposes taking recognition, except in an explanatory footnote to the Balance Sheet, of the appreciation due to a rising VALUATION or PARTICULAR ASSETS 93 market. Thus the Ne\^ York Banking Department asks banks to charge off the excess of book value over market value of securities, but where the difference is slight or sup- posed to be a mere temporary fluctuation, no attention is paid to the variation. Occasionally in America both prac- tice and law, as for instance the Maine Savings Bank Law, adopt an even less logical rule that securities may not be listed above par even though they cost a considerable premium, but if costing less than par they are to be listed 'at cost. In the justification of listing permanent holdings at cost it has been assumed that the lapse of time has, in itself, worked no change in the serviceability of the security. This is true only in case of permanent securities such as corporation stock in this country, or the perpetual an- nuities used by most foreign governments. Time differ- ences may be ignored also in certain bonds which while due at a definite time have so long a duration as to be practically perpetual, the bonds of the "West Shore Rail- road running 475 years being an illustration. But wher- ever an ordinary bond is bought at a premium it is to be recognized that the purpose of this premium is to make the nominal rate of interest conform to the market rate for the given security, and is a payment in lump sum to offset the receipts from future interest payments whose rate is higher than the market rate. If the current market rate is five per cent., a six per cent, bond running five years will not be worth as much as a bond bearing the same rate of interest but running twenty years. In one instance there is, in addition to the normal rate of five per cent., an annuity of one per cent, running for five years, in tlie other case the annuity runs twenty years. To con- tinue to list the bond in successive annual inventories at its cost price is incorrect. At the time of purchase an esti- mate is made of what rate the bond nets the investor, the 94 MODEEN ACCOUNTING three factors of time, rate and price being considered. Thus if 11.2.46 per cent, is paid for a bond running twenty years and paying annually six per cent, interest it nets the investor five per cent. In each successive inventory the bond should be listed not at 112.46 but at the price at which the bond with its shortened duration would net five per cent., that is, at 112.08, 111.69 and so on until the nineteenth" year when its value is 100.95. Or, looking at it in another way, the annuity of one per cent, running for twenty years was estimated to be worth 12.46 per cent. It is clearly faulty to consider a similar annuity running nineteen, and a constantly diminishing number of years, as worth the same price; but it should be estimated on the same basis, that is, at such a price that it continually yields the holder five per cent, interest. The figures for the valuation of bonds of different rates and maturities are easily obtained from tables of Bond- Values, many of which are in the market. The formula by which these values are obtained is derived as follows : Letting: Vn = the present value of a bond running for n inter- est periods. I = the amount of interest paid on each $100 at each interest payment. i = the rate of interest to be yielded the holder for each interest period. It is clear that the present value of the bond is made up of a series of values composed of each coupon maturing at successive periods and of the principal, assumed to be $100, due at the end of the n years. But the fir^t coupon due in one period (for convenience the period will be assumed to be a year) has for its present value , the 1 + i VALUATION OF PARTICULAR ASSETS 95 I coupon due in two years is worth at present that I (1 + i)^ in three years and so on until the last coupon which (1 + i)^ I is worth • . Adopting the conventional symbol J (l + i)° V = then the entire series of coupons is worth at 1 + i 1 — v" present I (v + v" + v' + v* . . . + V.) or I — . The i principal of $100, also due in n years, is worth 100 v" so 1 — v" that the equation reads : V„ = I — ^ — • + 100 v". This, i for the bond used as illustration in the text, would be 1 1 V,o = 6.- ' (1.05) =» 100 .05 (1.05) = In other words the present value of the bond represents two sums: One the present value of an annuity (I) fur- nished by the series of coupons, running for n years, the other the present value of the principal due in n years. The same result is gained by considering, in the for- mula, only the excess of interest (over the market rate) which the bond pays. A bond bearing five per cent, in- terest would, of course, sell at par when the market rate is also five per cent. A bond paying a higher rate of in- terest will be worth a premium equal to the present value of an annuity whose annual installment is the difference between the nominal rate of interest and that taken as the basis of calculation. The formula, derived in a manner similar to that given above, is : 1 y" P=(I-100i). — ^ — , 96 MODEEN ACCOUNTIlfG or, substituting the values used above: 1 1- (1.05) = (6-5)- .05 or the value at five per cent, of a twenty-year terminabk- annuity of $1.00. Where the nominal rate of interest i.5 less than that taken as the basis the result vs^ill, of course, show a discount instead of a premium. The value of the bond at the time of each successive inventory is obtained by merely changing the value of n so that it equals the number of interest periods still re- maining before maturity. Interest is more customarily paid semiannually. "Where that is the case the same formula is used but m represents the number of half-year periods,' and i of course, the rate to be obtained not for the year but for the half-year. Thus for a twenty-year six per cent, bond with interest payable semiannually n would be 40, i would be .025 and I would be 3. Tables are published for bonds with annual, semi- annual and quarterly interest ahd also to show the price at which a bond bearing interest annually would be as remunerative as one bearing interest semiannually, etc. Logically bonds bought at a discount should similarly be treated by being marked up in value with each annual approach toward maturity. If a six per cent, bond is worth 112.46, that is, it nets five per cent., a four per cent, bond would have an actuarial value (its market value would probably vary somewhat from this) of 87.54. Tha,t is, the bond bearing a nominal rate one per cent, above the net rate of five per cent, is worth a premium of 12.46 per cent. ; one whose nominal rate is one per cent, below the normal should sell at a discount of 12.46 per cent. To continue to list the latter bond at the purchase price is mathematically incorrect, for at maturity the holder will VALUATION OF PAETICULAR ASSETS 97 receive not only the regular payment of interest and his invested principal of 87.54 but an additional sum of 12.46, the full face of the bond being then payable. The value of a promise to pay this sum of 12.46 increases as the date for its payment draws near, and a correct valuation would therefore demand that each year the bond purchased at a discount should be marked up just as the bond purchased at a premium should annually be marked down. But accounting practice has not fully accepted this principle. In many cases the annual writing off of pre- mium paid is justified, but there is hesitation at writing up the bond bought at a discount. This is largely an evi- dence of the conservative tendency which looks askance at anything which tends to swell the value of assets, but encourages undervaluation. Moreover the courts in the apportioning of receipts of estates between the one with a life interest and the remainder-man, generally hold that premiums given and received are a part of the corpus of the estate and do not enter into revenue, but that where a bond is bought at a discount the tenant for life receives only the nominal rate of interest ; add while the rulings of the courts in probate matters do not necessarily apply to ordinary commercial accounting, the practice in the treat- ment of premium and discount on bonds is similar in both fields. , Interest accrued on investments should be estimated and shown on the Balance Sheet. This is not analogous to taking recognition of an appreciation in market value, for the interest is earned and is as much an asset as the face of the bond itself. "Whether interest accrued but not yet due, or interest due but not yet paid, may be used as a basis of dividends is a question discussed in Chapter XII. But accounting practice uniformly estimates interest, whether due to or by the company, even though the law may object to a dividend in anticipation of its receipt. 98 MODEEN ACCOUNTING Mercantile Credits The holding of mercantile credits — book accounts, ac- ceptances, promissory notes, etc. — being an essential part of ordinary commercial life they must be treated somewhat differently from investments. They are so clearly a part of the circulating assets ( are ' ' circulating capital, ' ' to use the term employed by the courts) that there can never be any justification for allowing them to appear at more than their real value. The argument frequently made that shrinkage in the real value of fixed assets, inasmuch as it works no change in the conduct of the business, may be ignored is not without some plausibility. But a loss in any of the circulating assets cannot be disregarded. It immediately manifests itself in reducing profits and must appear in some form in the Balance Sheet. For convenience Mercantile Credits are entered and carried on the books at their face rather than at their present actual value. Thus a thousand-dollar note due without interest in sixty days appears in the Bills Receiv- able account at $1,000 not at $990, leaving the adjustment to be made through an interest or discount account. This is much more convenient in checking over the contents of the bill portfolio, and, unless a daily revaluation of the notes is made, it is also as accurate as to list the note at the discounted value on the day when it is acquired. But when a new inventory is to be made it is necessary to take full account of interest adjustments. The adjustment of interest is, however, a mere matter of arithmetic and offers no problem in accounting. The estimate of probable loss due to insolvency of debtors, being an estimate merely, is a debatable and interesting problem. A company may hold a thousand notes of customers aggre- gating $100,000, its books showing: YALUATION OF PAETICULAE ASSE'TS 99 Dr. Form 34. Balance Sheet. Cr. Merchandise $140,000 Bills Receivable 100,000 Cash 10,000 $250,000 Capital $220,000 Profit and Loss 30,000 $250,000 If some of these notes are clearly worthless they should at once be stricken from the list of assets, without waiting even for the annual inventory. No justification can be found for retaining on the books the note of A for one hun- dred dollars if it is known to be worthless. As soon as that fact is manifest the note must be eliminated by charg- ing it at once to Profit and Loss, or pending the annual balance of the books to some subsidiary account indicating a loss. The accounts would then furnish the following: FoBM 35. Dr. Balanc e Sheet. Cr. Merchandise Bills Receivable Cash .... $140,000 . . . . 99,900 . . . . 10,000 $249,900 Capital Profit and Loss .... .... $220,000 . . . . 29,900 $249,900 Where there remains a slight chance that the debt may some time be paid and yet one on which it is not safe to count, it may be desirable to keep a reminder of the debt on the books without appreciably swelling the assets by including doubtful debts. This is conveniently done by charging off the bulk of the note, but leaving a purely nom- inal sum, perhaps one dollar, or even a smaller sum, as a reminder that there is still an unsettled claim outstanding. But a more delicate question arises in connection with 100 MODEEN ACCOUNTING probable losses which have not been made known. Of the xemaining 999 notes in the assumed case no ooe of the makers has as yet failed, and yet past experience shows -that it is a certainty that some of the notes will not be paid in full, and the probabilities are that at least one of them Tvill ultimately prove worthless. Each one of the notes must in the meantime be kept on the books at the face value, allowing the estimated shrinkage to appear as a re- , serve for doubtful debts. The entry to be made is to debit Profit and Loss and credit Reserve for Doubtful Debts or ^ome equivalent account. In the formal publication of the JBalance Sheet this would appear as Dr. Form 36. Balance Sheet. Cr. Merchandise $140,000 Bilk Receivable.. $99,900 Less Allowance for doubtful debts 100 99,800 -Cash 10,000 $249,800 Capital $220,000 Profit and Loss 29,800 $249,800 That such allowance should be made is not only dictated by business prudence and accounting practice, but is as well commanded by the United States Supreme Court in Providence Rubber Co. v. Goodyear (9. Wall. 788), and by the English courts In re Oxford Benefit Building & Inv. Soc. (35 Ch. Div. 502). The amount to be allowed is to be decided in each individual case but it certainly should not be much below what has been generally accepted in the specific business concerned. The basis of figuring is also subject to individual preference; some preferring to take a percentage of gross sales, some a percentage of debts jQutstanding, still others a percentage of credits given. VALUATION OF PAETICULAR ASSETS 101 With business of a constant character correct results could be reached as well with one method as another. But a change in the character of the business done would neces- sitate a change in the rate adopted. Thus if 2 per cent, on total sales was correct with a business which was 50 per cent, cash it would probably be insufSeient if the- change in business methods gave 80 per cent, of the sales, for credit and only 20 per cent, for cash. Similarly an increase in term of credit granted would invalidate an allowance based on debts outstanding. And any rates would need to be changed if there arose a general panic or other commercial disturbance. It is incorrect to list in the Balance Sheet merely the excess of debts due to the concern over the amounts due from it. The canceling of one against the other does not exhibit the true condition, for the failure of the concern's debtors to pay does not at all affect the necessity of pro- viding for the claims of its creditors. This, however, is done in the Balance Sheet of the Illinois Central, but the defect is partly remedied by reference to statements giving the detailed information. Merchandise General usage prescribes that merchandise on hand shall be inventoried at cost rather than at selling price. Prudence further demands that merchandise which evi- dently cannot be sold except at a loss, be marked down even below the cost price. If one could count not only on good faith but as well on unbiased judgment in making inven- tories, the taking of the present market value, instead of the cost price would not be objectionable, but rather to be commended. Indeed, the first principle of valuation laid down above, that of the ' ' going concern ' ' in strict logic demands that merchandise for sale be valued at the pres- 102 MODERN ACCOUNTING eiit selling price, with a reduction to cover selling ex- penses. A real change having taken place in selling value the original cost is of no effect, for whether bought at a high or low cost its value to the concern is determined at the normal price at which it can now be sold. But the German commercial code, in many respects a guide to those whose accounting practices are so €ree from legal control, in attempting to prevent overvaluation prescribes that the cost price of merchandise must be taken, except where there is a publicly quoted price — as for instance for grain in a produce exchange— which is lower than the cost price. Logic perhaps demands that the quoted price should be taken as well when over as when below the cost price, but this is not permitted by German law, although the Austrian law allows it to be done. American practice agrees with German law. In one important decision the Massachusetts court, on the con- trary, stated that depreciation or advance in the value of the stock unsold must be taken into account.^ But in this particular case there had been a loss of merchandise by fire instead of an appreciation in value; and it is to be hoped that this obiter dictum is not considered authoritative. In any event the judgment of accountants is adverse to such treatment of the inventory. The conservative rule, generally adopted, is that merchandise is to be inventoried at cost except where there is a decline in value, in which case the lower value is to be used. In the case of merchandise purchased for sale the cost price ordinarily can be easily obtained. There may, how- ever, be some room for question even here as to what items, if any, may be added to the quoted cost price for inventory purposes. It is apparent that if two consignments be pur- chased one at $1,000 c. i. f . and the other for $990 f. o. b. the freight and other charges on the second consignment • Meserve v. Andrews, 106 Mass. 419. (1871.) VALUATION OF PAETICULAE ASSETS 103 being just $10, it would be illogical to list the two lots at different figures. In other words the familiar principle of valuing the goods to a going concern applies here as well as in other eases. The /etailer needs the goods in his own store and the expenses of getting them there, whether paid by the manufacturer and included in the cost price, or paid by the retailer in addition to the cost price are legitimately included in the inventory value. It is sometimes urged that while cost, rather than sell- ing price, should be selected, it need not be the actual cost price paid, but the price which would need to be paid at the time the inventory is taken. The clearest case is where one consignment is purchased say at $1,000 and shortly after an exactly similar consignment is bought for $1,200. If an inventory is taken while part of the first consign- ment is still unsold, the faking of the actual costs will present, in the inventory, the absurdity of having identical goods listed as having different values. If all are in- ventoried on the basis of the later invoice, the profit which thus appears is said not to be an unrealized profit on sales, but an already gained profit on a fortunate purchase. The danger of such a course is apparent. A large stock of unsold goods can be made to show a profit by a subse- quent purchase of a small amount at a high price. Per- haps this is purposely done, and an excessive price is will- ingly paid just before inventory- in order to make a fair showing to stockholders. A stock of 100,000 yards, cost- ing and worth only one dollar the yard, could by a tricky purchase of 100 yards at $1.10 yield an apparent profit of $10,000. Thus the safeguard which is found in clinging to cost price would be nugatory and the way made easy to the pleasing practice of creating profits by marking up goods. To prevent this the actual cost paid should be taken despite the objection stated above. In cases -where parts of the different stocks of similar 104 MODEEN ACCOUNTING goods, bought at varying prices, have been sold, a still fur ther difficulty arises. Thus, to illustrate, 10,000 bushels of grain are bought in January at $1.00 a bushel, 10,000 in July at $1.20, and in August 5,000 are sold at $1:30. If it is assumed that the sale was of the first consignment there has been a realized profit of $1,500, but only one- third as much if the sale was of grain bought in July. "Where the consignments are kept physically distinct the proper treatment is apparent; where they are not distin- guishable the average cost should be taken, thus showing a profit of $1,000. Evidently the average should be the weighted average, not the simple average of prices, so that a purchase of 10,000 bushels at ^$1.00 and 2,000 bushels at $1.20 would be treated in the inventory as an average cost price of $1.03^ so that a sale of 5,000 bushels at $1.30 would give a realized profit of $1,333.33. Wheii the merchandise to be inventoried fcas not been purchased but has been manufactured the determination of cost price is much more difficult and the general ques- tion of manufacturing cost will receive further considera- tion. The principle is clear enough. All the costs which are immediately necessary to secure the goods may be included in the inventory price. But difficulties arise in applying this simple rule, because of the uncertainty whether certain payments such as partners' salaries should he included in cost of goods or treated as part of the gen- eral expenses of the business. Attempts have even been made to include a certain percentage, representing normal profits, in the cost price, a procedure which not only opposes accounting practice but which has been prohibit'^d by the courts.^ Goods in the process of manufacture for the general market should not be inventoried at more than the cost price ; but when they are manufactured on a specific con- « Providence Rubber Co. v. Goodyear. 9 Wall. 788. VALUATION OF PAETICULAE ASSETS 105 tract it is correct to take into aeeoimt the selling price, making due allowance for the unfinished work still to be done, the risks intervening and interest charges involved. Where the contract period extends beyond the current fiscal period such inventorying is not only permissible but is the only correct method: Otherwise the profits on the contract work would all appear in the year when goods are deliv- ered, although the labor involved belonged almost en- tirely to a preceding year. BIBLIOGRAPHICAL NOTE TO CHAPTER V 106 MODEEIST ACCOlTNTING On the Valuation of Investments. May, G. 0. The Proper Treatment of Premiums and Discounts on Bonds. Journal of Accountancy, II, p. 174. Sprague, C. E. The Accountancy of Investment. Fourth edition. New York, 1907. [A valuable treatise giving mathematical formulas.] ' Problems and Studies in the Accountancy of Investment. New York, 1906. [A supplement to the above.] ^ Premiums and Discounts. Journal of Accountancy, II, p. 294. [A criticism of the article by May.] See also the references to Chapters VII and XII, CHAPTER VI immaterial assets Goodwill Goodwill, which may be taken as the typical form of Immaterial Assets, represents the value of business con- nections, the value of the probability that present custom- ers will continue to buy in spite of the allurements of com- peting dealers. While the inclusion of intangible assets in the inventory of corporations is not infrequently the object of popular criticism the legitimacy of Goodwill has long been recog- nized both by the courts and by accountants. A clear statement of the principle is given in the case of "Washburn V. National "Wall Paper Company, where the court said: " "When an individual or a firm or a corporation has gone on for an unbroken series of years conducting a particular business, and has been so scrupulous in fulfilling every obli- gation, so careful in mainta,ining the standard of the goods dealt in, so absolutely fair and honest in all business deal- ings that customers of the concern have become convinced that their experience in the future will be as satisfactory as it has been in the past, while such customers' good report of their own experience tends continually to bring new customers to the concern there has been produced an ele- ment of value quite as important — in some eases, perhaps, far more important — than the plant or machinery with which the business is carried on. That it is property is abundantly settled by authority, and, .indeed, is not dis- puted. That in some cases it may be very valuable prop- 107 108 MODERN ACCOUNTING erty is manifest. The individual who has created it by j'ears of hard work and fair business dealing usually ex- -perienees no difiSculty in finding men willing to pay him for it if he be willing to sell it to them. ' ' ^ Similarly accountants have recognized that the pur- chase of Goodwill of an established firm may be a most valuable transaction, for it may save, as Guthrie has neatly put it, ' ' the period of perilous probation. ' ' Indeed even the Goodwill of a bankrupt house is at times legiti- mately sold at a high price, and where so purchased it is as true an asset as factory, machine, or stock of mer- chandise. But in valuing Goodwill for the inventory the limita- tion of its value to its cost must be most rigorously ob- served. It has been seen that the restriction of inventory value to cost price is of rather general application, but its force is much greater when the Goods to be valued are immaterial. No one would object to the inclusion in the inventory of treasure trove even though it cost the finder nothing. But Goodwill is rigorously excluded unless it has been secured at a cost. Hence it is recognized as legitimate for the purchaser of Goodwill to include it among his assets, but accounting practice prudently, though perhaps illogieaUy, forbids the firm which created the Goodwill to place in the Balance Sheet any value on the clientele which it has built up and which it could at any moment sell for a large sum. This conservative restriction is doubtless necessary to prevent a harmful exaggeration. Human nature is so in- curably optimistic, especially when it comes to estimating one's own possessions. The boy's jackknife, the citizen's fatherland, the man's children, are in normal cases a little better than similar possessions of anyone else. The same phenomenon appears in the valuation of one's business > 81 Federal Rep. 20. IMMATEEIAL ASSETS 109 assets, where the natural instinct to overvalue one's own possessions is augmented by the fact that* such overvalua- tion may be the means of overreaching some one else in a business deal. In proportion as it is difficult to verify Values it is therefore customary to limit the value at which they are appraised. Cash being of definite value may be listed though it cost nothing; quoted securities or com- modities may, according to some authorities, be listed at the market value even though that exceed the cost; but Goodwill, because of its vague nature and the difficulty of verifying its appraisal is to be excluded unless it has been purchased.^ But it is not always easy to determine whether there has been an actual purchase of Goodwill, or what price, if any, has been paid. Most frequently where a corpora- tion buys out the business of a partnership or of another corporation the purchase is made with stock, not with cash. "When, as is generally the case, the par value of the stock given is in excess of the value of the tangible assets it is at times difficult to determine whether the difference in these values represents Goodwill purchased or a mere dis- count of the stock issued. In ordinary American practice the accountants have assumed the existence of Goodwill wherever the tangible property purchased is less than the par value of the stock issued therefor. Thus in the recent capitalization of a large catalogue house, whose total assets were less than $20,000,000, there was added at the time of reorganization the item of Goodwill valued at $30,000,- 000. The exaggeration in this figure is clearly established by the quoted prices of the stock issued for its purchase. - For a possible exception to this see the decision in the English case In re Barrow Hsematite Steel Co. ([1900] 2 Ch. 855) where it was held that a decline in the value of part of the assets should be offset by the introduction of Goodwill before it could be claimed that capital had been impaired. 110 MODERN ACCOUNTING In general the recent organization of the so-called trusts included a high valuation for Goodwill, ordinarily roughly corresponding to the amount of common stock issued. In most eases this was grossly overstated, and openly and notoriously incorrect. This is shown for instance by the experience of the Asphalt Company whose earnings esti- mated at ten per cent, of the capitalization proved to be less than one per cent. ; or by that of the American Plait- ing Company where the $2,100,000 earnings estimated in the prospectus dwindled to a negative quantity in the first year of operation. It is, therefore, necessary to examine the conditions in which Goodwill exists, and to consider the principles governing its valuation. The value of Goodwill, or the other similar categories, " Franchise," " Patent Rights," " Trade Marks," " Trade Names," depends on the existence of some legal right or trade custom which will bring to the owner of the business profits in excess of that to be obtained in other ordinary channels of trade. If the firm's name and its past repu- tation for good dealing will bring to its doors a^flow of customers without the expense of profuse advertising or despite the lower prices of less favorably known rivals, there .is a source of profits in excess of what could be obtained by establishing a new house. If the right to use a particular location to the exclusion of others, whether that location be of a newspaper stand on a crowded cor- ner, or a street railway with an exclusive franchise to the streets, there is at least a possibility that it opens the doors to the receipt of profits which could not be gained in any line of business not thus specially favored. If any business is protected by a monopoly, whether the legal monopoly of a patent right or a partial business monopoly resting on the combination of all present competitors in a " trust," there is a possibility of maintaining prices at a level which will yield profits in excess of the current IMMATEEIAL ASSETS 111 normal rate, and hence a legitimate basis for the valuation of Goodwill. The one justification of a valuation of Goodwill is the existence of some transferable right which will secure to the purchaser profits in addition to the normal returns on the amount of capital invested in the business. Such a surplus over the normal income to be derived from invest- ment is practically an uncertain annuity and its value depends (1) on the annual amount, (2) on the degree to which it can be transferred, and (3) on the length of, time during which it will continue. The determination of the amount of excess profits is generally based on the records of past experience and relies upon the accounts of the firm or corporation selling its Goodwill. How long a period should be taken into survey is a delicate problem. A single year is not a sufficient period, for the high profits of that year may be altogether due to exceptional tempo- rary conditions. ISJor should too long a period be consid- ered lest the conditions of the remoter years be so dif- ferent from those prevailing at the time of valuation as to make an average of little significance. Especially if the business is declining, the inclusion of the operations of the earlier years in the estimate is objectionable, as tending to exaggerate the showing of profits. Yet in recent capitalizations the National Wall Paper Company based the estimate of the valuation of GoodwHl on the earnings of only eleven months. The Rubber Goods Mami- facturing Company took the eariiings of a single year; the National Salt Company averaged the earnings of two years, and. the National Cordage Conipany those of three to five years. In English corporation finance the latter figures seem to be most generally used. In determining the amount of surplus profits to be capi- talized two distinct methods are used. One is to capitalize the entire net profits, of course being sure that the profits 112 MODEKN ACCOUNTING stated are really net profits and that due allowance has been made for depreciation and other charges, and from this capitalization is deduced the value of the tangible assets. This was done by the National Wall Paper Com- pany. Another way is to deduct from the net profits the assumed normal rate of profits oh the capital actually Invested and then capitalize the remaining surplus earn- ings. This method is more commonly used in 'floating English companies. Of course the results will be the same provided the rate at which the earnings are capitalized is the same as the assumed rate to be derived from invested capital. ' 2. The transferability of the excess income is a point which varies greatly. When a lawyer, physician or other professional man sells his Goodwill it is always a question as to how far the clientele which he has had is a purely personal matter. On the other hand the surplus derived from an exclusive franchise of a street railway is clearly transferable. Between these two limits there is room for variation, depending largely .on the degree to which the personal element of the proprietor has been a determining factor in creating the profits. It is not uncommon where Goodwill is bought by a corporation to specify that the former proprietors, managers or ofScers shall agree to con- tinue their services for a given time after the purchase, as was done, for instance, in the case of the Cordage Trust. 3. The duration of the annual excess depends on two factors: those having to do with competition, and those relating to general trade conditions. Error has been com- mitted in the calculations of many of the large combina- tions both in this country and in England in assuming the continuance of large profits, where that is conditioned on the absence of competition. A notable instance was in the case of the Columbia Straw Paper Company, where IMMATEEIAL ASSETS 113 large profits were perhaps honestly estimated on the basis of the high prices to be obtained by a practical monopoly. But as soon as prices were raised old mills were reopened, new mills were immediately constructed, and, in addition, new competition arose through the introduction of wood- pulp a"s the basic material of wrapping paper such as was previously manufactured exclusively from straw. As a result the company was insolvent in less than two years. Almost equal error has arisen from neglecting the pos- sibilitj'^ of change of general trade conditions. Thus in the consolidation of English factories for making bicycles a large valuation was placed on the Goodwill based on the continuance of previous demand; but almost immediately after the shares of the combination were floated the fad for bicycle riding ceased, and with it the value of the shares so eagerly purchased by the public. Similarly the Goodwill of a distillery, or of a saloon, might cease be- cause of the emergence of a sentiment in favor of absti- nence or the enactment of a prohibition law. With all the variables referred to, it is evidently impos- sible to lay down a rate at which to capitalize Goodwill. Dicksee- gives a rough estimate that to determine the value of the Goodwill of a trading company the average net profits — interest on capital and allowances for proprietors' services having been deducted— should be multiplied from one to five times ; the multiplier to be used for a manufac- turing concern bsing from one to four, for a professional practice one to three, for newspapers and " other quasi- monopolies " a much higher figure, ten not being unusual In determining the value of Goodwill of the trusts already referred to the profits were multiplied by 10 for the Cordage Trust, by 10 for the Salt Trust, by 14f for the Rubber Goods Manufacturing Company, and by 16 for the National "Wall Paper Company. But in these cases the element of monopoly was perhaps erroneously sup- 114 MODERN ACCOUNTING posed to exist, and the profits were the total net profits, not those profits less the normal rate of interest on in- vested capital. Furthermore payment in these cases was made generally in stock worth far less than its par value. Mr. Charles S. Pairchild gives the following descrip- tion of the method of estimating the value of Goodwill : " In some cases the value of the Goodwill acquired has been very carefully estimated. For example, the pro- moters of one company made a special point of the con- servative methods employed in arriving at the value of the Goodwill of the companies which were consolidated. According to their statement, the new company was vir- tually buying the real estate, plants, stock, etc., on the basis of appraised cash value. In addition an allowance was made for Goodwill, calculated upon this basis; from the net profits of each company deduct 7 per cent, upon the capital actually employed, 1^ per cent, upon sales, which were about three times the capital, 2 per cent, for depreciation on brick buildings, 4 per cent, on frame buildings, and 8 per cent, on machinery. If the average net earnings were in excess of all this, and in this case it appeared from the promoter 's statement that the/ usually were, the excess was capitalized as " Goodwill " on the basis of 20 per cent, per annum— i. e., the value of the Goodwill was estimated to be five times the amount of such earnings in excess of 7 per cent, on capital and al- lowance for depreciation. " ^ As has been shown by Francis More it is correct to have a different rate for capitalizing different portions of the surplus earnings. Thus, to use the illxistration given by him, if it is assumed that 8 per cent, is the normal rate of profits, a concern having assets worth $100,000 and earn- ing $8,000 affords no basis for Goodwill, the earnings ' Publicaiums of the American Economic Association, 3rd Series, I. p. 156 IMMATERIAL ASSETS 116 sliowing no excess over the normal rate. If earning $13,- 000 the excess of $5,000 might be capitalized, say at seven years' purchase making a valuation of $35,000., But if the earnings were $18,000 it would be unwise again to add $35,000, but the additional surplus of $5,000, might per- haps be multiplied by five. And so each additional por- tion of surplus should be taken at a lower rate of capital- ization, or to express the idea more generally, the larger surplus earnings are relatively to normal profits, the lower should the rate of capitalization be. This is reasonable since a small excess is more likely to continue than a large one, affording a smaller field for c6mpetition, and probably being less subject to other fluctuations. "What has been said in support of the legitimacy of including Goodwill and similar immaterial assets in the inventory in no way justifies the practice, all too common, 'of listing a nonexistent or a greatly overvalued Goodwill. Such an item is not merely immaterial but also imaginary. Prom the view point of accounting, there is no more justi- fication for such a procedure than there is for placing in the list of assets a brick building which has no existence, or for stating in the Balance Sheet the moniey in bank at twice the sum actually on deposit. As was said by the United States Supreme Court, ' ' Goodwill/ is a legitimate asset where it is actually existent, but it must not be some- thing unsubstantial and shadowy but capable of pecuniary estimation."* The question has arisen as to whether Goodwill having once been properly entered in the books at its cost price should continue at that figure, or whether it should be subject to periodical revaluation or regularly written off, as machinery is marked down to allow for depreciation. .In this, as in other questions of accounting theory, opinions differ. In the discussion which has been carried on among ' Camden v. Stuart, 144 U. S. 104 (1892). ]16 MODEEN ACCOimTING English accountants, CMld, Cooper, Guthrie and Pixley are among those favoring a regular writing ofiE of Goodwill, while Dicksee, Caldicott, Gareke and Pells, and James argue that it may be continued at its original figure re- gardless of changes in its value. Some set a less absolute rule but differ, and somewhat strangely. Thus "Welton in general opposes the writing off of Goodwill, but says that it should be done when the company has not earned the anticipated profits on which the valuation of Good- will was based. But with Guthrie the writing down of Goodwill is conditioned on the company having unusual profits which can be appropriated for that purpose. The English courts have decided in Wilmer v. McNa- mara ([1895], 2 Ch. 245) that even where the Goodwill has actually declined in value it is not necessary to charge the shrinkage against profits. The decision was based on the conception that Goodwill is " fixed " capital, and the application of a previous decision ^ that a decline in the value of ' ' Fixed Capital ' ' (or permanent assets) need not be taken into account in determining profits. Prom one point of view it is true that Goodwill is the most permanent of assets. Anything else, even the factory site may conceivably be sold without necessarily terminat- ing the business. But Goodwill cannot be disposed of without selling the business itself. Purthermore the very indefiniteness of Goodwill renders its overvaluation less harmful than that of other assets. Every one knows that the price paid for Goodwill gives no indication of its pres- ent value, and that at any time a new valuation needs to be taken. Hence there is little danger of deception by con- tinuing it among the assets at the cost price. But this doctrine of the permanence of Goodwill seems inconsist- ent with the theory of valuing it as the purchase of a temporary, terminating annuity. Strict logic requires, at I See below, p. 208, IMMATERIAL ASSETS 117 least where the price paid for Goodwill is definitely based on a number of years' purchase of excess earnings, that the valuation should be written off in the same number of years. To require the writing off only when the expected returns are not realized appears unnecessarily hard on the stockholders for they are doubly burdened: first, by the decline in expected earnings, and then by a further charge against the diminished earnings to cover decline in Good- will. To mark down Goodwill when profits are unusually high is clearly illogical, though it is not thereby necessarily discredited in accounting practice, for it reduces the valu- ation of excess earnings at the very time and in direct ratio to the increase of such earnings. Probably the most satisfactory solution is ordinarily to write off Goodwill in proportion to the number of years figured in its valuation, for in any event it is an uncertain asset, and a depreciation of even fixed assets (in which class it is somewhat forced to include Goodwill) , while it legally need not be made, is justified on the plea of conservatism. And where it is clear that the valuation of the Goodwill was erroneous, that it is not worth its book value, the best method of adjustment is that advocated by Dieksee, to offset the decline in its value by a reduction of capital, not by a charge against profits. In American corporation finance Goodwill frequently is not openly shown on the Balance Sheet. Oftentimes it is included with the tangible property under the title ' ' Property, etc., " or it may be combined with other items of an intangible nature under headings such as " Good- will, Patents, Leases, Trade Marks, etc." (American Cot- ton Oil Co.), " Patent Eights and Goodwill " (American Glue Co.), " Franchises, Goodwill, etc." (American Graphophone Co.), "Goodwill and Patents" (Sears Roebuck Co.). "While such property rights as patents, trade marks, etc., are quite different in their legal nature 118 MODEEK ACCOUNTING from Goodwill yet economically they are very similar, both representing a transferable right from which excep- tional profits may be derived. Those which are distinctly terminable, as patents, copyrights, etc., differ from Good- will in that the value must some day disappear, and hence the necessity of marking down their value is apparent. Deferred Assets Another class of items appearing in the Balance Sheet are called Deferred Assets or Deferred Charges. These terms indicate that payment has been made of expenses properly belonging to a period subsequent to the date of the Balance Sheet. In this class are found such items as " Discount and Commission on Bonds," " Deferred Charges to Operation," " Cost of Stripping Surface of Mines," " Interest paid in advance " and many others. Attention has been called to the discussion as to whether certain expenditures, especially those made at the begin- ning of a company's operations, should be considered as mere expenses or as part of the cost of the plant to be charged to Construction account. The items appearing in Deferred Assets hold to some extent an intermediate posi- tion, for they are not conceived of as representing part of the cost of permanent assets, nor are they charged at once to the expenses of the year. Being clearly expenses they are yet expenses which are offsets of future earnings, not of past receipts. While in many cases not representing any actual asset, they are correctly treated as though they were assets. This may be clearly illustrated by an item representing " Interest paid in advance." This may be an irrecoverable expense. It may not even be a reduction of the amount of debts, for in many cases a prepayment of a debt does not bring with it a discoimt for the time before maturity. But to the going concern it is immaterial IMMATEEIAL ASSETS 119 whether the interest is paid in advance, or not being paid there is in the treasury cash sufficient to pay the interest when it matures. Thus the item " Interest paid in ad- vance " is practically the same, so far as meeting the interest expenses of the next fiscal period, as an equivalent amount of cash. The former, as well as the latter, may therefore legitimately be treated as an asset. As such accounts represent a prepayment or anticipation of an expense, and provide for the proper adjustment of net profits as between different fiscal periods ,they are some- times called Anticipation accounts, or Adjustment ac- counts. The latter term is, however, used somewhat ambiguously, and, especially in England, signifies what is also known as a Collective account, or, in recent American nomenclature, a Controlling account. In some cases, as where it represents interest prepaid for a short period, the Deferred Asset must evidently be treated as an expense of the next fiscal period. In other cases the Deferred Asset represents the prepayment of an expense which pertains to the operations of several years, as, for instance, the cost of stripping the surface may cover perhaps twenty years of mining operations. Here evidently it is strictly necessary that the total amount should be charged off within the period to which it applies. In some cases the Deferred Assets really represent pay- ments covering permanent advantages, as where Organ- ization Expenses are included under this general head. Here it is not strictly necessary that the charge should be written off but it may be carried indefinitely, just as it might legitimately have been added to the value of the plant. But conservative companies are apt to charge these items off more rapidly than strict necessity demands. Thus one company charges off annually one-sixth of the " Dis- count on Bonds ' ' although the bonds run for twenty years. 120 MODEKN ACCOTHSTTING In another ease one-eighth of a similar discount on bonds was written ofE in the first year, but in the following year the entire remainder disappeared. At times there appear among the assets items which represent not anticipated expenses but unusual losses which the corporation does not see fit to charge at once to Profit and Loss, nor to make manifest in a reduction of capital. In such cases the charges which are deferred are not the costs of future earnings, but losses which it is expected future profits will cover. A striking instance of such an item is found in the Balance Sheet of the United Railways Investment Company for December 31, 1906, where there appears " Earthquake, Fire, and Strike, $859,983." Openly to show such an item is a vast im- provement over carrying it concealed among the charges to plant and other material assets. Of course, it is in no sense an asset, properly speaking not even a Deferred Asset. But by treating it as shown above the loss does not necessarily interfere w^th current profits. The legitimacy of so doing is discussed at length in Chapter XII. BIBLIOGRAPHICAL NOTE TO CHAPTER VI Dawson, S. S. Goodwill. Article in Encyclopedia of Accounting, HI, p. 196. DiCKSEE, L. R. Goodwill and Its Treatment in Accounts. Third edition. London, 1906. [The most complete treatment of the subject.] GuTHBiE, E. Goodwill. Accountant, XXIV, p. 425. More, F. Goodwill. Ibid., XVII, p. 282. CHAPTER VII DEPRECIATION Destruction is the law of nature. Fixed capital, using the term here in its economic rather than in its accounting senSe, despite its name, is not exempt from this law. Even so-called permanent improvements, such as buildings, are all subject to the ravages of time, which Marshall aptly defines as " the complex of destructive agencies." All machinery is on an irresistible march to the junk heap, and its progress, while it may be delayed, cannot be prevented by repairs. This obvious economic fact is of momentous import to accounting, although full recognition has not been given .to it in general practice. It is one phase of the question of the inventory discussed in the preceding chapters. It implies that, in valuing all fixed assets, account must be taken of the lapse of time, and even in the case of ma- chinery giving no evidence either of use or misuse, the bare fact that it is a year nearer its inevitable goal is an item of which technical account must be taken. In estimating the cost of production there must be con- sidered not merely wages and material, interest and rent, repairs and renewals, but in addition some allowance must be made for the diminished value of the fixed assets due to gradual loss of serviceability. Consequently profits are not determined until after allowance has been made for depreciation. Depreciation is not a disposition of part of the profits, but an expense without which profits can never be \earned. The principle is clear. Materials consumed 121 122 MODEEN ACCOUNTIlS^G in manufacturing a commodity, as for instance fuel or oil, are, of course, an element of expense. This is so because an item of wealth disappears and its effect can only be to diminish pro tanto the expression indicating the net wealth. Its loss is in other words an expense. In the case of fuel the loss is immediate, and is, therefore, charged at once to expense. Exactly similar is it with the productive instru- ments whose use extends over a longer period. The article consun;ied in a single use must be considered an expense of the current production, the temporary structure or the tools lasting only a year are a charge against the produc- tion occurring during that year. The more permanent form of assets serving for productive use during a period of years should be spread as an expense during the period of use, whether that be five or fifty years. If, instead of considering the year as the fiscal unit of time, the entire economic period of production is re- garded as the unit, the purchase of a machine, or the pur- chase of a patent right are both expenses — expenses to the full amount of the cost. If a manufacturer, renting his plant, produces a thousand engines in a year, it is clear that the annual rental is a part of the expense of producing the thousand engines. But, if the fiscal period is extended, it is equally correct to say that the production of ten thou- sand engines includes the total payment of rent for ten years. Exactly similar is it with machinery and patent rights. Assuming the life of each to be ten years, the expense of producing ten thousand engines includes not only rental for ten years, but as well the total cost of the machinery used and the cost of the patent rights. A purely artificial division of the productive process into fiscal years is made. It is, therefore, necessary to make an artificial and at best merely approximate division of these total expenses invo the shares to be allotted to the operations of the several years. DEPRlECIATIOIsr 123 Where rent, interest, or other time payments are made in advance, it is customary, when any such sum is outstand- ing at the time the annual balance is taken, to show the prepaid rent, interest, or insurance as an asset. Thus on December 1 a company may have paid $300 being six months' interest in advance on $10,000, $1,500 as a quar- ter's rental in advance and $1,200 one year's insurance. A Balance Sheet made December 31 would show among the assets : Interest prepaid $250 ; Rent in advance $1,000, Unexpired insurance $1,100, making the apportionment, as is customary in the case of short time items, proportionate to the time elapsed. Such items are sometimes called " Anticipation " or " Adjustment " accounts and are in- cluded among the Deferred Assets. But logically the line of demarcation from depreciation is extremely vague. Considering the entire productive process, the total cost of machinery and patent rights, is, as already stated, simply an expense of production. But at the end of each year part of this expense is conceived as pertaining to future, not to past operations, and therefore a portion of the cost of these so-called permanent, but really temporary assets, is treated just as prepaid rent, interest, and insurance. In other words, the asset item representing the value of the destructible or otherwise terminable instruments of production is logically similar to any of the Anticipation or Adjustment accounts which also appear among the assets. The immediate ei^ect of allowing for depreciation is properly to equalize profits during different years. Other- wise the total cost of the machine must appear as an ex- pense of the year when it finally proves unserviceable. At that time, its value ceasing, it can no longer appear in the inventory. The amount of Goods on . hand being thus diminished, there must needs be a subtraction from the Profit and Loss, or other Proprietorship account. But if 124 MODEEN ACCOUNTING the original value of the discarded machine, say $20,000, was continued on the books throughout its entire life of 20 years it may roughly be said that the proprietors in the last year showed an excessive loss of $19,000, while the proprietors during the preceding 19 years overestimated their profits by the same amount. Such a procedure is improvident where there is no change in proprietors or stockholders; it is inequitable where the personnel has changed ; in all cases it is dangerous to the creditors who, up to the last year, have not been shown the true condi- tion of the company's assets. The early writers on accounting made no allowance for depreciation, and the advance that has been made in ac- counting theory is still somewhat ahead of legal practice. This is particularly true in the United States. Germany, France, Belgium, Switzerland, Austria all prescribe in their statutes that depreciation must be reckoned before showing profits. In England, as in the United States, there is no such regulation of accounting practice as is found on the Continent, but the decisions of the English courts are perhaps more satisfactory and consistent than those of this country. At least so far as material wear and tear is concerned the early case of Davison v. Gillies (16 Ch. Div. 347" (1879) ) and the later one of Bond v. Barrow Haematite Steel Co., Lim. ( [1902] 1 Ch. 353) give clear expression to the doctrine that depreciation must be reckoned. Less satisfactory is the position of the American courts. In the interesting case of Mackintosh v. Flint & Pere Mar- quette Railroad Company, the court disallowed certain items charged against operating expenses for depreciation of steamers and dining halls, saying: " No expenditure having actually been made to meet such depreciation the estimated amount thereof could not properly be deducted from earnings or net income." (34 Fed. Rep. 609.) DEPEECIATION 125 Unfortunately the appeal of this ease was never brought to trial as a settlement was made between the litigants out- side of court. But, in the earlier case of United States v. Kansas Pacific Railway Company, the Supreme Court of the United States held in regard to a charge for deprecia- tion : ' ' We are clearly of the opinion that it is not a proper charge. Only such expenditures as are actually made can with any propriety be claimed as a deduction from earn- ings." (99U. S. 459.) In the State courts there is a variety of decisions. One of the most satisfactory is a New Jersey ease (Whittaker v. Amwell Nat. Bank. 52 N. J. Eq. 400 (1894)) where the court held that in addition to the cost of repairs there must be " a reasonable allowance for depreciation for wear and tear or constant use. ... It cannot be successfully con- tended that all such machinery is not subject to deprecia- tion." In Michigan, too, the propriety of allowing for depreciation seems to be recognized in the case of Richard- son V. Buhl (77 Mich. 632) and it is most clearly allowed in the Superior Court of New York City in Conville v. Shook (24 N. T. Supp. 547 (1893)). But on the other hand it has been held in Georgia and California that Depreciation need not be allowed. The decisions in the latter State are particularly interesting and refer to the depreciation of the plants of water com- panies. To charge such depreciation against income was said by one of the judges to be " all wrong ' ' and ' ' not to be tolerated for a moment. ' ' ^ A recent most important advance in the legal recogni- tion of depreciation is found in the rules for preparing railroad accounts promulgated by the Interstate Commerce Commission. Here for the first time it is definitely pre- ■ See Tutt v. Land, 50 Geo. 339 (1873); Emery v. Wilson, 79 N. Y. 78 (1879); San Diego Water Co. v. San Diego, 118 Cal 556 (1897); Redlands Water Ck). v. Redlands. 121 Cal. 312 (1898). 126 MODERN ACCOUNTING scribed that a regular allowance, estimated monthly, must be made for depreciation of seven named classes of equip- ment. This ruling will doubtless have considerable effect in giving recognition to the correctness of the principle that depreciation is an unavoidable expense. Tw^o methods are used for booking depreciation. For instance in a company whose Balance Sheet, before taking account of depreciation is: Br. Form 37. Balance Sheet. Cr. Plant $100,000 Cash 10,000 8110,000 Capital $100,000 Profit and Loss 10,000 $110,000 an allowance of $2,500 for depreciation can be shown either by crediting that amount to the Plant account, re- ducing it to $97,500 or by crediting it to a separate account called Depreciation Account, or some similar title, in either case the corresponding debit being to Profit and Loss. In the latter case the Balance Sheet should be in the form below : Form 38. Dr. Balance Sheet. Cr. Plant at cost .... $100,000 Less deprecia- tion 2,500 $97,500 Cash 10,000 $107,500 Capital Profit and Loss. $100,000 7,500 $107,500 It is much more satisfactory thus to exhibit the original cost of the plant and not merely to show the present depre- DEPEECIATION 127 ciated value. Two companies might each show a plant valued at $50,000. It is not a matter of indifference that in one case this represents the total original cost of the plant, while in the other it gives the residual value of what was once worth $100,000. It has often been claimed that to credit the depreciation to a separate account, instead of to the account showing the asset, may lead to deception. This is rendered more likely because the terms used to in- dicate depreciation are frequently ill defined, and there is danger that a mere recognition of depreciation may be misunderstood as indicating a reserve of profits. Indeed this fear of deception is so strong that German law, at least according to the interpretation of Rehm, makes it illegal to book depreciation by crediting a separate account and requires that it be shown by writing down the value of the asset. But any danger from this score is fully obvi- ated by showing the credit to " Depreciation Account," not on the credit side of the Balance Sheet, but as a sub- traction in an inner column of the debit side, as indicated above. Some writers furthermore claim that by carefully using the title Depreciation Account, and not the com- monly used term Depreciation Fund, all confusion between depreciation and a reserve fund proper will be obviated. The Interstate Commerce Commission mrects that the credit be made to accounts entitled "Accrued Depreciation — Road," "Accrued Depreciation — Equipment," "Accrued Depreciation — Miscellaneous Physical Property, " a separate account being thus established for each class 'pf depreciating property. Admitting the necessity of allowing for \depreciation, the question arises as to the basis on whicn it is to be estimated. It is not possible to determine bty inspection the present value of a machine or plant. Appraisers may make the attempt, but in doing so one element! which they consider is the age of the machine and the depreciation 128 MODERN ACCOUNTING which time itself has wrought in its value. Some basis must be adopted which, even if not strictly accurate, can be conveniently applied. So far as depreciation by wear and tear is concerned three factors are to be considered: original cost, tenure of use, and residual value. The last- named is of importance, for a machine is often displaced before it becomes entirely worthless. Its residual value as junk is exceeded by its value as a second-hand machine, for the progressive establishment often discards machinery still capable of considerable use. With these factors it is clear that the problem is how to divide the difference between the initial value and the residual value among the years intervening between the purchase and the discarding of the asset. Various systems are in actual use, among which the most prominent are given below. The simplest method is to divide the total depreciation by the number of years' use, and charge the quotient as annual depreciation, or in other words to charge each year a fixed per cent, of the original cost. Thus a machine cost- ing $600, expected to last five years, at which time it will have a residual value of $100, should each year have a charge of $100 or 16| per cent, of its cost to depreciation. Expressed algebraically, V-V n in which D represents the amount of annual depreciation, Ti equals the cost price, V^ the residual value, and n the number of years. The advantage of this method is the extreme simplicity and the ease with which it can bb estimated. For short- lived assets it is doubtless to be preferred. Objection is sometimes made that it requires constant reference to the original cost price. If depreciation is directly subtracted DEPRECIATION 129 from the book value of the asset by crediting the amount to the ledger account in which the asset appears, this defect is of some significance, necessitating repeated reference to a value no longer exhibited by the accounts. But where a separate depreciation account is established and the original cost remains an integral part of the accounts, the criticism fails. A second method is to charge a fixed percentage of the decreasing net value. This gives not a constant, but a diminishing annual charge for depreciation. In the in- stance given above the depreciation instead of being 16§ per cent, of the original cost, would be 30.12 per cent, of the diminishing net value. The annual charges would, therefore, be as follows: Form 39. Ybab Value at beginning of year. Depreciation at 30.12^ of diminishing value. 1 $600.00 419.28 293.00 204.75 143.08 99.99 $180.72 2 126 28 3 88.25 4 61.67 5 43.09 Residual value V, Expressed algebraically the formula is: V, (1-r) (1-r) (1-r) (1-r) (1-r) in which r represents the percentage of the diminishing value to be annually deducted for depreciation, and V^ and F, represent, as before, the initial and the residual value of the asset. Hence is derived as a working formula : ■/VT" which is easily solved by the use of logarithmic tables. It should be noted that this formula cannot strictly be ap- 130 MODEEN" ACCOUNTING plied where the asset has no residual value, that is where Vj = 0, as for instance, in a terminable leasehold, or an expiring patent right. Practically it is applied even in such cases by assuming a nominal sum, say one dollar, or one cent, as the residual value. It will further be noted that because of the elimination of fractions the balance worked out generally will not exactly correspond with the assumed residual value of the asset, but as, at best, depre- ciation is a matter of estimate such small divergencies are of no significance. The advantage of this method, in addition to its easy application to accounts showing the depreciated value of the asset, is that it makes the charge for depreciation less with each additional year. The argument in favor of this course is that in the earlier years the charges for repairs will be slight, but these will increase as the machine be- comes older. As both repairs and depreciation are a charge to expenses of production, the increasing repairs, and the decreasing depreciation make a uniform charge to expense, and thus profits are more equally apportioned be- tween the several years during which the machinery as used. Furthermore a declining depreciation is thought to correspond better with the economic facts. The difference in value between a new machine and one that is one year old is probably much greater than the difference in value of a machine which has been used 19 years and the same machine a year later. Thus Tiffany estimates that machin- ery in a flour mill depreciates 12| per cent, of its cost the first year, 8 in the second, 5 in the third, 2^ in the fourth, and only 2 per cent, each year thereafter. This decreasing rate of depreciation is preserved by figuring depreciation as a percentage of the diminishing value. The objections to this method are obvious. It involves a complicated mathematical calculation, and the annual rate of depre- ciation gives little indication to the ordinary man of the DEPEECIATION 131 period required to write off the asset. Furthermore it increases the depreciation charge in the earlier years, and in the case of a new concern this may be distasteful as being an additional charge against profits at a time when business has not come into full swing and profits are low. A third method, known as the Annuity Method, is even more complicated. It rests upon the assumption that the cost of production includes not only repairs and the depre- ciation of machinery, but as well interest on the amount of capital invested in the machine. Depreciation on this theory should be a sum figured as a constant annual charge sufficient not only to write off the decline in value, but also to write off annual interest charges on its diminishing value. Assuming the rate of interest to be six per cent, the reckoning should show: Dr. FOKM 40. Machinery Account. Cr. Interest at 6% .... 36.00 $636.00 $511.30 Interest .... 30.68 $541.98 Balance $417.28 Interest .... 25.04 $442.32 $317.62 Interest .... 19.06 $436.68 $211.98 Interest . ... 12.72 $224.70 Balance ....$100.00 Depreciation $124 . 70 Balance 511.30 $636.00 Depreciation $124 . 70 Balance 417.28 $541.98 Depreciation $124 . 70 Balance 317.62 $442.32 Depreciation $124 . 70 Balance 211.98 $436.68 Depreciation $124 . 70 Balance 100.00 $224.70 132 MODEKlir ACCOUNTLNTG Algebraically the formula is derived as follows: Vj R-D)R-D)R-D)R-D)Er-D = V^ in which R equals 1 + (the rate of interest) , or in this case 1.06 and D the annual charge for depreciation. Hghcg ViR=-D(R*+R^+E2+R+l)= Vj or in simpler form: R^ -1 D = ViR= — Va R-1 and D = ViR= — V2 ^ or generally: D = (ViR° - V2) R^ R-1 R° - 1 " R - 1 These values are obtained easily by the use of logarithms, or still more simply by the use of actuarial tables prepared for the use of insurance companies; for evidently TiiZ" is the accumulated value of F, at 6 per cent, compound in- terest for n years, and the coefficient of D is the accumu- lated value at 6 per cent, interest of an annuity of one dollar paid at the end of each of n years. Such values are given in ordinary actuarial tables. The use of this system implies that at the time interest is charged to the plant there is a corresponding' credit to interest account. Consequently the net result to Profit and Loss account taken as a whole is that there is an equal annual charge of depreciation, and a diminishing annual credit for interest. An objection to the last-named method is that it intro- duces the custom of marking up the value of assets by an allowance for assumed interest. In this particular case DEPEECIATION 133 no inflation of profits results because there is an increased charge against profits for depreciation. But it is ques- tionable whether it is not so dangerous a practice as to make objectionable anything which seems to justify it. Furthermore, unless interest is charged on all capital in- vested, not merely on that subject to depreciation, there is a logical inconsistency in [reckoning it in depreciation. And finally, its value consists in separating the profits of manufacturing, or other business operations, in which de- preciating capital assets are used, from the profits derived from the use of capital. This is so because the large depre- ciation charge goes into the Trading account,^ while the countervailing credit to interest goes into the Profit and Loss account proper. The three methods of figuring depreciation have this marked difference. The annual charge against profits de- creases where depreciation is a fixed percentage of the diminishing value of the asset. It is constant where depre- ciation is a fixed percentage of the cost ; it increases where the third method is used. A comparison of the amount annually charged to depreciation under each of the meth- ods described is shown by the following table. Form 41. Depreciation of Asset Costing $600 with Estimated Residual Value at End of Five Years, of $100. Year 16M%on cost 30.1»on diminishing value Annuity system, 6% interest. Gross Cliarge Gross, less interest 1 $100 100 100 100 100 $180.72 126.28 88.25 61.67 43.08 $124.70 124.70 124.70 124.70 124.70 $88 70 2 94 02 3 99 66 4 105 64 5 111 98 Total $500 $500.00 $623.50 $500.00 ' See Chapter XV. 134 MODEEN ACCOUNTING Authorities differ as to the desirability of one or other of the three -methods. Dicksee's high authority favors the first for short-lived assets, the second for machinery in general, the third for long-time terminable leaseholds and similar assets. Where the courts prescribe depreciation they have generally allowed the basis and, indeed, the period to be left to the discretion of the company authori- ties. Even in Germany where statute law is most precise, demanding that depreciation be reckoned, and in cer- tain cases even prescribing the period, there is no legal preference given to one or other of the methods of cal- culation. Practice, however, in England, Germany, and the United States seems to favor, in general, the taking of the diminishing value of the assets as the basis of calcula- tion. But the Interstate Commerce Conimission definitely prescribes that when depreciation is reckoned there shall be a uniform monthly charge, based on the percentage of the original cost which, in accordance with the best sources of in- formation, equitably represents the average current loss from depreciation. In discussing the relative merits of the differing sys- tems of depreciation, it must be borne in mind that allow- ance for depreciation is only part of a broader scheme whose purpose is to equalize charges between different years. It has been shown that the real cost of manufac- turing includes both repairs and depreciation of plant. The total amount paid on both these accounts is properly a charge to the total cost of production during the period that the plant lasts. But the accidental fact that actual payments are not made uniformly is no reason why the annual charge should vary. One does not consider the semi-annual installment of rent or interest as an expense peculiar to the month in which it is paid. Neither should the fact, if it be one, that a machine declines in value more in the first year than in the last year of its life DEPEECIATION 135 justify making a greater charge to costs in the former year. The complete and scientifically correct method of figuring depreciation compels that there should be at the same time a recognition of the necessity of repairs and a simul- taneous apportioning of both repairs and depreciation between the years irrespective of the time when the ex- pense is actually incurred. There should, therefore, be two estimates made, one of the total shrinkage of value during the life of the machine, the other of the total cost of repairs during the same period. This being done there should be an equal apportionment of the sum of these two between the several years. In other words there should be an equal annual charge to expgnse and a credit to De- preciation account and to Renewal or Repairs Account. Replacement of outworn machines or repairs made can then be charged to these accounts. If the estimates are made with approximate accuracy there will result a dis- tribution of expense between the several fiscal periods. But where no such uniform annual charge is made to cover repairs, and where expense is annually charged with the repairs actually made, sometimes more and sometimes less, a more correct final showing will be secured by mak- ing a sliding charge to depreciation, as is done where it is based on a fixed percentage of the diminishing value. This does not mean that the allocation of depreciation in this manner is in itself more correct, but that this error in apportionment offsets and neutralizes the increasing charges for repairs. But this is at best a rather awkward^ rule of thumb. The fuller, more scientific treatment of both repairs and depreciation, as being properly a uniform annual charge, is coming, more into favor, and is implied in the scheme of accounts promulgated by the Interstate Commerce Commission. Whatever uncertainty there may be as to the three meth- ods of depreciation already described, there is no doubt as 136 MODERN ACCOUNTING to the illegitimacy of a fourth system that is not infrequent- ly used. This is to make the amount annually written off for depreciation somewhat loosely proportionate to profits. The natural inference from this practice is that in the ab- sence of profits no depreciation is to be reckoned; while the fundamental principle involved is that depreciation is something inexorable, inevitable, an expense to be esti- mated before it is possible to determine profits. This view is accepted not only by accountants but in Germany at least has been given legal authority by judicial decisions. The correct attitude has been taken in this country, too, by the Interstate Commerce Commission which has adopted as its rule the statement made by P. D. Leake : ' ' One of the most vital matters connected with productive industries and trading concerns is the regular assessment with sub- stantial accuracy of the annual net profit or loss which has resulted from the operations of each year; and unless a near approximation to the outlay on productive plant which has expired within each year is made and fully pro- vided for out of gross revenue, no correct statement of profit or loss can be obtained. ... No Profit can exist until Expired Outlay on Productive Plant has been pro- vided out of Gross Revenue. ' ' ^ Present practice is unfortunately not up to this correct principle. Any recognition of depreciation at all being relatively uncommon in the accounts of American corpora- tions, it is not to be wondered at that the few companies which show depreciation in prosperous years, when profits are large, grow faint hearted when business is poor. A few exceptions are to be noted, among which may be men- tioned the Allis-Chalmers Company which in 1906 charged nearly $300,000 to depreciation, although that resulted in a total deficit of nearly $400,000. ' Interstate Commerce Commission. Accounting Series, Circular No. 13. DEPEECIATION 137 Depreciation should cover all decline in value due to the use of productive assets. No less than this is required by accounting prudence. But while this standard is fre- quently not reached, it is not unusual to And corporations charging to depreciation sums far in excess of the actual decline in value. Yet such excessive depreciation offends the very principles of accounting. To charge too much to depreciation is no less a deviation from accuracy than to charge too little. Yet the two transactions are very dif- ferently regarded by the public and by the profession. To charge too little is considered dishonorable, to charge more than enough is considered a sign of conservatism and is not only done by the most reputable corporations, but where this occurs the action is very frequently praised by financial writers. The effect of excessive depreciation is to conceal the amount of profits, to create what is known as a " Secret Eeserve." Depreciation is normally charged to expense, or at least to Profit and Loss. If, in fact, there has been no actual decline in value, the result is that the Balance Sheet shows an understatement of both assets and profits. The questions involved are, therefore, those of undervaluation of Assets and Secret Reserves both of which are elsewhere discussed. Here it suffices to call attention to the fact that an excessive depreciation, while generally condoned, is still a divergence from an ideal accounting, and its effect is the establishment of a Secret Reserve. The question is frequently raised as to whether depre- ciation provides for the replacement of the wasting article. The question itself, although sometimes propounded by accountants, involves a misapprehension. Depreciation in itself merely means that there has been a decline in the value of certain assets. If this results in a net loss evi- dently there is nothing with which to replace a destroyed asset. For instance, a company with Plant $100,000, Capi- 138 MODEEN ACCOFNTmG tal $50,000, and Debt $50,000 suffers a depreciation of two per cent. If other expenses just balance income, this means a net loss of $2,000. The Balance Sheet then would read : Form 42. Dr. Balance Sheet. Plant $100,000 Less depreci- ation 2,000 $98,000 Loss 2,000 $100,000 Cr. Capital $50,OCO Debt 50,000 3i;l00,000 The plant is the only possession of the company, and there are no other free assets with which the loss can be made good. But where, after the deduction for deprecia- tion; there is a net profit, the case is different. Assuming that the expenses other than the depreciation were $10,000 and the income $12,001 the balance shows: Dr. Form 43. Balance Sheet. Cr. Plant $100,000 Less depreci- ation 2,000 Other assets. $98,000 2,001 $100,001 Capital $50,000 Debt 50,000 Profit and Loss 1 $100,001 In such a case the depreciation account signifies that other assets are now held equal to the depreciation. Part of the original plant has disappeared, but its value is represented by other assets. Evidently so, for if a decline in the value of one asset has not resulted in a net loss, there must, by the most fundamental principle of double entry bookkeep- ing, be an equivalent increase in the value of another asset. DEPEECIATION 139 The presence of a Depreciation Account signifies, then, the substitution of some new, presumably some floating asset in place of part of the value of one of the fixed assets. Whether this implies the presence of means to replace the old asset, or not, depends on the interpretation of the terms used. If the new asset consists of cash, evidently there are means on hand for replacement; if the assets exist in the form of some new fixed asset, that in itself does not directly give ready money.. Constructively there is power to replace because of the equivalence of assets. Practically that power may be hindered by inability to realize on the asset. But a similar difficulty would exist under any circumstances; for the existence of a special replacement fund, composed, say, of stock exchange securi- ties might not always prevent difficulty in raising funds in a pressing emergency. The existence of a depreciation ac- count implies, except in a Balance Sheet showing a net loss, the presence of new assets, that is of assets acquired since the purchase of the plant, of equivalent value. Whether these new assets furnish means of replacement depends on their nature and the conditions of the general market. An apparent exception occurs where the new wealth is used to pay off a debt, when the Balance Sheet becomes : Dr. Form 44. Balance Sheet. Cr. Plant $100,000 Less depreci- ation 2,000 Other assets . $98,000 1 $98,001 Capital $50,000 Debt 48,000 Profit and Loss 1 $98,001 Here the cancelation, presumably, gives an equivalent borrowing power, and the presence of additional assets or 140 MODERN ACCOUNTING the lessening of debts (that is the cancelation of negative assets) are practically identical. In addition to the loss from wear and tear even material goods are subject to further depreciation from economic changes. This includes changes in the residual value due to outside conditions, and, if it can be reckoned, the likeli- hood that the machine will be displaced by new models long before it is worn out. Experience may show that on the average a given class of machinery will be serviceable for twenty years, but that invention is so active that it is more profitable to displace the machines and buy new models as often as once in ten years. This is confessedly vague and indefinite, and implies the ability to calculate the future activities of inventive genius. The process is, of course, constantly taking place. Indeed, the success of American iron masters has sometimes .been attributed to the readiness with which they, discard serviceable machines in order to install new inventions. If an airship as now made would certainly run with undiminished mechanical efficiency for thirty years, probably no one would object to the statement that long before that time the present models will be displaced by some new and greatly im- proved type, and that a calculation to that purport should wisely be made., A more practical illustration is found in the lasts owned by manufacturers of shoes. Materially, these will serve for an indefinite number of years without destruction. Practically, it is a matter of certainty that the present models will be displaced by fashion long before they are worn out, and, as a matter of fact, the accumu- lated stock of out-of-date lasts is one of the serious burdens of shoe factories. The same principle applies to patterns used in foundries, sets of cards for Jacquard looms, and other assets whose continued serviceability is limited by the dictates of fashion rather than by wear and tear. Depreciation in all such instances is scarcely to he dis- DEPRECIATION 141 tinguished from a reserve created to provide against con- tingencies. If the loss of value ia certain enough to be calculable it approxiihates closely to ordinary deprecia- tion ; if less certain and yet not to be neglected it resembles rather a reserve discussed in Chapter XIII. The _ depreciation, or more properly speaking, the amor- tization of nonmaterial assets is, of course, not due to wear and tear, but is no less inevitable. Where there is a time limit, as, for instance, in the case of a ten years' mining concession, the depreciation must be accomplished within that period. In many eases it is legitimate to charge off the value even more rapidly. Thus a copyright is likely to become of little value before its legal termination. One general rule is here applicable, namely: The more indefi- nite or uncertain the value of the asset the more rigid and rapid should be its depreciation. The application of these general principles governing depreciation to the various classes of assets, and the de- termination of the proper rate to be allowed in each case is a matter of the greatest difficulty. Material goods are subject to depreciation for both physical and economic causes. Physical loss or deterioration is a question whose ultimate decision is in each case to be based on the opinion of technical experts. Only thus can an estimate, even approximating correctness, be made of the probable life of the asset and its residual value. The nature of the machine, the intensity of work, the amount of repairs, the character of the operations, and many other technical matters enter into the calculation for machinery. Equally is each building to be considered by itself, for the nature of its construction, the use to which it is put, the climate to j which it is exposed, the expenditures to be made in repairs, and other items are effective in determining its duration. Evidently in so complicated a problem, with so many uncertain, if not unknown quantities, no ohe even 142 MODERN ACCOUNTING attempts minute accuracy. All the more need for making the. calculation as carefully as possible. It is impossible to lay down specific rates of deprecia- tion which would have any absolute value. The following figures are those given by Dicksee, and indicate roughly the rates which are considered satisfactory where condi- tions are favorable. In each case the rates are based on the diminishing value. Asset Rate of Depreciation Engines 10 -12| per cent. Boilers 12^20 Shafting 5 - 7J " General machinery 7^-10 ' ' Special machinery 10 —25 ' ' Patterns 25 -33^ Horses 15-25 Somewhat similar tables are given by Tiffany, in which greater attention is given to buildings, and in which vari- ations are given to correspond somewhat with details of construction. But it must ever be borne in mind that no general rules can be laid down and each problem must be specifically treated. This doctrine is admirably laid down by the Interstate Commerce Commission which when asked to specify the rates of depreciation to be charged, replied: " Conditions under which equipment is used vary so greatly tha,t no uniform rate of depreciation for all roads could be reasonably determined. The proper rate will, of course, vary inversely with the life of the property to which it pertains, and its determination must take into consideration whatever affects the life of the property. Each reporting officer should determine the rate to be used according to such experience tables as he may be able to construct from equipment records. ' ' ^ ' Accounting Series, Circular No. 12a, p. 2, Case 109. DEPRECIATION 143 BIBLIOGRAPHICAL NOTE TO CHAPTER VII Delano, F. A. The Application of a Depreciation Charge in Rail- way Accounting. Journal of Political Economy, XVI, p. 585. [A criticism of the rules of the Interstate Commerce Com- mission.] DiCKSEE, L. R. Depreciation, Reserves, and Reserve Funds. London, 1903. [An important work.] Geinling, C. H. The Need of a Depreciation Fund in Railway Accounts. Banker's Magazine (London), LXXV, p. 692. Guthrie, E. Depreciation. Article in Erwyclopmdia of Account- ing, III, p. 357. [Contains table of rates.] Mathbson, E. The Depreciation of Factories, Mines, and In- dustrial Undertakings and Their Valuation. Second edition. London, 1903. [Of recognized authority, dealing with the subject from the viewpoint of the engineer.] Tiffany, H. L. Digest of Depreciation. Twenty-eighth edition. Chicago, 1890. [An elaborate table of estimated depreciation on various kinds of property, designed for use of insurance adjusters.] Turner, S. H. Depreciation and Sinking Funds in Municipal Undertakings. Economic Journal, XIV, p. 47. [Discusses the duplication of charges under the English law.] United States Interstate Commerce Commission. Classifica- tion of operating expenses as prescribed by the Interstate Commerce Commission. Third revised edition. Washington, 1908. Interstate Commerce Commission. Division of Statistics and Accounts. Accounting Series, Circulars Nos. 8 and 13, 1907. [The above documents formulate and explain the rules of the Commission applicable to railways.] Wilkinson, G. Depreciation and Reserves. New York, 1905. CHAPTER VITl CAPITAL STOCK 7. Issued for Cash The Capital account, in the initial bookkeeping equa- tion, represents the net wealth of the proprietor. It shows in a single item the net value of all the items of wealth, positive and negative, which are set forth in detail in the various Goods accounts. If the proprietor is an individual, the opening entry in the Capital account represents the net wealth with which he starts his business. If it is a partnership, separate Capital accounts are established to show the amount contributed by each of the partners. The keeping of the Capital account of individuals or partnerships is extremely simple. The original contribu- tion made by each of the proprietors is definitely known, and there is ordinarily no doubt as to its value. This orig- inal contribution is accordingly credited to the account representing the capital. This is frequently headed with the name of the proprietor, with perhaps a further state- ment that it represents a capital contribution, and is not a loan, thus: John Smith, Capital Account. The actual proprietorship interest in the business, however, necessa- rily changes from day to day with each transaction, with the incurring of each expense, the suffering of any loss, or the taking of a profit. "While each of these changes might logically be entered at once in the proprietor's Capital account, there is good reason, as was shown in 'Chapter I, for entering these daily changes in temporary proprietor- ship accounts, which at stated periods, customarily at the CAPITAL STOCK 145 end of the year, are all gathered into the Profit and Loss account. The balance of this account shows the net change in the proprietor's wealth which has occurred during the course of the year through business operations, or the misfortunes incident thereto. "When the net change has been thus ascertained, it is transferred to the proprietor's Capital account, so that at the end of each year, as at the beginning of the business enterprise, that account shows, as accurately as may be, the net wealth of the proprietor. There is nothing fixed, arbitrary or conventional regard- ing the Capital account of the private trader. If he starts with an investment of $10,000 that amount appears as the initial entry to the credit of his Capital account. If he gains $2,000 profits during the year and withdraws from the business $1,500 for outside use, the Capital account is credited with the former sum and charged with the latter, so that at the beginning of the new year his Capital account again starts out with a balance, $10,500, which in a single sum represents the net wealth of which he is for the moment possessed. If in the second year the results show a loss of $1,500 this, at the end of the year, is in turn charged to the Capital account, which starts out the new year with a balance showing that the net wealth has been reduced to $9,000. Prom year to year, then, the account shows the actual net wealth, making no discrimination be- tween the original capital contribution, the surplus or deficit due to business operation, or the alterations due to withdrawals or additions of capital by the proprietor. In corporations, however, the treatment of capital is not so simple. The original entry does not necessarily represent the amount of wealth which has been contrib- uted by the stockholders; increments to the net wealth are not annually added to the original sum, which remains constant at the par value. The Capital account of a cor- poration represents only the sum at which the company 146 MODEEK" ACCOUNTING is incorporated, the par value of the Capital Stock. The actual present net wealth is obtained only by combining with this item one or more other accounts, kept separate on the Balance Sheet and in the ledger, which show vari- ations from this nominal capital and alterations in it due to business operations and other changes. , The accounting problems having to do with the Capital account are therefore, mainly, those connected with the capital of corporations. They arise generally from a di- vergence between the nominal or par value of the Capital Stock issued and the actual net wealth of the corporation. But even these problems would, in most cases, cause no difficulty were it not for the further fact that in many cases the corporation is unwilling to show clearly its exact condition. It may have done some financing which is prohibited by law, and it then becomes a problem how to present the accounts in such a way as to conceal this ille- gal action. Or it may be that not law, but business pru- dence, has been violated and again it becomes a problem how to conceal this fact in the company's Balance Sheet. The accountant should have no interest in solving such problems, nor is he, as an accountant, primarily interested in the exact legal status of certain financial transactions. For instance, in some states a corporation may legally pur- chase its own stock in the market, in others this is pro- hibited. In either case, the accountant, as such, is con- cerned only in showing that the purchase has been made, not troubling himself as to the legal problem, and stiU less attempting to find a way in which to conceal the fact that such a purchase has been made. If it is kept clearly in mind that the only legitimate purpose of accounts is to show the truth, and if accounts are kept strictly to this rigid standard, the problems of the accountant will be materially lessened. When a new corporation is started, the first step, nor- CAPITAL STOCK 147 mally, is to secure subscriptions for the Capital Stock authorized by the charter. If such subscriptions are ob- tained for the full authorized capital of the company the initial condition is then that the company begins with an authorized capital of a given amount, the net wealth which it represents being composed entirely of promises made by the subscribers to pay that amount. In this initial stage, then, the Balance Sheet is: Form 45. Dr. Balance Sheet. Cr. Subscriptions $100,000 Capital Stock $100,000 This may be assumed to be the normal opening Balance Sheet for a corporation where the stock is fully subscribed. It is perfectly correct, for while no wealth has been paid into the treasury of the company, the signing of the sub- scription list creates an obligation on the part of the sub- scriber which is legally collectible by the company. It is as truly an asset, as the accounts receivable or the notes receivable held by a merchant. As the subscriptions are called and paid, the treatment is identical with that of any other form of account receiv- able when it is paid to the proprietor. The cash received is debited, the subscription account is credited, and gradu- ally the item Subscriptions disappears from among the assets, and there is substituted therefor Cash or some other form of property. But not infrequently the incorporators desire to begin business without securing subscriptions for the entire au- thorized Capital Stock. At the beginning of operations the entire sum, here $100,000, is not needed, and it is thought better not to receive subscriptions until later when it can be profitably used, and when the evidence of 3J 148 MODEEN AOOOUNTINQ successful operation will perhaps make it easier to secure the desired subscriptions. Assuming that, of the $100,000 authorized Capital Stock, subscriptions are obtained for only one-half, or $50,000, the booking of the transaction is variously made, the more common forms being given below. Form 46. Dr. Balance Sheet. Cr. Cash $50,000 Capital paid in $50,000 Form 47. Dr. Balance Sheet. Cr Cash $50,000 Capital Stock $100,000 Unissued Stock . . . . 50,000 8100,000 $100,000 Form 48. Dr. Balance Sheet Cr. Cash Unissued Stock .... .... $50,000 . . . . 50,000 Capital Stock outstanding. $50,000 In treasury. . . 50,000 $100,000 $100,000 8100,000 Form 49. Dr. Balanc e Sheet. Cr. Cash $50,000 , Capital author- ized $100,000 Less amount held in Treasury... 60,000 $50,000 $50,000 CAPITAL STOCK 149 Many accountants argue in favor of the first form given above, saying that $50,000 is all that the company has received, that it is all that serves as a guarantee to creditors; and that the unsubscribed and unissued stock is virtually nonexistent. The same idea is embodied in some laws. In German law, it is not permissible to show any capital not subscribed for. In Austria the law relat- ing to one class of corporations definitely states that un- issued stock' may not appear either in the Balance Sheet or in any other statement, and the Companies Act of Que- bec, passed in 1907, says: " Capital Stock shall consist of that portion of the amount authorized by the charter, which shall have been boiia fide subscribed for and al- lotted." Despite such legally authoritative statements there is some ground for holding that Form 46 is not altogether siifiicient. The argument that unsubscribed and unissued stock must not appear at all in the accounts of the company because it is nonexistent is somewhat specious. The amount of depreciation of machinery or plant is no less nonexistent. Indeed, unissued stock has a certain reality, for it does constitute a means by which directors can, at least in times of prosperity, raise* funds, while the depre- ciation of property represents an absolutely nonexistent quantity. Yet the appearance of depreciation, in the form of a Depreciation Account, is a recognized and legitimate convention of accounting. While unsubscribed stock is not an asset so far as the creditor is concerned, yet the existence of such stock, sub- ject to issue at the discretion of the directors, is a matter of which the stockholder should be informed. Perhaps the desired information is sufficiently given in a foot-note, or other memorandum attached to the Balance Sheet, which is the form used by British companies. But to many ac- countants it seems desirable to show the total authorized 150 MODERN" ACCOUNTING capital stock as an item entering into the accounts proper, with the unissued stock as an item appearing elsewhere in the Balance Sheet. This may be accomplished in various ways, three dif- ferent methods of presenting the facts being shown in Forms 47-49 above. The first of these is one very fre- quently found in American reports, and exhibits the entire unissued stock as an asset. Not infrequently the term " Treasury Stock " is used to designate unissued stock thus held, a practice which has been severely criticised, on the ground that the term Treasury Stock should be limited to stock which has once been issued and subsequently reac- quired. The objection is, however, made that in this form the Balance Sheet gives an exaggerated and perhaps mis- leading statement of the actual capital of the company. This objection can, however, easily be removed by making the modification shown in Form 48 where the total author- ized Capital Stock appears as a significant item in the ex- tended column of the Balance Sheet, yet attention is called to the fact that part of the stock is unsubscribed and that it appears among the assets. But a still better form is the last one given above, where under the general rule that a negative item can be shown in the Balance Sheet as a subtraction (see page 53 above), the Unissued Stock, in- stead of appearing on the left hand of the Balance Sheet, is subtracted from the item Authorized Capital. This is the form used in the Balance Sheet of the Atchison, To- peka and Santa Fe Railway, as shown on page 61. It should be noted that while there may be little differ- ence in the Balance Sheet obtained in Form 46 and that in Form 49, yet there is a real difference in the ledger accounts. In the former, the original Journal entry pre- sumably corresponds with the Balance Sheet given; there is no account showing Unissued Stock to be found in the Ledger, and the Capital Stock account, in the ledger shows CAPITAL STOCK 151 'Only a credit of $50,000. But in all the other forms, al- though presented differently in the Balance Sheet, the ledger entries are identical and aU differ from Form 46, for in each instance Unissued Stock, or some other similar account, is to he found in the Ledger showing a debit bal- ance of $50,000, and the Capital Stock account proper shows a credit for the entire $100,000. Very similar is the problem of the treatment of the capital stock which after issue has been reacquired by the company. Aside from the question of the legality of this action, which is not an accounting question at aU, the dis- cussion turns on whether stock so acquired is a real asset, and, if so, how it is to be represented in the accounts. The argument against the legitimacy of showing unissued stock, is also used, though with less cogency, regarding repurchased stock. In a certain sense any return of capi- tal stock to the issuing company may be considered as a virtual cancelation of that amount of the previously is- sued stock. That seems to be the distinct attitude of French law, and, according to Simon, is to be inferred from, although not clearly expressed in, German law. A distinction may be made according to the purpose for which the stock is acquired. If it is done with the inten- tion of reducing the Capital Stock, certainly the stock so acquired and canceled should be deducted from the amount of outstanding stock, and should appear as below: Dr. Form 50. Balance Sheet. Cr. Plant and other assets.. . $120,000 Investments 15,000 Cash 5,000 $140,000 Capital stock authorized. . . $100,000 Less canceled stock 10,000 $90,000 Bonds 50,000 $140,000 152 MODERN ACCOUNTING But if the stock is not acquired with the intent of reduc-' ing the capitalization, and is not canceled, accounting practice in this country certainly justifies and, indeed, requires that it be shown among the assets. Where this is the case the best form for presenting the Balance Sheet is: Dr. Form 51. Balance Sheet. Cr. Plant, etc 8120,000 Investments 15,000 Treasury Stock 10,000 Cash 5,000 $150,000 Capital Stock outstanding.... $90,000 Held in Treasury. 10,000 • $100,000 Bonds 50,000 $150,000 which is the form used in the accounts of the Chicago and Northwestern Railway. There is, however, no criticism of an alternative form, which indeed some prefer, in which the item is not listed among the assets, but appears as a deduction from the total capital stock on the liabilities side, thus resembling Form 49. It is, however, misleading, and hence incorrect, to allow the stock held in the treasury to be included in some gen- eral designation which does not clearly show that it is the company's own stock. In the statement above, to in- clude both Investments and Treasury Stock under the sin- gle title Investments would be thus misleading. This de- cidedly objectionable foi-m is not infrequently used, and occasionally, it may be, to the deception of creditors. The use of the phrase Treasury Stock to designate live stock reacquired by the issuing company is thoroughly recognized in this country, although the term seems not to be used in England, nor are equivalent terms used in France and Germany. Some writers claim that this is the CAPITAL STOCK 153 only proper use of the term, and that to apply it to unis- sued stock is incorrect. An examination of American bal- ance sheets wiU give numerous instances where Treasury Stock is used as including unissued stock. But there is an important difference between reacquired and unissued stock in that the former can legally be sold by the com- pany below par without making the purchaser liable for the discount. To indicate this distinction would seem de- sirable in accounting, and this could easily be done by limiting the term Treasury Stock in the way mentioned; and calling stock which has not been issued or subscribed for by some other designation, e. g.. Unissued Stock. Altogether different from the foregoing cases is the company which has received subscriptions for all of its capital but has not yet called for payment of the whole amount subscribed. If, for instance, the capital stock of $100,000 has been all subscribed for, but only $50,000 has been called in, it is really incorrect to present the capital as only $50,000 and the assets of the same amount without reference to the uncalled subscriptions. Yet practice is not uniform on this point, and to what extent the uncalled subscriptions are to be included in the accounts proper, and how far they are only to be referred to as an explana- tory item is not uniformly agreed upon. In England the standard form for Balance Sheets, that which until re- cently was given as a model in Table A of the Companies Act (see page 66), excludes the uncalled subscriptions from the accounts proper, the form used being: Form 52. Liabilities Nominal capital (10,000 shares of £10 each) £100,000 Capita! called up (£5 per share) £50,000 Less calls in arrears 100 Capital paid in £49,900 154 MODERN ACCOUNTING In this the Nominal Capital is no part of the Balance 'Sheet proper, and a distinction is further made between uncalled subscriptions and those called but in arrears. The capital actually paid in alone shows in the extended column. In France, however, the uncalled subscriptions appear generally as an asset j and in Germany, while not always shown, the omission is said by Rehm to be contrary to both law and principle. In this country it is less common to issue stock not fully paid up, but the propriety of show- ing the uncalled subscriptions as assets is backed by the authority of the frequently cited case of See v. Heppen- heimer stating explicitly that it is a " rule of the common law that the unpaid subscriptions to the capital stock of a corporation form an asset for the payment of the debts thereof." Where the calls are in arrears it may be better to indicate that fact clearly, as is done in the English form above, on the principle that a call in arrears is of doubtful value at best. Either of the forms given below is satisfac- tory. Form 53. Dr. Balance Sheet. Cr. Cash Uncalled subscriptions . . $50,000 . 50,000 Capital fully subscribed Paid in $50 000 Subscriptions uncalled 50,000 $100,000 «!1 00,000 or: Form 54. />. Balance Sheet. Cr. Cash $50,000 Capital fully subscribed.. $100,000 Less subscriptions un- called 50,000 Capital paid in $50 000 $50,000 $50,000 CAPITAL STOCK 155 It is sonketimes stated that it is illogical to include the contingent asset of uncalled subscriptions in the Balance Sheet, since, as a rule, neither contingent assets nor lia- Bilities are taken into account. Thus, in the ease of a bank, where the stockholder who has paid up his subscription in full, is liable to a further assessment of 100 per cent, if that is needed to pay off creditors, this additional contin- gent asset is never included in the Balance Sheet. But there is a marked difference ; the additional liability of the shareholders of a bank is only available in case of insolv- ency, while the subscriptions are an asset on which the directors can at any time call, and are therefore more evidently an item to appear in the Balance Sheet. Subscriptions to capital stock are not infrequently made at a premium. This is particularly common in the case of banks, where for one or another reason the institution prefers to start in with assets in excess of the nominal capital. It is also common where an established company increases its capital stock in circumstances which make investors glad to pay a premium for a share in an enter- prise which is already eminently successful. In all such eases the premium is economically a capital contribution and nothing else ; but the requirement that the capital ap- pear at its par value makes it necessary to enter the sum thus paid under some other head. The customary title is " Surplus " which is the term always used by National banks, which frequently capitalize thus in order to escape the necessity of annually withholding one tenth of the profits to form a compulsory reserve amounting to twenty per cent, of the nominal capital. The only alternative to crediting the premium to Surplus, or some practically identical account such as Reserve, is to credit it to Profit and Loss, a procedure which is positively prohibited by German law, permissible under English law, but in any case condemne^d by business prudence in all countries. The 156 MODERN ACCOUNTING premiums being no part of the real profits of the business should be specially held in some account which indicates that it is not intended for distribution in dividends. At times the accountant meets difficulty in determining whether or not a premium has been paid on the stock, and this unavoidable uncertainty is sometimes used as a means of showing an apparent surplus when none exists. To take a familiar illustration, a company is organized with Capi- tal Stock of $100,000. A contract is made whereby an owner of a plant agrees to turn over his property valued nominally at $90,000, and $9,000 cash in return for $90,- 000 stock. The interpretation of this transaction fre- quently made is that the cash contributed is a premium on the stock. A more conservative interpretation is that the real value of both plant and cash is only $90,000, so that no surplus exists. Sometimes an attempt is made to base the interpretation of the transaction on the terms on which the other stock is placed. If this is -subscribed for, the subscription to be paid in cash at the rate of 110, the presumption is evident that the stock given in exchange for the plant and cash was also really taken at a premium of practically that percentage, and that the surplus really exists. But even this criterion is faulty. The company might be capitalized say, at $90,100, of which $90,000 is given in exchange for the plant, and $10,000 cash. It would be a simple matter for the promoters to subscribe for the remaining $100, at 110, or at any other exorbi- tant rate, if by so doing they could establish the surplus which is claimed in the purchase of the property. The reality of a claimed surplus is, therefore, not to be estab- lished by any such simple rule of thumb, but can be deter- mined only by a careful estimate of the real value of that which is given in payment of the subscription. Thus far it has been assumed that all subscriptions for Capital Stock are to be paid in full at some time. This CAPITAL STOCK 157 is the well-established principle which has been accepted by all courts. But in some instances a distinction has been made between stock subscribed for, and stock sold in the market. A subscription not paid in full carries with it a corresponding liability to pay the unpaid portion, which from the point of view of the corporation constitutes an asset. Yet in some circumstances the courts have allo\yed the sale of stock for less than par, the stock to appear as full paid. The most important case on'the subject is that of Handley v. Stutz (139 U. S., 417 (1891) ). In this case an embarrassed company sold some of its stock for less than par in order to raise funds to enable it to carry on its business. The court, while upholding the general prin- ciple that creditors have a right to rely on the subscribers liaving paid par for their stock ; nevertheless, in the excep- tional case of a going concern which cannot place its stock at par, sanctions selling it at the best price obtainable. It should be noted that this decision applied only to excep- tional conditions; that Chief Justice Fuller gave a very able dissenting opinion; that Justice Brown, who himself rendered the decision, declared in the later case of Cam- den V. Stuart (144 U. S., 104 (1892)), that it must not be used to evade the obligation of subscribers to pay for stock which obligation " cannot be defeated by a simulated payment of such subscription, nor by any device short of an actual payment in good faith ' ' ; and that an able legal critic has declared that, " the reason and conscience of the profession have been shocked at the. doctrine " enunciated in Handley v. Stutz.^ In the state courts, moreover, it has recently been held that " one who receives stock as full paid without paying for it occupies the position of a subscriber who has not paid his subscription." (See v; Heppenheinier, 61, Atl. 859.) In England, too, the highest court has given a most > E. "W. Huffcut, 26 Am. Law Rev. 865. 158 MODERN ACCOUNTING drastic decision in Ooregum Gold Mining Company of India v. Roper ([1892J A. C, 125), where the House of Lords held that when a corporation sells its new stock below par— even though at double what the old stock commands in the market — the purchasers are liable for the discount to the corporation as well as to the creditors of the company. In this decision the Lord Chancellor said: " It may be that such limitations on the power of the company to manage it^ own affairs may occasionally be inconvenient, and prevent its obtaining money for the purposes of its trading on terms so favorable as it could do if it were more free to act. But, speaking for myself, I recognize the wisdom of enforcing on a company the disclosure of what its real capital is and not permitting a statement of its affairs to be such as may mislead and deceive those who are either about to become its share- holders or about to give it credit." In England, too, statute law requires the payment of full cash value for stock, save that when the articles of the company make special provisions therefor, the Companies Act of 1900 allows the payment of a commission for the placing of shares. But in the revision of the Act in 1907 an amendment, which had passed the House of Lords, gen- erally authorizing the issue of shares of established com- panies below par, was rejected by the Commons, and with- drawn by the Lords. But where, for any reason the stock is issued for a less amount of cash than the par value, and the courts free the purchaser from any liability for demand for further payments, the accounting is still a simple matter. If cash has not been paid in full, and if the remaining percentage is not a claim against the holder to appear as an asset of the company, the only alternative is that it must appear as a discount on the issue of the stock, and must be treated similarly to the discount taken off a note or bill discounted. CAPITAL STOCK 159 There may be some question as to whether the discount should immediately be charged to the Profit and Loss ac- count, or whether it may be placed as a charge elsewhere. But there is no dispute that a cash discount on stock is- sued must clearly show in the accounts of the company, and such is the practice wherever discounting is openly allowed, as, for instance, in the limited cases in England, or in certain companies in Austria. The understanding of this simple statement opens the way for a discussion of the more difficult problem of the method of treating stock issued not for cash, but in purchase of property which is found in the following chapter. The reduction in the amount of Capital Stock, at least when performed directly, offers no particular problem of accounting. If it is decided to reduce the capital, as- suming that the legal requirements are complied with, the booking is identical with that in case of the payment and cancelation of any other credit balance, the cash paid out and tlie reduction of the liability balance offsetting each other. Or, if the stock retired is redeemed not with cash but with bonds, as was the case in the refunding oper- ations of the United States Steel Corporation, the bonds paid out offset the Capital Stock retired, just as in a mer- chant's books the Bills Payable given to a creditor offset the amount previously standing as an account payable. But at times the retirement of the stock is made dependent on the existence of surplus profits, and the payment to the stockholders is treated as if it were actually a charge against profits. Provision for the retirement of stock may be made in precisely the same manner as is the payment of bonds by a sinking fund, as described fully in Chapter XIV. Evidently the same difficulty arises in either case. If the retirement of capital, not being a loss transaction is yet charged against profits, there must be created a corresponding credit, sometimes called Retired Stock, 160 MODEEN ACCOUNTING ' sometimes, more correctly, " Reserve created by the re- tirement of capital out of profits." In any event when the stock has been purchased for the purpose of reducing the amount, it is misleading to carry the canceled stock among the assets. The Capital Stock account should itself be debited, for whatever argument there may be in favor of carrying live Treasury Stock as an asset, there can be none in favor of retaining stock which has actually been canceled. Such stock is certainly nonexistent. Where the stock is reduced not by purchase but by surrender of part of their holdings on part of the stock- holders, sometimes the case where the company has met with losses and desires to remove the deficit from the Bal- ance Sheet, the reduction of the capital acts tJ create a corresponding Surplus. This may be used as a fund to which the existing deficit, if such there be, is charged. To illustrate : a company with the following : Dr. Form 55. Balance Sheet. Cr. Assets 8140,000 Deficit 10,000 $150,000 Capital Stock $150,000 $150,000 arranges with the stockholders to surrender twenty per cent, of their holdings to cover the deficit and provide a surplus. After the reduction of the capital stock the books would show: Form 56. Dr. Balance Sheet. Cr. Assets $140,000 $140,000 Capital Stock $120,000 Surplus 20,000 $140,000 CHAPTER IX CAPITAL STOCK JI. Issued for Property, etc. The subscription to stock demands the payment of its full par value, and there being ' ' in equity, no distinction between a party who makes a formal subscriptioii for stock and fails to pay for it and one who accepts a full paid certificate without paying for it," there is the gen- eral assumption that all stock issued, with certain minor exceptions noted in the preceding chapter, is to be paid for in full value. Where the payment is to be made in cash the verification of this assumption is easy and sim- ple. The real difiiculty comes where stock is issued in exchange for property. Here, too, the general assumption is that full value is giveii. As has been clearly stated in New Jersey, " the distinction between the contemplated issue of corporate stock for property and its issue for money lies not in the rule for valuation but in the fact that different estimates may be formed of the value of property." (Donald v. American Smelting and Refining Company, 48 Atl. 772.) Such undoubtedly should be the case from the accounting view point, as well as in law. The accountant recognizes no difference between things of the same value, for it is the mohey value of goods and of capital in which he deals. Unfortunately, in practice, very different principles prevaiL Not only is stock time and again issued for prop- erty, which in the mind of every one eoneerned is worth much less than par value of the stock with which it is 161 162 MODERN ACCOUNTING purchased,. but the very terms of the sale give conclusive evidence to the general public that there has been gross overvaluation. The reason that this is so is that there is lacking any satisfactory criterion as to the real value of the property purchased with stock. Such purchases are frequently large plants, as, for instance, the manu- facturing establishments bought by any of the " trusts." Including, as it may, land, buildings, machinery, raw ma- terials, finished goods, mercantile credits, goodwill, per- haps also mines and quarries, railroads and steamers, and any other forms of assets, it is clearly impossible to form an authoritative estimate of the value of the plant. For such a complicated property there can, of course, be no publicly quoted price, nor can any reliance be placed on its cost to the vendor, for he may have acquired it either at an exorbitant price, or at a bargain sale far. below its real value. The courts, therefore, are inclined to be lib- eral, and to leave the determination of value in all such cases to the discretion of the officers of the company. An illustration of the extent to which this deference to the directors' discretion may go is found in a decision of one of the Federal courts to the effect that the purchase by a corporation, for $200,000 bonds and $3,600,000 stock, of a railroad bed, the construction of which cost $2,000 and for which the vendor had paid $15,000, was not, on the face, a fraudulent transaction. (Stewart v. St. Louis, etc., R. R. 41 Fed. Rep. 736 (1887).) But the accounting point of view is not necessarily the same as the legal. The fact that the court cannot deter- mine the real value of the purchased property, has nothing to say as to how the accountant, knowing the value, should enter it in the books and exhibit it in the Balance Sheet. Yet the accountant is greatly influenced by the attitude of the courts on these matters, and it is necessary to con- sider some of the rules which the courts have laid down. CAPITAL STOCK 163 "Where the purchased property is worth the par value of the stock there is no difficulty whatever. The exchange of stock for an equal value of any kind of property, is,- to the accountant, no whit different in principle from the puTchase of merchandise by means of a promissory note. Where, however, the property is worth less than the par value of the stock with which it is purchased, the courts have attempted to discriminate between cases where the property is not even worth the supposed market value of the stock, and those where it equals the market though still below the par value. While the issue of stock at less than its market value has been condemned, the courts have justified, especially in an emergency, the issuing of stock below par when it was shown to have been issued at its full market value. This is consistent with the decision quoted above, that in emergency even stock issued for cash may be placed at less than its face value. Evidently it is much more difficult to interfere with the issue of stock for property, with all the difficulties of appraising the prop- erty, than when it is issued for cash, which makes any dis- count manifest. It is furtliermore argued by the courts that no one has been injured, and that, oftentimes, if par were required, it would be impossible to issue the stock at all, since no one would be willing to take it on that basis. The latter argument, however, involves an economic fallacy, for it assumes that the only way in which an em- barrassed corporation can acquire, say, $10,000 worth of property is by issuing stock of a greater par value. This assumption is unfounded in logic or experience, save as reliance is placed on the meager experience of American corporations in recent years. To illustrate, there may be taken the case, of a corporation with $60,000 capital stock and earning $3,000 yearly. Considering the nature of the business this profit may be insufficient, and the stock may sell below par. But the directors see that by acquiring 164 MODERN ACCOUNTING (jertain additional property, worth only $30,000 the net profits may be raised to $6,000. But the owner of the property is unwilling to sell his property for $30,000 of the stock of the company. Is there, therefore, no other way to acquire the property than by increasing the amount of the capital stock to be issued, making it $40,000? This is the position taken by the courts. But the owner's un- willingness to take $30,000 stock for his property, is due to the fact that this would entitle him merely to a f in- terest in the earnings of the company, and the prospect of getting $2,000 is not sufficient to induce him to take the risk. The reason why he would sell the property for $40,000 stock is that such a deal would give him a right to ^ of the earnings, and a chance of receiving $2,400 is a sufficient inducement to him. But it does not therefore foUow that the company need issue $40,000 stock for the property worth only $30,000. Two other methods of se- curing the end are open to the company. The stockhold- ers might agree to contribute -j^ of their holdings and to give this $24,000 of stock in purchase of the property, which should be a satisfactory inducement to the vendor, as that would give him exactly the same relative rights as though he had received a new issue of $40,000. Or if that were not possible, a simpler method is open of issuing new Preferred Stock of $30,000 bearing cumulative dividends of say, 8 per cent. This again would bring the same re- turns to the holder as woiild $40,000 new Common Stock. It might even be issued with a smaller preferred dividend, possibly 7J per cent., as the greater security would allow some reduction in the returns. Thus it is quite easy to issue stock in such a form as to make a smaller amount equally as attractive as an excessive amount of a less fa- vored issue. Nor is this a method which is merely theo- retically possible. It is currently followed in Germany where the issue of stock in excessive amoimts is rendered CAPITAL STOCK 165 difficult by legal prescriptions, but where corporations do occasionally become embarrassed and need to obtain funds on unfavorable terms. The provisions of Massachusetts law looking toward the issue of ' ' special-preferred ' ' stock are of similar purport. But aside from the faulty economic assumption implied in the legal doctrine here discussed, the accountant objects seriously to the theory that to the corporation itself the new stock can have a value below par. Stock perhaps should not be said to have a " nominal " value, but to have a par value, of $100. That is to say that the value of the stock should be equal to 100 cents on the dollar. The Balance Sheet should show the real condition, and with certain technical forms understood, the statement that a company has $100,000 Capital Stock should mean, and mean only, that it has $100,000 net assets. To speak of a corporation issuing stock at its market value, but at less than par should be considered self-contradictory. The expression " Capital Stock " means Proprietorship of the amount stated, and to say that the receipt of less assets is still payment in full is surely misleading. Indeed this peculiar doctrine of distinguishing be- tween the real value and the par value of newly issued stock is criticised even from the legal point of view, as, for instance, the " Cyclopedia of Law and Procedure " states that the Supreme Court of the United States, in sanctioning the gratuitous issue of stock because it " was without value " refused to " follow the decisions of the highest courts in the states construing their own statutes, ' ' and that the opinion in Handley v. Stutz, already cited, " is a departure from the general current of authority as it stood at the time." Fortunately there is evidence of a tendency toward greater strictness both in legislation and in court decisions. Especially in New Jersey, which has had a perhaps un- 166 MODEEN AOCOTHSTTING merited reputation for looseness in corporation finance, has there been a clear enunciation of the correct princi- ples both in the pages of the statutes and in the interpre- tation of the judges. A series of the decisions of the high- est court of that state illustrates this. In. Wetherbee v. Baker it was said that " the courts have inflexibly en- forced the rule that payment of stock subscriptions is good as against creditors only where payment has been made in money, or in what may fairly be considered as money's worth " (35 N. J. Eq. 513 (1882) ). Ten years later it held that : " to justify a corporation in issuing stock under our act for property purchased there should be an approxima- tion at least in true value of the thing purchased to the amount of the stock which it is supposed it represents." (Edgerton v. Electric Improvement, etc., Co., 50 N. J. Eq. 361). Again, after nearly a decade, it was held in Donald v. American Smelting and Refining Company, that where the overissue is based on a false estimate on the part of the directors, " their honest judgment, if reached with- out due examination into the elements of value, or if based in part upon an estimate of matters which really are not property, or if plainly warped by self-interest may lead to a violation of this statutory rule as surely as would corrupt motive" (48 Atl. Rep. 772 (1901)). And in See V. Heppenheimer it was stated that " although this practice [issuing stock in excess] has been frequently in- dulged in and has brought obloquy upon our state and its legislation . . . such practice is entirely unwarranted by anything either in our statutes or in the decisions of our courts; and whenever it has been "indulged in it has involved a clear infringement of, if not a fraud upon the plain letter and spirit of our legislation." In England, too, there is the recent very interesting dictum of Vaughan Williams L. J. "I hope that the day may come when it wiU be gravely considered by the legislature CAPITAL STOCK 167 "Whether it is not for the advantage of the community that an act should be passed that in all cases the full nominal value of the shares shall be paid in cash and noth- ing else." (Moseley v. KofEyfontein Mines, Lim. [1904] 2 Ch. 117.) To the accountant, however, the problem is simpler than to the jurist. Two facts, one economic or financial, the other legal, he needs to know, and knowing these the method of entering the transactions is already determined. The first is. How much was actually paid for the stock? If less than par that difference must appear in his ac- counts. The equivalence of Goods to Proprietorship must be maintained, and where there is an admitted divergence between par and issue price, it can only be maintained by the interposition of a correcting item. Thus if Prop- erty received (P) is less than the Capital Stock (C) the Balance Sheet may not properly show P = C. There must be a formula P = C — D which can be expressed with equal truth in the form P -|- D = C. The legal fact, as to whether the unpaid difference is a sum whjch can be col- lected, if need be, from the shareholders, is of less signifi- cance to the accountant, and, indeed, may, with some show of justification be left undecided by him. If collectible it is an asset and may appear as such in the Balance Sheet. If not an enforeible claim, and that is the turning point in all the decisions cited in this chapter, it is in the nature of a discount, and its treatment is equally clear. Possibly the harassed accountant may be excused from attempting to decide the legal question on which such varying opinions exist, and may show the discount without seeming to de- cide whether or not it is an asset, making an equivocal statement which is excused by the difficulty of the prob- lem. In a word, wherever the property received is not fairly equivalent to the par of the stock the difference should be clearly shown in the accounts, and most clearly 168 MODEEN" ACCOUNTmG is this done by simply listing it as Discount on Stock. This is identical with the method of treating the difference between the nominal value of a note given by the propri- etor and the cash received therefor which, somewhere in the accounts, must be shown clearly as Discount. To those at all familiar with corporation accounts it is clear that unfortunately the discount allowed on stock is seldom shown. This is generally because of unwillingness to show clearly the exact nature of a transaction which is of doubtful legitimacy. While the transaction itself is not altered by the method in which it is treated in the accounts, its legal status may be greatly improved by with- holding from the accounts any evidence that the discount has been allowed. It is so difficult to determine accurately the value of any piece of property, that the courts hesitate to pass upon its equivalence to the stock issued therefor. If the accounts make a showing that full value has been received for the stock, the court may not attempt to dis- prove the statement. But the circumstance that a mislead- ing statement hoodwinks the court, and thus allows the transaction to stand free from legal interference, by no means indicates that the failure to show discount on stock issued for less than its full face value is in accord with the correct principles of accounting. In actual practice two subterfuges are resorted to. As- suming again a corporation acquiring a plant worth, all things included, $50,000 and issuing therefor $100,000 stock, instead of showing : Dr. Form 57. Balance Sheet. Cr. Plant Discount on Stock . . .. 850,000 . . 60,000 $100,000 Capital Stock ... .... $100,000 $100,000 CAPITAL STOCK 169 the first method of concealing this status presents the fol- lowing statement: Form 58. Dr. Balance Sheet. Cr. Plant • $100,000 Capital Stock S100,000 It is true that some writers on accounting justify such an entry. For instance, Keister, whose " Corporation Accounting " enjoys no little vogue, says in discussing a similar transaction: " There is no objection to the above entry. The machinery cost $30,000, but it is entered up at its nominal value of $60,000. It is not a speculative re- source, therefore it matters not what value is placed upon it " (page 71). To such a statement little direct argument can be made. Granting that the valuation of the fixed plant does not affect the Profit and Loss account and so has no immediate effect on dividends, certainly the creditor, the outside pub- lic, and even to no small extent the stockholders are in- terested in knowing the exact state of affairs. The other subterfuge resorted to, and one which the same author says is proper, is to include a purely fictitious asset to make up the difference between the value of the plant and the amount of stock. Here the plant is correctly listed at $50,000, but there appears a new asset, ex nihilo fit, frequently called " Goodwill " or in Keister 's ter- minology " Franchise." As has been already shown there is no objection to in- eluding Goodwill or Franchise in the assets if such has been purchased. The discussion is here limited to the con- sideration of a case where the entire property, with all its rights and appurtenances, is confessedly worth only $50,- 000. and where the addition of the item Goodwill is clearly 170 MODERN ACCOUNTmG a subterfuge. The insertion of a nonexistent Goodwill, which was the method used by the promoters of the Co- lumbia Straw Paper Company, as well as the exaggeration of the value of existing assets— the method pursued, for instance, by the United States Shipbuilding Company— is entirely opposed to the fundamental principle of truthful- ness in accounting. An illustration will emphasize this obvious statement. Had the stock been issued to subscribers who contributed $50,000 gold, no one would for a moment justify a Balance Sheet which either multiplied the amount of gold received by two, or calmly added to its list of assets an utterly imaginary $50,000 in silver, in order to make the assets equal the nominal capital. But the " rule for the valua- tion of property is not different from that of money," and there is no reason for a different standard of integrity where stock is issued in one way from that required in another. It is not argued here that equal exactness can be secured in the two cases. All that is discussed is the book- ing where the deficiency in value is recognized by those preparing the accounts. No plea is made for a fanciful or impossibly high degree of accuracy. It is only argued that conscious misstatement, which exists all too often in corporation finance, which, indeed, has been characteristic of American higher finance, is an outrage to the principles of accounting. Justice to the reader, however, requires the statement that the standard here urged is not in accord with current custom, and is subject to one line of reasonable criticism. "While it cannot be denied that the listing of an asset at an overvaluation is technically " untruthful " it may be claimed, with a good show of reason, that it is not neces- sarily misleading. It may even be urged that " truthful- ness " can never be obtained by any system of valuation CAPITAL STOCK 171 of such a property as a manufacturing plant, and that any attempt to make a valuation is more likely to be mislead- ing than is the bare statement that it cost, not so much money, but so much Capital Stock. This leaves the cred- itor or investor to guide himself, so that, if he goes astray, it is due to his own wandering and not to his being misled. There is much force in this argument which, indeed, is not altogether contradictory to what has been stated in these pages. Such a scheme of valuation is even approved by Mr. A. Lowes Dickinson ' to oppose whose opinion on ac- counting matters, the layman must, indeed, be daring. On this principle all property purchased by stock is listed at the par value of that stock, but with an explanatory state- ment, clearly shown in the Balance Sheet, that the assets thus listed were obtained, not for cash but in exchange for stock. This principle is furthermore embodied in the present Massachusetts Business Corporation Act and in the English Companies Acts. But despite the high authority opposed to the views set forth in this treatise, the claim is still made that to reject the standard of attempted accuracy is a confession of impotence, which, while it exhibits a commendable modesty on the part of professional accountants, seems, to the layman, to do scant justice to the ability of that profession. It is interesting to see how this problem in accounting bears on the much discussed question of stock wintering. The view generally expressed is that " stock watering "— a term vague and as yet ill-defined— is in itself a fraud upon investors and a crime against the public. From the view point of accounting the misdeed is more definitely ■ "If stocks or bonds are issued for the purchase of any definite property, it may be presumed that the property is worth the par value thereof." Proceedings of the International Congress of Public Ac- countants. 1904, p. 185. 172 MODERN ACCOUNTESTG located. The amount of stock issued is relatively unim- portant. Such a transaction, as Vice-Chancellor Pitney has said: " Does not at all or in any manner increase its intrinsic or practical value or in the least degree promote the real prosperity of the enterprise. . . . Its rental value will be practically the same. . . . The division of profits . . . among the stockholders will be on the same basis, and the amount received by each stockholder will be the same . . . and the market values will finally settle down to the gauge of the dividends earned and declared." (61 Atl. 850.) The issue of excessive stock may be bad busi- ness policy, indeed T. L. Greene takes the ground that in the future it will come to be recognized as such, but the watering of the stock, in itself, aside from accompanying complications is the merest peccadillo. The wrong con- sists in the " prevarication," the positive misstatement, that among the assets is a plant worth $100,000 when everyone concerned in the transactions knows it is worth only $50,000, or the untruth that the company has ac- quired Goodwill worth $50,000 when it is absolutely dnno- cent of any such possession. If the other accounts in the Balance Sheet are correct little concern need be felt over stock watering. Its evil will be slight, its correction auto- matic. The onus of stock watering is that it leads to a misstatement of the value of assets and the rigid insistence on absolute integrity in accounts, both prevents and cures any harm from large issues of stock. It must not then be granted for a moment that it " makes no difference " at what figure a given asset, speculative or otherwise is listed. It makes all the difference in the world, the dif- ference between truth and falsehood. The principles of accounting throw light also on the question of stock dividends. Assuming the following : CAPITAL STOCK 173 Dr. Form 59. Balance Sheet. Ct. Plant, etc $85,000 Merchandise 12,000 Treasury Stock 10,000 Cash 8,000 $115,000 Capital Stock $100,000 Undivided profits 15,000 $115,000 the company has accumulated profits of $15,000 and is in position to pay a five per cent, dividend. If this is paid in cash the balance sheet becomes: Dr. Form 60. Balance Sheet. Cr. Plant, etc $85,000 Merchandise 12,000 Treasury Stock 10,000 Cash 3,500 $110,500 Capital Stock $100,000 Undivided profits 10,500 $110,500 If the directors, however, think it unwise to distribute so much of the cash on hand, they may declare a dividend payable, not in cash, but in stock, as indeed they might declare one payable in merchandise. If a stock dividend is declared and paid there results the following : Dr. FOKM 61. Balance Sheet. Cr. Plant- etc $85,000 Capital Stock $100,000 Merchandise .... 12,000 5,500 Undivided profits... . . . . 10,500 Cash .... 8,000 $110,500 $110,500 174 MODEEF ACCOUNTING Not at all different in principle is it where there is no stock in the treasury, for if the condition had been : Dr. Form 62. Balance Sheet. Cr. Plant, etc $85,000 Merchandise 12,000 Cash 18,000 $115,000 Capital Stock $100,000 Undivided profits 15,000 $115,000 new stock could have been issued (provided the company had power to increase its capital stock) with which to pay the dividend. In the latter case the final Balance Sheet would show: ^ Dr. Form 63. Balance Sheet. Cr. Plant, etc $85,000 Merchandise 12,000 Gash 18,000 $115,000 Capital Stock $105,000 Undivided profits 10,000 $115,000 The only difference in the two cases is that in one stock already held in the treasury is decreased, in the other Capital Stock outstanding is increased. However objectionable such a transaction may be con- sidered in its effect on the public, or however much it may be prohibited by particular statutes of individual states, it is, to the accountant a perfectly simple and, indeed, from his view point a perfectly legitimate transaction. New stock is indeed issued without the receipt of addi- tional wealth, but the wealth has previously been received by the corporation, as is shown by the credit to Undi- vided Profits, The cancelation of $5,000 undivided profits CAPITAL STOCK 175 against $5,000 stock is a full payment therefor, so far as accounting is concerned. This is clearly brought out in "Williams v. Western Union Telegraph Company, where the point at issue was whether a stock dividend was legitimate when the com- pany had a large accumulated surplus. The court said: " We know of no law that is violated and no public policy that is invaded by issuing to the stockholders stock to represent that amount of property rather than in any mode to divide it up and distribute it among them. If it can issue stock in payment of property to be obtained by it as part of its capital for its legitimate uses, why may it not issue stock in payment for property in effect pur- chased of them and added to its permanent capital and which they relinquish the right to have divided? So long as every dollar of stock issued by a corporation is repre- sented by a dollar of property, no harm can result to in- dividuals or the public from distributing the stock to the stockholders." (93 N. Y. 190.) The difficulty which the accountant cannot overcome is when he is asked to book a stock dividend where no profits have been earned, a transaction which unfortu- nately sometimes occurs. Had the Balance Sheet given above showed no Undivided Profits, the payment of a divi- dend of any sort, whether in stock, or cash, would be equally objectionable, for a dividend implies profits to be divided. Were either cash or stock to be distributed as a dividend, in the absence of accumulated profits, a correct accounting would require the showing of a deficit due to the payment of the dividend. But this, showing at once the illegality of the dividend, is not satisfactory to the directors guilty of such action. The only way to hide the unlawful act is to introduce into the accounts some fic- titious asset, creating thereby a correspondingly unreal profit, which, once created, can in turn be canceled against 176 MODERN ACCOUNTING either cash or stock paid out in dividends. It is to be noted, however, that the wrong accounting here consists in the preliminary creation of fictitious profits, by falsely marking up the value of the assets, and not in the stock dividend as such. A dividend, whether in cash, merchan- dise, real estate, or stock is, in the absence of statutory prohibition, legitimate whenever real profits exist, and only when they so exist. But such profits failing, a cash dividend is just as objectionable as one in stock ; in fact it is more so, as the paying out of cash may damage existing creditors, the issuing of stock cannot. A transaction, unusual in character but not infre- quently occurring, is where some of the outstanding stock is donated to the company by its original holders. The stock thus received is ordinarily sold for the purpose of raising cash for the use of the company, the selling price generally being below par, as the stock, having previously been issued as full paid stock, carries with it no liability to subsequent purchasers at a lower price. Thus, to cite as illustration an actual case, a company gave its entire capital stock, $300,000 in purchase of prop- erty, the vendors agreeing to donate $40,000 of the stock to the company. Assuming that the property purchased was actually worth $300,000— in this particular case a false supposition— the accounts should show: Form 64. Dr. Balanc e Sheet. Cr. Property Treasury Stock .... $300,000 . . . . -40,000 Capital Stock. . Surplus from stock $300 000 donated 40,000 $340,000 $340,000 The company was then in a position to sell its stock at the market price and thus raise money for working capital. CAPITAL STOCK 177 If sold at less than par the discount could be charged against the surplus, the balance of which should show the actual amount received when the stock is all sold. The donation of wealth is so unusual a business trans- action that by some critics it is always considered tainted. But it is at least conceivable that it may be perfectly legit- imate. Granting that the property is really worth $300,- 000, it may nevertheless be difficult to persuade outside capitalists of that fact, and the organizers of the corpora- tion have no ready money with which to exploit the prop- erty. In order to secure the success of the enterprise the vendors, confident of the ultimate success, may be willing to make the sacrifice in order to get it started, just as an inventor may sell a half interest in a patent at a price which he is perfectly confident is far below the capitalized value of the anticipated earnings. While it is possible then to conceive of such a trans- action as being just what it pretends to be, it is perhaps not extravagant to claim with Schuster that " generous benefactors, who give away their savings to trading com- panies are freaks of nature who need not trouble che legislator's [or the accountant's] mind." In many cases, probably in the great majority of cases, the transaction thus described is the barest subterfuge to enable the com- pany to sell its stock below par free from liability. In the case cited the vendors were really selling their property for $260,000 in stock, and the company was placing $40,- 000 of its stock on the market to raise working capital. But to have sold such stock below par Ayould have involved obligation on the part of the purchaser to make up the difference, and so there was a resort to a subterfuge both stupid alid palpable. Here again the error from the ac- counting view goes back to the first entry, namely, the statement that the property acquired was worth $300,000, when in fact it was clearly worth not over $260,000. Like 178 MODEElSr ACCOUNTING all other cases of overissue of stock the culpable element, at least from the accountant's view point, is in the mis- statement of facts regarding the valuation of the assets acquired. That being correctly given no real problem can arise. For if the Balance Sheet had correctly shown the status as follows: Dt. Form 65. Balance Sheet. Cr. Property $260,000 Discount on Stock 40,000 $300,000 Capital Stock $300,000 $300,000 even though the discount were treated as something which could not be collected, there need be no misleading of the public and. the donation of the stock could not hide the fact of the discount on the later sale. By some rigid accountants, among whom are Seymour Walton and most German writers, the donation of part of the stock by vendors is to be construed inevitably as a de- duction to be made from the nominal purchase price of the property. But no such severe standard has been set by the courts. It is true that in an earlier New York case it was held that such a contribution was at least cor- roborative evidence of overvaluation (Douglass v. Ireland, 73, N. T. 100. (1898) ). But the more recent English case of Innes & Company ([1903] 2 Ch. 254) takes a differ- ent view; and the Colorado case of Speer v. Bordeleau (79 Pac. 332. (1905) ) distinctly states that such a transac- tion is not evidence of issue below par. But whether the presumption is in favor of valuing the property at the amount of stock originally given the vendors, or at the net amount retained by them, if it is established that the for- mer figure wculd be an actual overvaluation, there is no CAPITAL STOCK 179 excuse for such an incorrect representation in the accounts. The accountant should transcend the limitations under which the courts labor. The donation of stock has a further purpose, one which might be otherwise obtained, of providing a fund which can be used in covering the organization expenses, or those which may be incurred during the early years of the cor- poration. The securing of such a fund is a perfectly legit- imate, indeed a praiseworthy, procedure. The contribu- tion of stock is no more unreasonable, and has exactly the same effect as the sale of the stock at a premium for the same purpose of providing a fund for initial expenses. As these are incurred they can be charged against the Sur- plus, which thus gradually disappears. The process is identical whether the Surplus is raised by the contribution of stock, or by the practical contribution of cash under the name of premium on stock. Some question may be raised as to the nomenclature used in the transaction just discussed. In the Balance Sheet in Form 64 a descriptive title " Surplus from do- nated stock ' ' is used, and that is incontrovertibly correct, although it may well be that a less cumbrous term would serve iii its place. Some writers have employed the term " Working Capital " for the credit item. This innova- tion is of doubtful propriety, for ' ' Working Capital ' ' ha» long had a specific meaning as a collective term for what are often called ' ' quick assets, ' ' e. g., cash, accounts re- ceivable, perhaps merchandise, etc. The new use of the term has some vogue in America, but it is not found in England, nor does it conform to the use of the term in legal definitions, nor even to the more established and bet- ter recognized accounting practice in this country. The most important stock transactions of recent years have been those of the so-called trusts, where the stock of the new company is issued largely to acquire the busi- 180 MODEEN ACCOUNTING ness and plants of established competing firms or corpora- tions. There are two forms in which this may be done, omitting the case where the stock is issued to purchasers for cash and the subsidiary plants purchased with the funds thus received. The stock of the consolidating com- pany may either be given to the stockholders of the old company as individuals, in exchange for their holdings; or the new stock may be used to purchase the plants, good- will, etc., from the subordinate companies. In extreme and simple form this may be illustrated by the case of Corporation A organized with $1,500,000 capital stock which is used to make a combination of Corporations B and C, whose Balance Sheets are respectively: Form 66. Dr. Balance Sheet of B. Cr. Plant and other assets. . . $600,000 Capital Stock $300,000 Surplus 300,000 $600,000 $600,000 Dr. Form 67. Balance Sheet of C. Cr. Plant and other assets.. . $300,000 Capital Stock $300,000 The agreement made is that three shares of stock of Cor- poration A shall be given in exchange for each share of stock in B, that $400,000 stock shall be given for the plant, goodwill and other assets of C, and that the re- maining stock of A is to be issued to subscribers for cash at par. Assuming that the bargain is an equitable one all CAPITAL STOCK 181 around, the Balance Sheets of the three corporations, after the transactions, will be : Dr. FoHM 68. Balance Sheet of A. Cr. Stock of Corporation B 3,000 shares at $300 . . . $900,000 Plant, etc.; 300,000 Goodwill at cost 100,000 Cash 200,000 $1,500,000 Capital Stock $1,500,000 $1,500,000 Br. Form 69. Balance Sheet of B. Cr Plant and other assets. . . $600,000 $600,000 Capital Stock $300,000 Surplus 300,000 $600,000 Form 70. Dr. Balance Sheet of C. Cr. Stock of Company A 4,000 shares at $100.. . $400,000 $400,000 Capital Stock $300,000 Surplus 100,000 $400,000 The Balance Sheet of B is of course unchanged as the transaction was between A and the individual stockholders. The Balance Sheet of C shows stock of A held as its only asset. Remembering the assumption made above that the consolidation is equitable, which implies that full par value is given and received, C must show a Surplus (Profit) of $100,000. A shows the stock of B bought of the share- holders, but not the assets of B which still belong to that corporation, the only change being a shifting in the per- 182 MODEEN AOCOUiSTTING sonnel of the stockholders. But it shows not only the former assets of C, but also the Goodwill which it bought from C, which was not included in the assets of C, but which is legitimately included in those of A. It is furthermore clear that the stock of A might have been issued at a premium, and that any possible varia- tions in terms and prices could occur without affecting the principles elucidated in this most simple illustration. As to the legality of the combination under statute law the present discussion is not concerned, but providing a consolidation takes place in the manner specified, the ac- counting should be as above. It may be that the holding corporation prefers to show in its Balance Sheet not the stock of B but the detailed assets, a plan in part adopted by the United States Steel Corporation. "While such a showing is desirable for cer- tain purposes, formally and legally A does not own the assets of B so long as B retains its legal corporate exist- ence. If the merger works a dissolution of B the case is otherwise. BIBLIOGRAPHICAL NOTE TO CHAPTERS VIII AND IS. On the technical bookkeeping entries to be made : BBNTLEy, H. C. Corporation Finance and Accounting. Chapter VII. New York, 1908. Carnes, a. J. Manual on Opening and Closing the Books of Joint Stock Companies. Third edition. Baltimore, 1891. Keister, D. a. Corporation Accounting and Auditing. Eleventh edition, Cleveland, 1905. Rahill, J. J. Corporation Accounting and Corporation Law. Fresno, 1906. For a more serious discussion of the principles involved see : Charpentibk, J. Etude juridique sur le bilan dans les soci6t6s par actions, pp. 42-81. Paris, 1906. CAPITAL STOCK 183 Rehm, H. Die Bilanzen, p. 342-477. Munich, 1903. Simon, H. V. Die Bilanzen der Aktiengesellschaften, p. 201-227. 3 Aufl. Berlin, 1899. For a discussion of the laws relating to issue of capital stock: Claek, W. L. and Marshall, W. L. A Treatise on the Law of Private Corporations, §§ 389-401. St. Paul, 1901. Cook, W. W. A Treatise on the Law of Corporations having a Capital Stock. Chapter II. Methods of Issuing Stock. Chap- ter III. Watered Stock. Fifth edition. Chicago, 1903. HuFFCUT, E. W. Selling New Shares at Less than Par. American Law Review, XXVI, p. 861. [Discusses Handley v. Stutz and Ooregum Co. v. Roper.] Palmer, F. B. Company Law. Fourth edition. London, 1902. CHAPTER X LIABILITIES As was shown in Chapter III the credit side of the Balance Sheet is frequently headed " Capital and Liabili- ties." This is a comprehensive title, for in the approved form of the Balance Sheet the mere valuation accounts — such as Depreciation Account — being subtracted from the nominal assets there remains on the credit side only Capital — including all unrepresented capital, such as Surplus, Reserves, and Undivided Profits— and the out- side liabilities of the concern. In a limited sense, it is true, liabilities are also a subtrahend from the assets, for a debt, as shown in Chapter I, is really a negative asset. But to show only the net excess of assets over lia- bilities, or of some one asset over the particular liability which it secures (as, for instance, to show only the equity in a piece of real estate, instead of showing both the value of the property and the mortgage on it) is universally rec- ognized as incorrect and misleading. An exception is found in the Double-Account Balance Sheets used by cer- tain English companies. There, in the Balance Sheet proper is shown only the excess of assets over the sum of capital and funded debt. But this exception is formal rather than real, for the accompanying Capital Account clearly exhibits the full status. The same principle is applied occasionally in American accounting, as, for in- stance, in a modified form, in the Balance Sheet of the Atchison, Topeka, and Santa Pe Railway Company. Somewhat similarly the Illinois Central shows in the Bal- LIABILITIES 185 -nee Sheet only the excess of the current assets over the current liabilities. But there is a. reference given to a de- tailed exhibit on another page where the full information is to be found. Rehm goes further and suggests that the proper form of a Balance Sheet, from the economic view point, is one in which negative items are shown as subtractions, prac- tically as follows: Assets. Form 71. Balance Sheet. Liabilities. Plant, etc $610,000 Other assets.. 50,000 $660,000 Less Debts 40,000 $620,000 Capital Liabilities: Capital Stock $600,000 Reserve Funds 10,000 610,000 Profits: Excess of in- come $12,000 Depreciation. . 2,000 10,000 $620,000 While from a theoretical point of view debts are nega- tive assets, and differ radically from capital, it is well-nigh universal to list both capital and liabilities on the same side of the Balance Sheet, and no criticism is ordinarily made of this practice. All that is necessary is clearly to differentiate the two, and to be sure that there is no un- derstatement of the amount of liabilities. The accounting problems having to do with liabilities are extremely simple as compared with those relating to assets. This is principally due to the fact that the ques- tion of valuation, so perplexing in regard to assets, prac ticaUy disappears when liabilities are concerned. One may suffer, indeed one must expect, some diminishment in the value of assets but debts, so long as the principle 186 MODERN ACCOUNTING of the going concern is recognized, must be shown at their full amount. The only problems which arise in the book- ing of liabilities are those which group around the clas- sification of liabilities, the calculation of interest, the treatment of unissued, repurchased, and canceled debts, and a few questions in which there may arise a doubt whether there is an existing liability or not. These will be considered in order. The clearness and consequent value of the Balance Sheet is increased if some classification is made of the various kinds of debt. Thus a showing of the funded or long time debt separate from the short time or floating debt is of great importance, indicating, as it does, the im- mediate financial strength of the concern, and whether or not it is likely to suffer loss because subject to a sudden demand from its creditors. The distinction between debts for which notes or acceptances have been given and open book accounts is also important. The extent to which such classification is to be carried, as in the corresponding clas- sification of assets, is a mattet of discretion, governed by individual circumstances. The statements rendered by the National Banks to the Comptroller five times yearly con- tain seven different subdivisions of liabilities to depositors. One of these same banks will give, in the condensed Bal- ance Sheet published for advertising purposes, only the single item Deposits. Both of these statements are correct ; each, for its purpose, is full as well as fair. But what- ever subdivisions are made, the classification adopted must be strictly observed. It may be perfectly correct to include all liabilities to depositors under the one head ' ' Due to de- positors. ' ' But where a subdivision is made it is incorrect and fraudulent to list under the title ' ' Accounts payable ' ' items which really are " Bills payable " or to include either of these items under the title " Funded Debt." The questions which relate to the calculation of inter- LIABILITIES 187 est on debts are the most interesting which arise in regard to the accounting of liabilities. As a matter of conven- ience debts, whether receivable or payable, are ordinarily listed in books at their face value rather than at their real value. Where the note is discounted, it follows that there must be a counter entry to a Discount account. Where the note, or other obligation is not discounted, but bears interest from date, the adjustment is not made until some later date. When a formal Balance Sheet is pre- pared it is accordingly necessary, in order to make a cor- rect showing of the liabilities of the concern, to make an exact reckoning of interest on outstanding liabilities. This is exhibited in the Balance Sheet, either as a liability " Interest accrued," which for convenience may be added to the face of the debt, or, in case the note was discounted in advance, as a deferred asset, perhaps under the title " Discount paid in advance." Such an estimate is very simply made in case of short time obligations. When bonds are emitted the calculation is more complicated, and the treatment in the accounts is not uniform. The estimation of simple interest accrued on the bonds since the time the last interest payment was made is of course identical with the calculation of interest on a short note, and no divergence of practice occurs :n that regard. The main point of difficulty is in regard to the premium or discount allowed on the bonds at the time of issue. As shown in discussing investments, the pre- mium paid on a bond is virtually the price paid for the privilege of receiving nominal interest at a rate higher than the market rate. Viewing the transaction from the borrower's point of view, the premium received is, there- fore, a lump payment made in return for the obligation to pay an excessive rate of interest during the life of the bond. If the credit of the company and the conditions of the market would have enabled the company to issue 188 MODERN ACCOUNTING a five per cent, twenty-year bond at par, its six per cent, bond, running the same time, should sell at approximately 112.46. This premium of 12.46 is, therefore, the present value of the annuity of one per cent, which the company must pay for twenty years. But the interest installments as paid are normally and properly charged as an expense, and consequently the 12.46 per cent, should be spread over all the years during which the interest is thus paid, in order properly to equalize the profits of the several years. The correct entry, therefore, is to credit the premium re- ceived to " Premium on bonds issued " a part of which is annually written off to offset the interest paid the bond holders. It might, however, all be placed in some Reserve, and this is not infrequently done. This, while theoret- ically incorrect, is condoned by many authorities on the ground that it leans to conservatism. The opposite treat- ment of crediting the premium at once to Profit and Loss is manifestly incorrect, for the premium is in no sense profit and least of all profit of. the single year in whieli it is received. The apportionment of premium between the years is most scientifically done on the basis of the declin- ing value of the annuity which it represents, according to the method described in discussing the valuation of invest- ments. Exactly the same principle applies to bonds issued at a discount, just as the same principle applies to bonds bought below par. The discount should appear at first among the assets, but should gradually be written off as the years pass, thus making the annual charge to interest correspond to the real rather than the nominal rate paid. This practice is frequently met with as, for instance, in the accounts of the Lackawanna Steel Company, and the Chicago and Alton Railway. At times the annual charge is based on the actuarial estimate of the value of the an- nuity, at times merely divided into equal annual charges. LIABILITIES 189 at times, still less scientifically, but even more conserva- tively charged off much more rapidly, or even all charged off to expense in the first year. Among American Railways, however, the custom is to charge discount on bonds to the construction account. The temptation to do this is great, as in the early years of a railroad's life the burdening of the income account with any additional charges is, of 'course, unpleasant. But curi- ously enough this practice is justified by many writers, among whom may be mentioned T. L. Greene and Rehm. Greene makes the statement absolutely, as applying to all discount on bonds issued. Rehm more cautiously applies it only to the discount on bonds whose nominal rate is equal to the current market rate, or to that part of the discount which represents a rate higher than the market. The argument in favor of this is that the discount repre- sents, at least in so far as it makes the actual rate paid higher than the current market rate, an additional cost of the road, a cost due to the lack of credit. Thus if five per cent, is deemed the normal rate, the discount on a four per cent, bond necessary to make it net five per cent, repre- sents interest; but discount on a five per cent, bond, or discount on the four per cent, bond in excess of 12.46, represents not interest, but the cost due to poor credit. But such a differentiation is extremely difficult to ap- ply. All that one can confidently assert, in the case as- sumed, is that the market rate for a twenty-year bond of this particular company is five per cent., while the nominal rate was made four per cent. Furthermore, the charging of discount to construction results in the absurdity of making the road cost more the longer the bonds have to run. In the case mentioned for each million dollars re- ceived from bonds , and expended on construction there would need to be added some $140,000 for discount, but had similar bonds running fifty years been issued, for each 190 MODEEN ACCOUNTING million thus provided there must be added approximately $220,000. To be consistent, those who argue that discount due to deficient credit is part of the cost of construction should go further and increase the cost annually whenever the company pays more than the normal rate. The company whose poor credit forces it to pay 11.47 per cent, discount on a five per cent, bond, could have sold a six per cent, bond at par. But this would necessitate an annual pay- ment of one per cent, additional interest above the normal market rate. Why should not this annual payment be charged to cost of construction if the equivalent and alter- native payment of 11.47 per cent, once for all is thus to be charged? Yet no one of those writers who attempt to differentiate between discount due to a subnormal nominal i-ate, and discount due to deficient credit, advocates such a practice. The Interstate Commerce Commission at- tempts the diflBeult distinction between discount on securi- ties and commissions on their sale. The former is held not to be properly included in the cost of p*roperty, the latter may be. Occasionally bonds are issued repayable at a premium. "Where such repayment is optional on the part of the bor- rower the provision for the premium is in the nature of a special reserve. If, however, the repayment at the pre- mium is accepted as part of the financial policy of the concern, the premium as well as the par value of the bonds becomes an obligation and should appear in the Balance Sheet. The two elements may, however, be kept separate. Where bonds thus redeemable at a premium are sold at a price other than the redemption figure, the difference be- tween the two should be treated just as premium. or dis- count on bonds redeemable at par ^re treated. The treatment of bonds authorized but not yet issued is not different in principle from that of unissued stock, LIABILITIES 191 already discussed. Any one of the alternative forms given on page 148 may be applied to such bonds. But, as in the case of stock, if the unissued bonds appear in the Balance Sheet among the assets, the nature of such holdings must be clearly shown. It is illegitimate to include them with outside investments under a general heading, " Invest- ments," or " Bonds and Stocks." "Where the unissued bonds are secured by a lien on specific property there is additional justification in including them among the as- sets rather than in merely deducting them from the out- standing debts. The property pledged to secure the bonds gives them a somewhat independent value, and makes them perhaps an available asset even in the ease where the com- pany is in a poor financial condition. Furthermore, bonds, unlike stock, may, in the absence of special legislation, be freely issued below par. Hence it is not important to distinguish in the case of bonds, as it is in the case of stock, between those which are unissued and those which have been reacquired. But in any case the most complete and hence the most satisfactory way of presenting all the facts is to exhibit the unissued bonds on both sides of the Balance Sheet. This treatment is found, for instance, in the Balance Sheets of the Chicago and Northwestern Railway, and may be simply illustrated as follows: Dr. FoBM 72. Balance Sheet. Cr. Miscellaneous Assets Bonds of Company held in Treasury $50,000 etc., etc. Bonded Debt Outstanding $100,000 Held in etretc^--^^^150,000 The treatment of bonds purchased in the market is sim- ilar to that of stock thus purchased and held in the treas- 192 MODEKN ACCOUNTING ury. The purchased bonds may, however, at any time be canceled and the outstanding debt thus reduced without any further formality, while the purchase of its own stock by a company does not in itself work a reductton of the nominal capital, to accomplish which certain legal pro- cedures must be followed. A distinction should be made between a bond redeemed, especially where it is formally canceled, and one merely bought on the open market and held in the treasury as a live bond. Where the former takes place it must disappear entirely from the Balance Sheet. The showing of contingent liabilities, that is of liabili- ties for which the proprietor may be held under certain contingencies but which he never expects to have to meet, is a perplexing problem. An illustration is where a manu- facturer sells machinery with a guaranty. Ordinarily such an obligation to indemnify the purchaser in case the machinery fails to render proper service does not show in the books at all, and yet it may constitute an important fact in determining the financial status of the manufac- turer. Probably the best way of treating such a transac- tion is by establishing a special reserve to provide against an uncertain contingency, rather than to treat it as an absolute liability. More simple is the case where accep- tances or indorsements are given as an accommodation to trade associates. This, of course, constitutes a real liabil- ity and should at once appear on the books of the indorser, being offset by an asset representing the claim against the one who has been accommodated. Again funds may. be raised by indorsing and rediscounting trade paper, in which case the obligation is not incurred as a mere accom- modation but as a regular business transaction. Pecul- iarly enough, in ordinary bookkeeping, such obligations are customarily omitted. The discounting of the trade paper formerly held cancels that item from the books and noth- LIABILITIES 193 ing further appears to indicate a possible obligation. This is in contrast to usage in transactions which at heart are identical, that is, where funds are obtained on the prom- isor's own note, secured by trade paper as collateral. I Where this is done the custom is to show the trade paper still among the assets and the collateral note itself as a lia- bility. But whether the funds are secured by indorsing the trade paper and rediscounting it, or by hypothecating it as collateral does not affect the real position of the bor- rower. Yet it is exceptional to exhibit the liability as indorser on rediscounts, the usage of National Banks being the most prominent example. A dividend which has been declared becomes at once a liability of the company and must accordingly be shown in the Balance Sheet. This corresponds with the legal posi- tion, for while undivided profits are not a liability of the corporation, and the stockholders have no right to compel their distribution, the declared dividend is an obligation, for which, in case of bankruptcy, the stockholder has the same rights that any other creditor has against the com- pany. Undeclared dividends do not appear at all on the books, unless in the case where there are cumulative pre- ferred dividends in arrears. The position of such divi- dends is somewhat unique. So far as the company and the preferred stockholders are concerned there is no obligation to pay, indeed the company cannot pay unless profits are earned. But from the view point of the common, or de- ferred stockholder delinquent cumulative dividends on preferred stock are a liability which must be met before anything can be paid to him. Consequently there is a good argument for making an exhibit of the amount in arrears. Practice is, however, not uniform on this point. Perhaps the best treatment is to follow Pixley's suggestion that they appear in an appendix to the Balance Sheet rather than in that statement itself. 194 MODEEIST ACCOUNTING The provision for pensioning employees raises a ques- tion as to whether there exists a liability which should ap- pear in the Balance Sheet. An agreement definitely made to pay pensions is nothing more than one way of paying wages. In order to apportion charges properly between years, the amount necessary to provide for future pensions must be counted among the expenses of each year ; and the corresponding sum is a real obligation payable to employ- ees some time in the future. Evidently in such a case to omit such a liability from the Balance Sheet is incorrect. But if the provision for the pensions is not a definite mat- ter of bargain, but is rather an optional beneficence of the proprietors, the accumulated fund is of the nature of a re- serve rather than a liability. In some cases, where the pension system is well established the annual appropri- ations thereto are paid to trustees who hold them, and the accumulations thereon, in trust for the beneficiaries. In such eases both the assets and the liability entry may properly be left entirely out of the accounts of the com- pany. Here the payment of wages consists of two parts, one paid currently to the workman, the other paid to his trustees. After such payment the company need, in neither ease, make further accounting. The treatment of pensions therefore depends on the exact legal nature of the pension agreement, and on the financial policy adopted in its administration. BIBLIOGRAPHICAL NOTE TO CHAPTER X Dickinson, A. L. Interest and Sinking Funds. Accountant, ICVII, p. 715. PixLEY, F. W. Auditors, their Duties and Responsibilities, I, pp. 351-357. Ninth edition. London, 1906. Rehm, H. Loc. cit., pp. 272-342, 477-493. Simon, H. V. Loc. dt., pp. 173-201. [The last two authors present opposing views of the nature of discount on bondsJ CHAPTER XI PROFITS The Profit and Loss Account, called also Revenue, Income, Loss and Gain and other similar names, is a tem- porary, collective account, recording the changes in net wealth due to the business operations of a stated period. In some cases it indicates, as well, the disposition which has been made of the net profits. It is temporary, as it covers only a given period, usually the fiscal year, and is in the end closed out, in partnerships by being divided between the proprietors' accounts, in corporations by transference to Dividends, Reserve, Surplus, or other simi- lar accounts. It is a collective account in that it embraces the balances shown hf other subsidiary ' ' Proprietorship ' ' accounts, such as expense or the, various subdivisions there- of, and the various accounts indicating profits received during the year, such as Merchandise, Interest, Rent. It shows changes in net wealth and is therefore subsidiary to the Capital, or other nlain proprietorship accounts. It shows not merely the net wealth as a single sum, nor the accretions of wealth during the entire previous busi- ness career, as distinct from the original capital, but as well, just what changes in the net wealth have been brought about during the fiscal year. It shows, properly, changes due to business operations,, not those due to other causes, although here the line is uncertain and practice unsettled. Like other accounts it contains two sides. On the one are entered items, of which Expense is the type, whose 14 195 196 MODERN" ACCOUNTESTG effect, per se, is to indicate a diminution of net wealth. On the other side appear items which indicate an increase in net wealth. The debit side may, in addition, contain not merely expenses and losses, but also the disposition, or allocation of the net profits, which sometimes, as when it shows dividends paid, indicates a reduction of the net wealth belonging to the concern, but not a loss ; and some- times, as when a sum is carried to Surplus or Reserve, merely a technical bookkeeping transfer. The pui'pose of the Profit and Loss account is, primar- ily, to show the net profits of the concern for the period, with special reference to the amount of net profits avail- able for dividends. This may at times be derived from the Balance Sheet, indeed some writers, of whom Rehm is a prominent example, claim that the prime purpose of the ordinary Balance Sheet is to exhibit profits available for dividends. But in practice this is not true, and in any case the Profit and Loss account by its greater ex- plieitness and completeness is a valuable adjunct to the Balance Sheet, so that the two statements are generally published together, as being mutually complementary. If a distinction is to be made, it may be said that the Balance Sheet interests more particularly the creditor, the Profit and Loss account the proprietor or stockholder. The depositor in the bank finds in the former the com- parison between deposits and cash reserves, the nature of investments, and the amount of guaranty, facts all of which affect his determination as to continuing his ac- count. The wholesale merchant learns from the Balance Sheet of his customer the relation of assets to liabilities, and the kind of each, and decides as to increasing the line of credit. The stockholder, on the other hand, is interested more particularly in profits, and the examination of the Profit and Loss account should show him whether the stock is a desirable investment. But the distinction here made PEOFITS 197 is only relative. The creditor is- unwilling to continue to trust a losing concern, and the investor will resist the temptation to buy stock with high dividends, if these are gained by doing a business with insufficient reserves and imminent liability to bankruptcy. So, creditor and pro- prietor alike need both Balance Sheet and Profit and Loss statement to give the information desired in business nego- tiations. Before considering more particularly the details of' the Profit and Loss account and the problems pertaining to it, it is necessary to show the connection between this account and the various classes of accounts which were discussed in the preceding chapters. The Profit and Loss account being merely a subdivision of the Capital account and indicating current changes in the net wealth, it is evident that its connection with the Goods accounts is most vital. Any changes in the net value of the assets must, with certain exceptions to be noted later, be reflected in the Profit and Loss account. Consequently, any of the transactions previously discussed, or any of the bookkeeping estimates which more or less accurately portray transactions affecting the book value of the assets, must also be represented in the Profit and Loss account. Any change in the Goods accounts, representing business changes other than mere exchange transactions, must, in ordinary cases have a counter entry which is ulti- mately included in the items posted to the Profit and Loss account. The problems of Profit and Loss are generally, then, not new questions but the same that have already been dis- cussed. The valuation of assets (the problem of the inven- tory) is clearly a question as to Profit and Loss, for changes in the book value of assets mean corresponding changes in the net wealth. The question as to whether Organization Expenses should go into the inventory is clearly a ques- 198 MODERX ACCOUJSTTIJSrG tion as to whether they should be kept out of the Profit and Loss account. Depreciation, if established, must be booked by a charge to Profit and Loss. Thus the Profit and Loss account is merely another view of the general problems of accounting, and much which has already been discussed, while pertinent to the consideration of Profit and Loss need not be repeated in this chapter. Most of the charges made to the Profit and Loss ac- count are unequivocal and undisputed. An expense is, in most cases, easily recognized, and the necessity for charg- ing expenses against Profit and Loss is generally not ques- tioned. But there are two classes of cases in which a di- lemma really arises as to whether a given item should appear in the Profit and Loss account or elsewhere. In the first class the alternative to entering it in the Profit and Loss account is to include it among the Goods listed in the inventory. In the second class the alternative is the entry in the Capital account direct, or where that is impossible because of the requirements of corporation law, the entry into some subsidiary account showing that a deduction should be made in the nominal capital, but one which need not go through the medium of the Profit and Loss account. 1. The first of these problems has been discussed in con- nection with the inventory. Is the interest paid during construction, is the expense of organization, a real loss, something to be debited against profits, or is the payment represented by an immaterial asset, or at least by a De- ferred Charge, which for present purposes is to be con- sidered as an asset? "Was the money paid for improving the road-bed properly an expense, or is it an added ele- ment in the cost of construction and, as such, to appear among the assets? Assets and losses, expenses and im- provements, exchange transactions and those affecting net wealth, are mutually exclusive conceptions. Determina- PROFITS 199 tion that a disbursement was for one of these purposes excludes it from the other, so that all this class of ques- tions is merely a restatement of the problem of the in- ventory already discussed. 2. The second alternative is, however, a new one. The alternative to an entry in the Profit and Loss account, is here an entry, not among the assets but in some other of the accounts which have here been called " Proprietor- ship " accounts. Exclusion from Profit and Loss does not here force an inclusion in the other group of accounts, representing assets. It means that an actual deduction in net wealth has taken place and that, if this is not to ap- pear in the account showing current business changes in net wealth (the Profit and Loss account), it must appear in some other of the same group, either in the Capital account itself, or in some account, other than Profit and Loss, which is subsidiary to the Capital account. In a word, the question is whether all changes in net wealth shpuld go through the Profit and Loss account. Can capi- tal be lost, without having such a technical loss as must appear in the debit of the Profit and Loss account? May there be an increase in the net value of the assets, repre- senting a growth of capital, but not profits in the sense that is meant by a Credit balance to the Profit and Loss account ? These two different classes of perplexing entries may be illustrated by referring again to the fundamental equa- tion of bookkeeping in which the total Goods, consisting of plant and other assets, equal the total Proprietorship, divid«d into original capital and profits, i. e. Plant, etc., $100,000 + Cash $5,000 = Capital $95,000 + Profits $10,000. In a preceding paragraph reference was made to instances where cash is paid out, say for an improvement in the 200 MODEEN ACCOUNTESTG road-bed. The dilemma consisted in the uncertainty whether, Cash being thus diminished, the validity of the equation is to be maintained by making an equivalent addition to the other term of the Goods account, or by sub- traction from Profits. In one case there results Plant, etc. $101,000 + Cash $4,000 = Capital $95,000 +; Profits $10,000, in/the other Plant, etc. $100,000 + Cash $4,000 = Capital $95,000+; Profits $9,000. But in the second class of doubtful entries there is no question as to the lessening of total values. There has been a decline, say in the value of the plant, amounting to $1,000. The problem here is virtually whether the Bal- ance Sheet should show: Plant, etc. $99,000 + Cash $5,000 = Capital $95,000 +' Profits $9,000, or whether the correct statement would be either : Plant, etc. $99,000 -f Cash $5,000 = Capital $94,000 + Profits $10,000, or the equivalent expression : Plant, etc. $99,000 + Other assets $5,000 + Losses $1,000 = Capital $95,000 + Profits $10,000. In practice, a still different and incorrect treatment is given to the transaction, which shows: Plant, etc. $100,000 + Other assets $5,000 = Capital $95,000 + Profits $10,000, despite the undeniable fact that certain values have really disappeared. This problem has been discussed at length by the courts, but, unfortunately, not always from the view poinf PEOFITS 201 of accounting. It has perhaps been worked out most mi- nutely in questions of probate, where a life interest in an estate is left to one person while the body of the estate goes to some other legatee. Here it is of vital importance to distinguish between the income .going to the tenant for life and the body of the estate going to the remainder-man. In this relation the conception has been introduced of there being a growth or increase in the body of the estate which does not constitute a part of the income. Con- versely there may be a loss of part of the principal without ■effect on the income derived from the remainder. The theory, while well worked out in detail in its application to the settlement of estates, is recognized as being pecul- iar to probate law., and while interesting to the account- ant is not applicable to commercial accounts. Again the matter frequently comes up in bankruptcy proceedings, where the liability of directors, or of stockholders, to creditors turns on whether a certain dividend paid was really profit earned. In disputes arising between differ- ent classes of stockholders, or in the suits brought by the holders of income bonds, there has also frequently arisen the question as to what constitutes profits. But in most of these cases the decisions are not so conclusive as could be desired. Oftentimes the decision turns entirely on the construction of some special clause in the articles or by- laws of the company,^ or after a long discussion of vital principles the case is finally decided on some technicality leaving the main question unsettled ; ^ or in general, the 'For instance the oft-quoted decision in Bavison v. GilKes was subsequently said to have rested entirely on special articles and not on general law. Vide L. R. 41 Ch. Div. 18. 2 For instance the decision on the appeal of the National Bank of Wales case. Here most important principles were raised in the Court of Appeal, but these were questioned but not reversed in the House of Lords, the decision being made on a technicality as to the defendant's responsibility. Dovey v. Cory [1901] A. C. 477. 202 MODEEN ACCOUNTING decision is at best a decision as to what profits are avail- able for dividends, rather than as to what constitutes profits. In England the discussion has bfeen clearer than in the United States. It has been especially favored by the ex- ceptional form for the Balance Sheet provided for parlia- mentary companies. The fact that the Capital account is here kept separate, as in the simple form Form 73. Dt. Capital Account. Cr. Capital assets Balance £95,000 5,000 Shares £100,000 £100,000 £100,000 Dr. Balance Sheet. Cr. Balance of Capital Account £5,000 Accounts payable 20,000 Profits 5,000 £30,000 Bills receivable £15,000 Casii 15,000 £30,000 seems to encourage the idea that the Capital account, or at least the plant purchased with receipts from capital have little or nothing to do with the profits exhibited in the Balance Sheet. The inference is easily drawn that there can be a loss in the value of the capital assets which would affect only the Capital account and which would leave the profits of the year undisturbed. Doubtless, because of being accustomed in double accounts to treat capital as a thing by itself, the English courts have been more ready to take advanced ground on the general problem. "Whatever decision may ultimately be rendered by ac- countants, the problem at least is clear. Recognizing the of certain assets, say by fire, or by shipwreck, by PKOFITS 203 default of securities, or by normal exploitation, the only point of debate is as to the channel through which that loss shall be shown. In accounting terms it is simply whether a given, recognized loss is to be debited to Profit and Loss or to some other account which would indicate a deduction from net wealth, but which would say nothing about current revenues. To a certain extent it is a ques- tion of terminology, in part, it is a question of law. Does the term " Net Profits " mean the net change in wealth, due to whatever cause, or does it mean the changes due only to a certain set of business factors? Does the law allow dividends to be made of tlie surplus of certain re- ceipts (realized or constructive) over certain expenses (whether paid or merely recognized), or does it order that only the surplus of present assets over the net assets of a year ago may be divided? The problem may be illustrated by assuming a case of relative simplicity where a company is organized to pur- chase a coal mine and to exploit and sell the coal. Waiv- ing the question of the difficulty of making an intelligent estimate of the value of the coal deposit, it may be assumed that $250,000 is paid for the property and that this is an equitable price for the million tons of coal which the mine contains. On these terms the selling price should return the principal, pay all the operating expenses, and yield a fair profit on the original investment. The proceeds of each year's sales obviously should considerably exceed the annual cost of operating the mine ; but it is perfectly clear that the excess of receipts over annual expenditures will not all be profits. Out of the price received for each ton of coal 25 cents is a return of a similar sum paid orig- inally for the coal in situ ; and allowance for this cost price must inexorably be made before profits can correctly be determined. With the assumptions made, the mining company can no more legitimately treat the net annual 204 MODERN ACCOUNTING receipts as net profits than can the merchant neglect the cost price of his commodity, or the manufacturer disre- gard the factory cost of his product in his estimate of profits. Thus assuming again that the total cost of min- ing and selling the coal, including all the direct outlay for operation, amounts to 55 cents per ton, the company, after exploiting 100,000 tons, should show in its Profit and Loss account : Form 74. Dr. Pro-jit and Loss. Cr. Expenses $55,000 Exhaustion of mine 25,000 Balance available for div- idends ■ 20,000 $100,000 Sales 8100,000 $100,000 and having paid out the full profits the Balance Sheet should show: Form 75. Dr. Balance Sheet. Cr. Cost of mine $250,000 Cash, etc 25,000 $275,000 Capital $250,000 Depreciation of mine 25,000 $275,000 The same process being continued until all the coal is dis- posed of the Balance Sheet should be : Dr. Form 76. Balance Sheet. Cr. Mine — cost price $250,000 Less exhaustion 250,000 Cash, etc $250,000 $250,000 Capital $250,000 $250,000 PEOriTS 206 During the course of business the net cash receipts amount to $450,000, but because of charging to Profit and Loss a sum representing the cost price of coal, the total profits shown and distributed amount only to $200,000, while there steadily accumulates in the treasury a sum which at the end of operations equals the original cost of the mine.^ This would serve to return the capital stock. Such treatment of the accounts met with the practi- cally unanimous approval of accountants, when in 1889, the accounting world was startled by the now historic de- cision in the English case, Lee v. Neuchatel Asphalte Com- pany, Limited. (L. R. 41 Ch. Div. 1.) Here action was brought by a shareholder to prevent a company formed to work certain asphalt deposits from paying dividends without making allowance for the exhaustion of the de- posits. But the court refused to interfere. Unfortunately for the peace of mind of accountants, jurists, and com- pany directors, the decision itself was somewhat vague in principle, contradictory in detail, and difficult of appre- hension. But the case at least decided the principle that there is no requirement compelling companies to make al- lowance for the exhaustion of their capital invested in " wasting " assets. So counter was this to the teaching of text-books, and the practice of accountants that it immediately attracted attention and criticism. In the current discussion in the Accountant, the organ of the Chartered Accountants, it was almost universally condemned. It was claimed that the decision showed " a feeble grasp of the fundamental principles of accounting " and to be " utterly at variance with the views of all practical accountants and prudent men of affairs. ' ' The ' ' Dictionary of Political Economy ' ' appearing soon after the decision maintained that it ' ' con- ' For the sake of siinpli.;ity the question of interest accruing on this fund is disregarded. 206 HODERN ACCOUNTING tradiets every sound principle of business and bookkeep- ing." Palmer, one of the most eminent authorities on company law has said: " The views on Lee are not shared by some other learned judges and they do not commend themselves to the common sense of accountants, economists, or business men in general, ' ' and he declares its system of ascertaining profits to be " obviously unsound." In face of such united criticism coming from such . varied authorities it requires some temerity to argue in favor of the decision; especially so since the decision, while it has frequently been followed in England and in the United States ^ has been said to have really no bearing on the question of the treatment of wasting assets, as in reality the value of the remaining deposits was greater than the original price paid for the concession.^ It should be borne in mind that the decision was not expressed in accounting terms, nor was it a decision as to what con- stituted profits, but merely that a company, organized to work a wasting property might, in accordance with the terms of its own articles, distribute the net annual receipts without withholding a sum to represent the exhaustion of the mineral deposits, there being no creditors who were thereby harmed. In the above case the question related solely to the treatment of the income of a company specifically organ- ized for the exploitation of wasting assets, or as it is loosely phrased, " with wasting capital." The nature of such an enterprise precludes its permanence. The more suecessfiil its operation, the shorter its life. Like Nan Netticote, of the childish conundrum, the more brilliant its career, the • See e. g. the clear and important decision Excelsior Water & Mining Company v. Pierce. 90 Cal. 131 (1891). United Verde Copper Co. v. Roberts 156 N. Y. 585 (1898). 2 Bond V. Barrow Hematite Steel Co. [1902] 1 Ch. 353, and Wilmer V. McNamara & Co. [1895] 2 Ch. 245. PEOFITS 207 sooner it ends ; the more efficient its management the more quickly will its resources be exhausted. Such an enter- prise differs radically from an ordinary industrial under- taking where the element of permanence and continuity is implied. Tlie decision in Lee, therefore, did not neces- sarily apply to any enterprise other than those with Wasting assets. Five years later a decision almost equally important was given which greatly extended the idea that losses might be suffered without affecting the Profit and Loss account. This was in the ease of Verner v. The General and Commercial Investment Trust, Limited ( [1894] 2 Ch. 239). This concerned a company organized to purchase stock of various other companies, the sole function of the Trust being to make speculative investments dividing the net income as dividends to its own stockholders. The in- vestments made were in diverse enterprises and were made purely for the sake of the income to be derived therefrom. In this particular instance, nearly $5,000,000 had been raised by shares and debentures, all. of which had been in- vested. But some of the investments had been poorly se- lected, and many of the investments having fallen in value, some of them proving altogether worthless, there was an admitted loss of over $1,000,000, equal to one quarter of the capital. Receipts of interest and dividends, however, largely exceeded the current expenses, and the case turned on the legitimacy of paying these net receipts as dividends, instead of using them to make up the loss due to the de- cline i]j the value of the investments. The decision held that such dividends were proper, despite the general legal principle that dividends may not be paid out of capital. Here there was, of course, no question of wasting assets. Investments were not made for the purpose of exploitation and exhaustion, but for permanent income. In the deci- sion, Lord Justice Lindley held that while in general divi- 208 MODEEN ACCOUNTING dends cannot legally be paid out of capital, ;y^et that does not imply that in all eases the loss of capital must be made up before dividends may be paid. A distinction was made between the loss of what was termed fixed capital and of circulating capital. Dividing the income of a company, without the replacement of the circulating capital con- sumed in producing the income, is a payment of a divi- dend out of capital, such as is prohibited by law. " Fixed capital may be sunk and lost and yet the excess of current receipts over current payments may be divided, but floating or circulating capital must be kept up, as otherwise it will enter into and form part of such excess without deducting the capital which formed part of it wiU be contrary to law." In this decision the principle that capital need not be kept up before declaring dividends, which in Lee v. Neu- chatel Asphalte Company was applied only to wasting capital, was extended to so-called " fixed capital " per- manently 'invested in a peculiar enterprise known as a trust. In the following year the doctrine was extended in the case of Wilmer v. McNamara and Company ([1895] 2 Ch. 245) where a decline in the value of the Goodwill of a company was held not to interfere with the payment of dividends on the ground that this loss also was one of fixed and not of circulating capital. Even more far reach- ing was the decision in the Kingston Cotton Mill Company case ([1896] 1 Ch. 348) that the rulings, which in Lee and Verner were applied to companies of a peculiar nature, would also apply to an ordinary manufacturing concern. In the ease of the National Bank of Wales ( [1899] 2 Ch. 629) a decision was given which was even more sweeping in its effect. There the loss which had occurred was one which might be considered a loss of circulating PEOFITS 209 capital, for it was due to the shrinkage in the value of loans made by the bank. But the decision sanctioned the payment of dividends in a year when profits had been earned despite the fact that the losses of previous years were still uncovered. Soon afterwards Justice Wright relying probably on this decision, stated in the case of Crichton's Oil Company: " I do not think that there is any rule of law that profit on one year's trading cannot be divided merely because in the Profit and Loss account there is a deficit over on the balance of former years." ([1901] 2 Ch. 196.) A similar Opinion was expressed by Vaughan "Williams in the decision in the case of Hoare and Company, Lim- ited. " However much capital you have lost at any given date, if yoilr Profit and Loss account shows a profit bal- ance, then to the extent of that profit balance you are en- titled to distribute that money as dividend notwithstand- ing the fact that you have lost capital which you have not replaced."' ( [1904] 2 Ch. 208.) The adoption as a general rule of the principle enun- ciated in these decisions would be to treat each year as a separate unit, and if a judicious arrangement of the ac- counts could be made so as to show alternately net annual profits and losses, to allow a continued distribution of dividends despite the fact that there was a constantly growing deficit due to the loss of circulating as well as fixed capital.* The validity of the decision in the National Bank of Wales case has, however, been very seriously questioned, for although it was upheld in the House of Lords (Dovey V. Cory [1901] A. C. 477) the judgment in the last court was bused entirely on technical grounds, relating to the liability of the defendant director, and in no way vouched for the correctness of the doctrines relating to profits. ' See F. B. Palmer, Company Precedents, I, p. 764. 210 MODEEIST ACCOUNTING Furthermore, each one of the Lords rendering opinions in the latter case took unusual pains to call attention to the the fact that his approval of the decision of the lower court did not imply approval of the doctrine there enunciated as to the treatment of lost banking capital. Again in 1904 it was held that where a company showed a deficit from a preceding year, it was illegal to pay as dividends the prof- its earned later until the preexisting deficit had been made up, and that such a dividend was a payment out of cap- ital. (Towers v. African Tug Co. [1904] 1 Ch. 558). But unfortunately no discussion is given of the principle in- volved, for the decision concerned the competency of cer- tain stockholders to sue and not the legitimacy of the dividend which was assumed to be illegal without discus- sion. And the significance of the decision in Verner is somewhat lessened by the later important case of Bond v. Barrow Haematite Steel Company ([1902] 1 Ch. 353) where, while accepting the earlier decisions regarding the loss of fixed or wasting capital as binding, the court re- garded damages to iron mines and the destruction of a blast furnace and workmen's cottages as all being losses of circulating, not of fixed capital. The latter decision emphasizes the unsatisfactoriness of the distinction which the courts have attempted to draw between a loss of fixed and one of circulating capital. If by this is meant a loss of fixed and circulating assets, there is, of course, the difficulty already alluded to of determin- ing in any concrete case which class of assets has been lost. As the Lord Chancellor said in Dovey v. Cory, " The dis- tinction between fixed and floating capital, which may be appropriate enough in an abstract treatise like Adam Smith's ' Wealth of Nations ' may with reference to a concrete case be quite inappropriate. ' ' In no system of classification known to economists from Adam Smith down is an iron furnace included, as it has PEOFITS 211 been included by the court, in the list of circulating cap- ital. But the objection to this distinction from the tech- nical view point of accounting is even more serious. Part of the assets may be lost, but no particular asset is an embodiment of any particular credit in the Balance Sheet. The asset in question may, indeed, have been bought with the cash paid in on subscriptions to Capital Stock, or from the proceeds of an issue of bonds, or by incurring float- ing debt, or by investing the profits of the business. But the destruction of this particular asset is not thereby made specifically a loss of Capital, or of Funded Debt, or of Current Liabilities, or of Profits. To the accountant the distinction between the Credit items in the Balance Sheet and the Assets is vital. They represent entirely different conceptions and are not to be confused. The decisions of the American courts are perhaps even more confusing and less satisfactory. This is striking be- cause of the fact that in this country the courts have clung rather tenaciously to an invention — now happily obsoles- cent — of Justice Story, that the capital stock of a corpora- tion is a trust fund, to be held for the benefit of the credi- tors. So rigid a doctrine would seem to carry with it an unusual care that the capital should not be encroached upon. While the courts have, of course, rigorously op- posed the direct payment of dividends out of capital, it has already been shown that there has been no consistent recognition of depreciation. As to the specific question of the loss of capital as something distinct from the loss of profits, the most striking decision is that of the Supreme Court of the United States in the case of Eyster v. Cen- tennial Board of Finance : ' ' The receipts of the exhibition, over and above its current expenses are the profits of the business. . . . They are, in fact, the net receipts, which, according to the common understanding, ordinarily repre- sent the profits of the business. The public, when r^^fer- 15 212 MODEEN" ACCOTHSTTING ring to the profits of the business of a merchant, rarely ever take into account the depreciation of the buildings in which the business is carried on, notwithstanding that they may have been erected out of the capital invested. Properly speaking, the net receipts of a business are its profits. So here, as the business to be carried on was that of an exhibition and its profits were to be derived only from its receipts, to the popular mind the net receipts would represent the net profit." ^ (94 U. S. 503.) In this case the enterprise was a peculiar one, analo- gous to a single ship venture; and perhaps to be decided on rules different from those of ordinary mercantile under- taking. In the case of Main v. Mills, a Federal Court de- clared: " There is, perhaps, at this day no better estab- lished rule of law than that the capital stock of a moneyed corporation, whether it be a banking, insurance, mining, or manufacturing company is to be treated and deemed as a trust fund for the purpose of securing the payment of the debt of the corporation. . . . The officers of such a corporation have no right to make dividends to stockhold- ers unless there are profits to be divided, over and above all losses, because the necessary result of so doing is to deplete the capital fund. ... If there are gains and losses, the gains should be set off against the losses so far as may be necessary to keep the capital fund whole." (16 Fed. Cas. 506 (1874).) The State courts have varied in their decisions. The most interesting decisions are in Connecticut — that " net profit ordinarily means what is left after making good the capital "; in Michigan, where net profits are said to be ascertained by a comparison of present assets at actual 1 It is to be noted here that the depreciation referred to is not the ordinary wear and tear due to time's ravages, but the loss of value, save as junk, of the buildings when the exhibition closed. PEOFITS 213 values, with the total original investment; in Iowa, where profits are made equal to assets, at actual value, less lia- bilities; and in California, and New York where the de- cision in Lee v. Neuehatel Asphalte Company, is openly applied to the dividend of a local mining company."^ > The cases referred to are: Cotting v. N. Y. & N. E. R.R. Co. 54 Conn. 156 (1886); Richardson v. Buhl 77 Mich. 632 (1889); Hubbard V. Weare 79 la. 678 (1890); Excelsior Water & Mining Co. v. Pierce, 90 Cal. 131 (1891); and United Verde Copper Co. v. Roberts, 156 N. Y. 585. CHAPTER XII PROFITS (continued) The questions concerning the relation between capital losses and the payment of dividends are threefold. The first is as to the legality of such dividend; the second is as to the business poliej^; and the third as to the proper booking of such transactions. Each of these may in turn be subdivided as referring to Wasting Capital in the tech- nical sense, to ordinary Fixed Capital, using the term loosely, and to Circulating Capital. 1. The legality of dividends, where the " loss " is merely an exhaustion of wasting capital is well established both in England and in this country. That dividends are legal despite the loss of fixed capital is supported by high — but not the high- est—authority in England and by the United States Su- preme Court, with the State courts divergent. But " all of the authorities agree that circulating capital must be kept up." (Bond v. Barrow Haematite Steel Co. [1902] 1 Ch. 353.) 2. The question as to the business policy of making dividends despite losses of capital is, however, independent of the legality of such action. It is most easily decided where the loss is of the first class, that is a loss of wasting capital, or taking the typical case, where the operations of the company consist in exploiting a mine. It has already been shown how the decision in Lee v. Neuchatel Asphalte Company was almost universally criticised. Even Pixley in his latest edition of Duties of Auditors, styles the pay- ment of such dividends " a suicidal policy and contrary 214 PEOriTS 215 to the practice of soundly managed public companies " and " distinctly unwise and unbusinesslike." Despite the high authority of the critics cited there is strong reason for justifying the payment of dividends without making allowance for the exhaustion of the mine. The discussion reduces itself to the question whether min- ing and similar enterprises are to be regarded as perma- nent undertakings, the capital of which should be main- tained, or as temporary ventures corresponding to the character of the natural resources, from which capital as well as profits may be withdrawn as quickly as may be possible without injuring creditors or impairing credit. Those holding the former view claim that so much of the receipts as represents the return of capital should be re- served by the company, and invested so that at the time of the final exhaustion of the mine it would own other assets equaling the entire amount of the capital stock. This view seems entirely to overlook the essential char- acter of the enterprise. A mining venture is always a speculative undertaking. Subscribers to the capital know well that in the nature of things it cannot be a permanent undertaking, and presumably they are aware of its specu- lative character. Their sole object is to exploit a given deposit of mineral, and the logical thing seems to be to have the fruits of such exploitation turned back to the subscribers as quickly as may be. Granting that creditors are not misled nor harmed (and protection can easily be secured by contract) it seems absurd to require that a body of capitalists willing to invest in a peculiar specu- lative enterprise should be forced to form what is prac- tically a trust company to invest part of the annual receipts against some far distant day of accounting. If one pre. fers a' speculative enterprise with possible large gains, what is more unreasonable than to require that his venture should gradually be transformed into something entirely 216 MODERE" ACCOUNTrN'G different, an investment in long time and low rate secu- rities. Better by all means, unless it is thought that paternalistic laws should force him wiUy-niUy to become conservative, to turn back to him the proceeds of the ex- ploitation and aUow him to make another similar venture if he sees fit. Moreover, the very nature of the organization prob- ably is an argument against the accumulation of a reserve. The ofBcers of the mining company presumably were se- lected because they knew how to mine. But this so far from supporting, furnishes a presumption against, the sup- position that they are desirable persons to keep and admin- ister a large trust fund. From all points of view it seems much more sensible to allow the gradual return of capital invested in an enterprise which by its nature is termin- able, than to demand the accumulation of a sinking fund. A dictum of the United States Supreme Court, al- though given in other circumstances, is pertinent to this discussion: " A stockholder (said Mr. Justice Davis in Clearwater v. Meredith) enters into a contract with the company that his interest shall be subject to the direction and control of the proper authorities of the corporation to accomplish the object for which the company was or- ganized. He does not agree that the improvement to which he subscribed should be changed in its purposes and character at the will and pleasure of a majority of the stockholders so that new responsibilities and, it may be, new hazards are added to the original undertaking. He may be willing to embark in one enterprise and unwilling to engage in another. (68 13. S. 40.) This statement was made regarding an extension of a line of railroad out of profits which otherwise would have been distributed to the stockholders. If it applies to a mere extension of a similar enterprise, much more should it hold as regards enterprises so utterly divergent PEOFITS 217 in character as the speculative exploitation of a mine, and the establishment of a trust fund. On the other hand there are certain circumstances in which it might be highly desirable for the company to withhold a sum corresponding to the exhaustion of the wasting capital and reinvest in other similar enterprises. Thus a manufacturing company owning its own coal or iron mines might most wisely reinvest in new mines as the old ones were depleted. But this is a special case. All that is claimed is that there should be no general rule that there must be a withholding of receipts. Even a reinvest- ment in a similar enterprise requires special justification; the creation of a fund to be invested in outside securities of an entirely different nature is much less to be favored. The policy of paying dividends despite the loss of cap- ital where the investment was in other than wasting prop- erty is not so easily defended. Here there is a real loss, not a return of capital; here the enterprise is normally a permanent not a terminating one; here the whole purpose of the enterprise is not to exhaust and return the capital but to use it in business. Circumstances may, however, justify even such a pay- ment of dividend. For instance, an individual's entire income is derived from ten houses each worth $10,000 and each yielding 10 per cent, net income. If two of these houses burn down, uninsured, the common sense view is that the proprietor's income is thereby cut down from $10,000 to $8,000 per annum, and that coincidentally there is a loss of capital of $20,000. It never occurs to him that he must consider his income as entirely cut off for two years until the principal can be restored. Sim- ilarly it might be an act of cruelty to dependent stock- holders to stop dividends entirely until an exceptional loss is reimbursed. The main difficulty is that in a corpora- tion such an occurrence really calls for a reduction of 218 MODEEN ACCOUNTING the nominal capital, a cancellation of part of the capital stock. The red tape and legal expense of doing this, per- haps too the bad effect on the company's credit of giving public notice that there has been an encroachment on cap- ital, make directors loath to do so. The criticism properly to be made is not so much that dividends are paid before restoring the capital (i. e., increasing the assets until they again equal the capital), but rather that the capital stock has not been reduced to correspond with the amount of re- maining assets, before the dividend is paid. To allow divi- dends to be paid while assets are less than the nominal capital seems to render nugatory all the legal provisions regarding the reduction of capital stock. Why enact such careful legal restrictions and yet suffer tlie same results to be reached by the methods permitted in the case of the General and Commercial Trust? The hardship of going entirely without dividends for a series of years may per- haps be considered only a fair return for the exceptional privileges granted to stockholders. As to the policy of paying dividends when there nas been a loss of so-called " circulating capital " there is no argument, provided the meaning of that phrase is taken to be that the income of the company is less than the outgo, and furthermore that there is no accumulated reserve out of which dividends can be paid. Certainly if nothing has been earned all agree that there should be no dividends. 3. The critics generally assume that the courts justify the Neuchatel Asphalte Company and the General and Commercial Trust in presenting accounts misleading and incorrect. Thus Palmer in his masterly work on Company Precedents says : ' ' The views expressed in Verner v. Gen- eral and Commercial Investment Trust involve the propo- sition . . . that the Balance Sheet need not disclose the true condition of the company. It deals as regards the assets riot with existing facts but with past history. It PEOFITS 219 shows what the particular assets cost, not what they are worth. Thus if a company buys a property for £10,000 and the value has fallen to £1,000, it will properly be entered on the Balance Sheet as property that cost £10,000 ; and it will remain at that figure, even though each year, by con- sumption or otherwise, it depreciates more and more. ' ' ^ This implies that the court justifies the use of the last form given on page 200. But this opinion, which is shared by many another critic, not merely ignores the possibilities of accounting technic, but more strangely disregards the express words of the decision itself in which Lord Justice Lindley states: "It is obvious that capital lost must not appear in the accounts as still existing intact ; the accounts must show the truth and not be misleading or fraudulent." ( [1894] 2 Ch. 267.) Similarly in the later case of Barrow Hffimatite Steel Company ( [1900] 2 Ch. 857) Justice Cozens-Hardy very clearly intimates that, although a loss of capital may not prevent the Profit and Loss account from showing a balance available for dividends, the Bal- ance Sheet would at the same time show or imply the loss which had taken place. While the professional accountant sonletimes advises a client as to the legality of certain transactions, the lan- guage of accounting is itself not concerned with legal tech- nicalities. Whether or not the law permits a company to hold its own stock, to issue stock or bonds below par, to make stock dividends, or as in the case here to pay divi- dends while assets are less than the nominal capital is an important, but purely legal matter. If the transaction named has taken place the question as to its technical legality has not— or at least should not have— anything to say as to the statement of facts by the accountant. It may be logical to claim that all losses or gains, however caused, should go to Profit and Loss, and not direct to some '■Vol. I, p. 757. 220 MODEEN ACCOUNTING other Proprietorship account. But such a claim, while logical enough, does not at all conform to accounting prac- tice of any land or time. Once granted that some losses need not appear to the debit of Profit and Loss, the duty of the accountant is plain, and his task is simplicity itself. The loss— say that cited by Palmer— being excluded from Profit and Loss must appear elsewhere. If law requires or permits the reduction of nominal capital stock, and that is done, the loss is deducted immediately from the Capital account. Thus a company which at first shows Form 77. Dr. Balance Sheet. Cr. Plant . . $10,000 .. 15,000 Capital Stock $22,000 Miscellaneous Assets Profit End Loss . . . 3,000 $25,000 $25,000 will after the unfortunate experience, have as its Balance Sheet: Form 78. Dr. Balance Sheet. Cr. Plant $1,000 Miscellaneous Assets 15,000 $16,000 Capital Stock (reduced). . $13,000 Profit and Loss 3,000 $16,000 If the legal steps necessary to reduce the nominal cjip- ital have not been taken, the showing should b;e: Form 79. Dr. Balanc e Sheet. Cr. Property Miscellaneous Assets .... $1,000 15,000 . 9,000 $25,000 Capital Stock .... $22 000 Profit and Loss 3 000 Loss on Capital Account . $25,000 PROFITS 221 Of course some other descriptive term may be used in place of " Loss on Capital Account," the only requirement being that it be not misleading. And greater explicitness can be introduced by indicating the shrinkages, perhaps as follows : Form 80. Dr. Balance Sheet. Cr. Property Original Cost . . $10,000 Less Shrinkage. 9,000 $1,000 Miscellaneous Assets 15,000 $16,000 Capital Outstand- ing $22,000 Less Shrinkage, per Contra 9,000 $13,000 Profit and Loss 3,000 $16,000 The matter is simple— all that is needed is clearness and honesty — and the facts can be presented in various satisfactory forms. The undesirability of paying divi- dends while capital is diminished has nothing to do with the necessity of truthfully showing what has taken place. That such is seldom or never done is perhaps unfortu- nately true, but it does not depend altogether on the much criticised decisions of the courts. The rule that a shrinkage of capital should be shown in the Balance Sheet is, perhaps, to be modified in cases where the loss is incapable of exact, or even approximate, estimation. Thus the cost of an oil well represents wast- ing capital which logically should be written off as the oil is exhausted. But the estimate of the oil supply is so much a matter of guesswork that it may be better to retain the known cost, without attempting any estimate of the rate of exhaustion. Accordingly mining enterprises gen- erally make no allowance for exhaustion. But in some cases,, of which the Colorado Fuel and Iron Company is an instance, regular charges are made against profits for 222 MODEEN ACCOUNTING each ton mined. The idea is, of course, to show the pres- ent actual value. Where the amount of shrinkage is known, it must appear in the accounts. But where the accuracy of a valuation is specious, where the only ascertainable value is the original cost, it may be less harmful for the Balance Sheet to show the cost, indicating that it does not repre- sent the present value. The interested persons can then make their own allowances for shrinkage of capital assets. There are a few questions which arise regarding the Credit side of the Profit and Loss account, that is, as to whether certain increases in the net wealth should appear in that account. Among these may be mentioned the re- ceipt of premium on capital stock. It is evident that such receipts are in no sense profits arising from the business, and custom is opposed to crediting them to Profit and Loss, although by the dictum of Lord Romer in Hoare and Company ( [1904] 2 Ch. 213), they may legally be applied to the payment of dividends. In banks, where the issue of stock at a high premium is especially frequent it is cus- tomary to credit Surplus, and such treatment is alto- gether to be approved. Premium received on bonds is different in its nature. Here the receipt is an offset for high interest paid, or a. "bonus received because of exceptional credit. It is directly proportioned to the time that the bonds run. And as the annual interest is charged against profit during each year of the life of the bond, the only correct method is to credit as an offset to this charge a proportionate part of the pre- mium received. No objection would, however, be made to a conservative placing of the entire premium in some general Reserve account, and, of course, if the amount re- ceived is small, it would be hypercritical to demand that it be minutely divided through a long series of years. Premium arising from the reissue of stock forfeited because of nonpayment of assessments should be treated PEOFITS 223 as any other premium on stock, that is, carried to Reserve or Surplus rather than to the current Profit and Loss ac- count. But the objection to crediting the excess to profits is based on accounting principles, not on law (Gratz v. Redd, 4 B. Mon. Ky. 178). More interesting is the broader question as to whether appreciation in the value of the so-called capital assets is divisible as profits. This is clearly the reverse of the ques- tion previously discussed. There the concept of a loss of capital as something distinct from a loss of revenue was introduced. The reverse, that there is possible an increase of capital which is not profit involves the same principle. Discussion has been somewhat confused by not clearly dis- tinguishing between an appreciation which has been real- ized, and one which is estimated only. But where the. gain is actually realized, it certainly may be credited to Profits, although if the gain be exceptional it would conservatively be placed to some Surplus or Reserve account. This doubt less is inconsistent with the doctrine of Lee v. Neuchatel Asphalte Company. Indeed one argument given by the court in favor of excluding the shrinkage in value of cap ital assets was that a contrary rule would imply that divi- dends might be paid out of the increase in value of capital, which was said to be " contrary to all practice and to principle." But this very doctrine, in so far as it relates to a real- ized gain, was soon fully admitted in Lubbock v. British Bank ([1892] 2 Ch. 198) which has since been followed in various decisions. However successfully the courts at- tempt to distinguish between capital and revenue, or even between a shrinkage of capital and a loss of revenue, there is now no effort to differentiate between a realized gain due to the appreciation of capital assets and other income.^ • Some exceptions to this may be found in case of the final distribu- tion of assets of liquidated concerns. 224 MODERN ACCOUNTING More delicate is the question of unrealized profits. In the discussion of the Inventory in Chapter IV, it was shown that mere fluctuations in value may be disregarded ; and that even permanent appreciation, if it is of assets whose nature is such that the gain cannot be realized by the going concern, should similarly be left out of account. Thus an estimated appreciation in the value of the factory site should be left out of account, even though the estima- tion have every element of certainty. The prohibition of thus marking up assets precludes any credit in the Profit and Loss account, or elsewhere. But where the apprecia- tion is in merchandise, or in what are commonly called circulating assets, there is less uniformity. It has been seen that German law distinctly prohibits the taking of profits due to appreciation of unsold merchandise, even where the increased value is evidenced by quoted prices in produce or stock exchanges. But on the other hand Aus- trian law authorizes the taking of such profits. A leading Massachusetts case held: " The profit and loss of trade in merchandise is not confined to that which results from sales. Depreciation or advance in value of the stock un- sold must also be taken into account. (Meserve v. An- drews, 106 Mass., 419 (1871),) But in this case there had been a loss by fire so that the ruling regarding an advance in value is less authoritative. Furthermore, the case re- ferred to a final settlement or dissolution of partnership, which differs in important particulars from the status of a going concern. The opinion of accountants, always siding toward wise conservatism, is well-nigh unanimous against taking profits on unsold goods. But the difficulties are not yet all settled. Frequently goods have actually been sold at an advance, but the pay- ment for them has not yet been received. Or interest on loans and investments may have accrued, but either is not yet matured, or if matured, is not yet paid. Had cash PEOFITS 225 been received these would most obviously be couiited as profit, but objection has at times been made to including in profit anything not received in cash. From the maze of discordant decisions the puzzled accountant seeks in vain for a safe guide. The earlier English cases were satisfac- torily clear, especially Stringer's case (L. R. 4 Ch. 475 [1869]) where it was held that cash need not be in hand, and that the obligations of the Confederate government honestly estimated as good, were a correct basis for deter- mining profits available for dividends. This decision has long been accepted as authority, yet an entirely different doctrine was enunciated so late as 1902 in Badham v. Williams, in which Justice Kekewich gave an opinion so remarkable as to deserve quoting at some length : " If it is a mere question what were the profits made in a par- ticular year, it seems to me that the duty is to ascertain what cash has been received and what cash has been ex- pended, and, if that is fairly done, you know the profits of the year. If there is a large outstanding liability which cannot be settled, the partners will estimate that, and it will not be considered as part of the profits. If there is a large outstanding possible loss, and there is a large sum due to a client, then you would provide for that. But in ascertaining what is really actually divisible for the year fairly, you take the cash account as it stands. ..." " A merchant in London consigned a cargo to some foreign port for sale in 1901. Suppose the payment is made by bill perhaps at six or three months, it may run into 1902. Now, are they to treat that as concluded in 1901 and consider that business as attributable entirely to 1901 when the bill may not be met at maturity? Are they to consider those as so much cash for the purposes of that business ? It seems to me that that would be entirely wrong in the absence of a special agreement. For the pur- poses of the balance sheet, no doubt, they would estimate 226 MODEEN ACCOUNTING that there is an- outstanding asset which they hope to real- ize; but for the purpose of ascertaining the profit and loss— that is to say, what is to be divided it seems to me that they must consider only what they have received, be- cause those bills will only come in when met at maturity in 1902," (86, L. T. R. 191.) In the United States the courts have more generally considered that only actual receipts and payments are proper entries in the Profit and Loss account. It is true that the United States Supreme Court in 1893 (Reagan V. Farmers Loan & Trust Co., 154 U. S., 362) held that accrued interest payable should be considered, but that did not cover the question of interest receivable. As has been seen the same court in Eyster v. Centennial Board of Fi- nance identified profits with net receipts. In California, moreover, it has been specifically . held in People v. San Francisco Savings Union that interest accrued, even on United States bonds, cannot be considered in determining profit. In the course of the decision, which is well worth reading in full, the court says: "It is not easy to com- prehend how profits or surplus profits can consist of earn- ings never yet received. The term imports an excess of receipts over expenditures and without receipts there can- not properly be said to be profits. Money earned as in- terest, however well secured or certain to be eventually paid . . . does not constitute surplus profits within the meaning of the statute." (72 Cal. 199 (1887).) In New Jersey and Missouri, on the contrary, it has been held that profits are not necessarily limited to money received. (Jones v. Davis, 48 N. J. Eq. 493 (1891). Slay- den V. Coal Co. 25 Mo. Ap., 439 (1887).) Much of the confusion is doubtless due to a mere dif- ference in terminology, and oftentimes the term' " prof- its " in legal use means " profits available for dividends." The courts may well place certain restrictions on the pay- PEOriTS 2127 ment of dividends which would not at all correspond with the accountant's limitations of the concept of profits. In- deed, this is in many cases done by statute; as is true in a number of the Spanish American Republics, which pre- scribe that only liquid profits may be paid as dividends. It may be accepted that it is incorrect to base a dividend on unrealized profits, or indeed that an unrealized gain is " not profit, but the hope of profit." There is good busi- ness conservatism in the argument of Dupin, " One does not divide hopes, however well-founded; one does not di- vide a phrase, but money. A dividend before going out of the treasury of the company, ought first to have come into it."i But the distinction between unrealized and realized profits is by no means the same as that between profits which have been received in cash and those otherwise rep- resented. Profits are in fact realized when once the trans- action is completed. If it is a sale of merchandise the selling price includes both profit and a portion of the cap- ital. It matters not whether this price is represented by cash, or by the note of the purchaser, or by other assets received in payment, provided, of course, that there is no valid doubt as to their real value. If the claim against the purchaser is good, profit has been realized; if the claim is not good, there is not only an absence of profit but a further loss representing the original investment. To rec- ognize part of this sum as good and to discriminate against the other larger part is clearly illogical. Illogical is the attitude of the California court that the claim for one per cent, interest against the government may not be counted good, while the hundred per cent, of principal still stands among the assets at its full value. The whole discussion of the form in which profits are received involves the frequently recurring confusion to ' Quoted in Bastide: Des Dividends fictifs, p. 36- 228 MODEKN ACCOUNTING ■which reference has been made, between assets and the ■credit side of the Balance Sheet. The assets cannot be dis- tinguished as being this capital and that profit. All the assets together equal capital and profits. Hence as Mr. Ernest Cooper has pointed out the question as to whether the profits are liquid or not cannot legitimately be raised.^ Furthermore, it is quite possible for a company to pay >iividends even though it has no cash. Thus the Dutch JEast India Company regularly paid part of its dividends in spices. A more modern instance is the dividend de- clared in 1907 by the Atlantic Coast Line and paid by its own certificates of deposit, then lying in the treasury. But it certainly would be unwise for a court to compel the payment of a dividend in the absence of liquid assets ■and the decisions cited are based on this practical objection rather than on any recognized principle that profits exist only when in cash. And even unliquidated earnings have at times been made the basis of compulsory dividends, 'as in the case of the charter of the Prussian See-Handlungs- Gesellschaft, which prescribed the issue of scrip where •cash was not available. In charity to the courts the de- cisions cited are to be interpreted not as meaning that only cash earnings are profits, but that the courts will not compel a company to pay a dividend when the absence of cash or its equivalent might compel a perhaps disad- vantageous borrowing, or a loss due to a forced sale of some of the assets. Other decisions of the courts are rational only in a similar loose interpretation. Thus it has been held : ' ' All the debts (other than funded debts) . . . are debts to be paid before the profits can be ascertained." (Corry v. Londonderry & Enniskillen Ry. Co., 29 Beaven 263 [3860]), and while it was later said to be a "curious theory . . . that there never can be any available income ' Accountant^ XIV, p. 746. PROFITS 229 or any profits as long as there is a debt remaining unpaid " (Mills V. No. Ry. of Buenos Ayres Co. 5 Ch. App. 621 (1870)) the same theory has more than once been openly propounded in American courts. Even the United States Supreme Court held that: " Net earnings are what is left after paying current expenses and interest on debt and everything else the company is liable to pay ": (War- ren V. King, 108 U. S., 389, 398 [1882]) and the same high authority later defines profits as denoting: " What remain after defraying every expense, including loans fall- ing due, as well as the interest on such loans." (Mobile, etc., R. R. V. Tenn., 153 U. S., 486 (1894).) Taken literally the notion that debts must be paid be- fore profits are ascertained is to the accountant both ' ' cu- , rious " and " absurd." But that the court should refuse to order a dividend, when the depletion of the treasury might make an impending debt disastrous is perfectly rea- sonable. It is only to be regretted that in taking a con- servative position, it should be done at the cost of confused terminology and questionable theorems. The limitation of profits to cash receipts is closely con- nected with the question of borrowing funds with which to pay dividends. If profits have really been earned, the replenishment of the cash account through borrowing re- moves any objections which the accountant might have to the declaration of a dividend. But Lord Justice Lind- ley characterized the payment of dividends with borrowed money as being " as unjustifiable in point of law as it would be reckless and blameworthy in the eyes of business men." (Verner v. General & Commercial Trust [1894] 2 Ch., 266.) Here again the decisions are discordant. In some eases the payment of dividends with borrowed funds has been condemned (Davis v. Flagstaff Silver Mining Co., 2 Utah 74'; Belfast & Moosehead Lake Ry. Co. v. Belfast, 230 MODERX ACCOUNTING 77 Me., 445 (1885)), but the lucid decision in "Williams V. Western Union Telegraph Company (93 N. Y. 162 (1883) ) showed that where the surplus had been invested in the plant, the company " could borrow money on the faith of it and divide that " (p. 192). ' In the even more extreme case, where the Balance Sheet showed for a time no surplus because improvements had been charged against past profits, it has been held legitimate to credit back to revenue such expenditures, and then to borrojv funds so as to distribute the surplus thus reestablished. This was clearly brought out in Excel- sior "Water and Mining Company v. Pierce, where the ex- pense of constructing a tunnel was charged up against - profits. Afterwards the company borrowed funds repre- senting the cost of the tunnel and used them to pay divi- dends. The court said: " The result is precisely the same as if the money had been borrowed sooner and the identi- cal money borrowed paid out on the tunnel. Nothing has been accomplished beyond what the directors had a right to do, and surely the mode in which it has been done can make no difference. In fact, the transaction may be re- garded as a temporary borrowing from the dividend fund of the sum necessary to meet an immediate demand, with the advantage to the corporation of keeping its money em- ployed and saving it the payment of interest." (90 Cal. 131 (1891). )'i The accountant cannot disregard the decisions of the courts, or he may find that he has led his clients into an action for which they may be held liable. But it is evident that many of the decisions to which reference has been made are at least, on the face, opposed to what the ac- countant considers fundamental principles of his profes- sion. Some of. these contradictions can be smoothed over 1 See ako Mills v. Northern Railway, etc. (L. R. 5 Ch. App. 621 (1870).) PEOFITS 231 by recognizing that the courts and the accountants are attaching quite different meaning to the technical terms of commerce. Difficulty may be avoided by the accountant continuing to lean, as in the past he has generally done, toward conservatism, for wjiile the courts, as in the ques- tion of loss of capital, sometimes permit, they never compel an excessive estimate of profits. But for a more perfect rationalization of the legal dicta concerning profits, it will probably be necessary to await the day when the growing dignity of the profession of accounting shall cause its principles to permeate the ranks of bench and bar. BIBLIOGRAPHICAL NOTE TO CHAPTERS XI AND XII Books Bastide, J. Des dividends fictifs. Toulouse, 1903. Buckley, H. B. The Law and Practice Under the Companies Acts, pp. 584r-592. Eighth edition. London, 1902. Chakpentiee, J. Etude juridique sur le bilan dans les soci^tfe par actions. Paris, 1906. Claek, W. L. and Marshall, W. L. A Treatise on the Law of Private Corporations, pp. 518-520. St. Paul, 1901. Cook, W. W. A Treatise on the Law of Corporations Having a Capital Stock, p. 546. Fifth edition. Chicago, 1903. Dale, B. How Are the Profits for the Year to be Ascertained? Second edition. London, 1897. Dickinson, A. L. The Profits of a Corporation. New York, 1904. (Published also in the Official Record of the International Congress of Public Accountants held in St. Louis, 1904.) [A brief but comprehensive and most valuable treatise.] DiCKSEE, L. R. Auditing. American edition, pp. 232-250. New York, 1905. Palmer, F. B. Company Precedents. I. 737-768. Eighth edition. London, 1902-1903. [Contains an extended review and a criticism of the English decisions in the Lee series.] PixLBY, F. W. Auditors, their Duties and Responsibilities. I. Chapter XIII. Ninth edition. London, 1906. 232 MODERN ACCOUNTESTG Periodicals Are the Decisions of the Courts Respecting the Distribution of the Profits of a Limited Company Opposed to Sound Commercial Finance? Accountant, XXIX, 80. CooPBH, E. Chartered Accountants and the Profit Question, Ibid. XX, 1033. [See also editorial discussion, pp. 1073, 1088, 119.] Dawson, S. S. Capital and Divisible Profits. Ibid. XXIX, 119. Divisible Profits of Companies. A Plea for Fuller Parliamentary Recognition of Double Accounting. Ibid. XXVm; 417. [Argues that losses of fixed capital should be excluded from the accounts.] James, A. The Divisible Profits of Companies. Ibid., XXVIII, 285. Welton, T. a. On the Profits of Companies Available for Distribu- tion. Ibid., XIV, 677. For a discussion of the correct method of exhibiting capital losses, see: Keen, F. M. The Balance Sheet of a Limited Company. Ibid., XXIV, 399. The Reduction of a Company's Capital. Accountant, XXVI, 867. Vavasseur, a. Traite des sf^icietes civilea et commerciales. § 649. Paris, 1897. CHAPTER XIII SURPLUS AND RESEEVES In the accounts of individual traders the Profit and' Loss account is, at stated intervals, closed out, and the balance is carried to the credit of the proprietor's Capital account. Profit and Loss is thus in practice, as well as; in theory, a mere temporary subdivision of the main Pro- prietorship account, and at the close of the year is indis- tinguishably merged with the latter. In corporation ac- counting it is necessary to keep the accretions of wealth separate from the original capital contributions. Never- theless there is customarily a closing of the books, and an. apportionment of the annual profits of corporations simi- lar to that which takes place in the books of the individual or of the partnership. At such a time a part of the profits are normally voted as dividends and immediately pass out of the control of the corporation. But it is unusual to dis- tribute all of the profits earned and there is ordinarily further action by the directors or stockholders deciding to retain part of the profits. The profits thus reserved from distribution are called Surplus, and constitute an addition to the capital of the concern, practically as in the partnership the profit balance is retained as capital by being added to the proprietor's account. Even in corporation accounting the sinlilarity between Capital and Surplus is sometimes observed, as for instance in the tabular statements prepared by the Comptroller of the Currency, in which Capital, Surplus, and Undivided Profits are all grouped and included in a single sum; and 233 234 MODEEN ACCOUNTING not infrequently in published balance sheets Capital and Surplus are similarly combined. "While there are legal differences in the treatment of the two categories, yet from the view point of accounting, a Surplus represents capital secured by reserving profits, in contradistinction to capital contributed directly by the stockholders. ; Some technical exceptions are to be found to the state- ment that a Surplus means reserved profits. A Surplus occasionally is established by a corporation de novo, before any profits have accrued, out of part of the contributions made directly by the stockholders. This is particularly the case in organizing banks where stock is often sub- scribed for at a premium. It is questionable whether this premium can rightly be credited to the Profit and' Logs, or Revenue account. Some accountants permit this and the English courts have declared it legal (In re Hoare & Co. [1904] 2 Ch. 213). But statute law in Germany, and the better practice both in England and the United States, hold that such premiums are no part of ordinary profits, and as they cannot be credited directly to capital are to be placed in a special Reserve or Surplus account. Where this is done there is technically no reservation of profits, but at least it is a reservation of the excess above capital, the peculiarity being that an excess over capital, normally caused only by the gain of profits, is in this case created by a contribution of the stockholders. Other circumstances in which a Surplus is created otherwise than by accumulating profits are: where the stock of a company is reduced without full return to the stockholders of the par value ; where stock is bought in the market at less than its face value; and less clearly where bonds are similarly redeemed. The payment some- times made by stockholders in return for having their holdings given the privileges of preferred stock, or other SIJEPLUS AND EESEE.VES 235 similar advantages, likewise properly gives rise to a Sur- plus which strictly speaking is not profit. Occasionally, too, stockholders make a voluntary contribution, generally of stock, for the purpose of providing means for raising cash for working expenses, which again creates a Surplus not derived from profits. In all these cases it would not be illegal, except when statute law distinctly prohibits, as is the case in Germany, to treat these receipts as profits available for dividends, and they may therefore all be regarded as exceptions to the general statement that a Surplus or Reserve is a portion of profits withheld from distribution. Accounting nomenclature, however, is so vague, that it is not always easy nor possible to determine from a Bal- ance Sheet whether certain items represent an actual res- ervation of profits or whether they are merely Valuation Accounts; that is, accounts indicating that a deduction must be ("made from the book value of the assets. This may be illustrated by taking a company whose books, at the end of a year, make the following showing: Dr. Form 81. Trial Balance. Cr. Plant at cost S50,000 Accounts receivable 50,000 Expenses 50,000 Miscellaneous Assets. . . . 25,000 $175,000 Capital $100,000 Sales 75,000 $175,000 This shows an apparent gain of $25,000, but no allowance has as yet been made for depreciation, without which prof- its cannot be determined. Assuming the depreciation to be $5,000 the Balance Sheet may show : 236 MODEEN ACCOUNTING Dr. Form 82. Balance Sheet. Cr. Plant at cost $50,000 Accounts receivable 50,000 Miscellaneous Assets .... 25,000 $125,000 Capital $100,000 Depreciation' 5,000 Profits 20,000 $125,000 The directors or stockholders decide that business is so profitable that it will be desirable to extend the plant within a few years, and in preparation therefor vote to withhold $5,000 of the profits as the beginning of a fund with which to make the expected extensions ; and in order to be on the safe side they vote to reserve $1,000 to cover any possible future loss which may occur when attempt is made to realize on the accounts receivable. They fur- thermore decide to hold $5,000 as a Surplus, or permanent addition to the capital resources, and vote a dividend of $8,000. This leaves an unappropriated balance of $1,000. The Balance Sheet then reads as follows: Dr. Form 83. Balance Sheet. Cr. Plant at cost Accounts receivable. . Miscellaneous Assets.. $50,000 50,000 25,000 $125,000 (1) Capital $100,000 (2) (3) (4) (5) (6) (7) Depreciation Fund. . Reserve for exten- sions "Reserve" for Bad Debts Dividends declared.. Surplus Balance of Undi- vided Profits 5,000 5,0(D0 1,000 8,000 5,000 1,000 $125,000 ' The depreciation account is purposely left on the credit side instead of being subtracted from the valuation of the plant in order to emphasize the distinction made below. SUKPLUS AND EESEEVES 237 The terms here used are customary ones, but usage is not absolutely fixed and other titles are frequently met in Balance Sheets. So far as it is possible to give a fixed definition the differentiation in the terms used is about as follows: Surplus indicates a portion of the profits withheld from distribution for the purpose of establishing a per- manent addition to the effective capital of the concern. It does not imply any specific use to which it is to be put and is perhaps the most comprehensive of all the terms employed to designate reserved profits. Reserve generally contains the idea of some special pur- pose for which the reservation is made. This is, however, not uniformly so, as there are frequently found certain Reserves made for some specific purpose, and a more gen- eral Reserve, which would correspond exactly to " Sur- plus " as used above. By some Reserve is differentiated from Surplus by implying some peculiar investment, as is shown later, but this is not a generally accepted con- vention. In Germany Reserve is the common term, there being no equivalent to Surplus. Undivided Profits merely indicates, as the name sug- gests, a portion of the profits on which no specific action was taken. But the fact that it was not voted as a divi- dend does constitute it, in fact though not in name, a Sur- plus Reserve. The reason for differentiating is the unwill- ingness to distribute so closely the profits as to run the risk of having a Debit balance appear in the Profit and Loss account. Other titles are used. Rest, in England, is the equiva- lent of Surplus or of Reserve (in the general sense) ; Re- serve Fund is used, either as synonymous with, or with varying differentiations from. Reserve; Specific Reserves are often called by some distinguishing title, as, for in- stance. Renewal Fund, Sinking Fund, etc. ; and in Ameri- 238 MODEEN ACCOUNTING can Railroad practice the undivided profits appear as Bal- ance of Income Account. In examining a Balance Sheet, such as is shown above, the most important thing is clearly to distinguish between the items, of which Depreciation Fund (2) is the type, and those of which Reserve for Extension (3) is the type. This is all the more difficult in practice because the titles used are frequently more similar than those given above, for (2) is often called Reserve for depreciation, or Reserve Fund for Depreciation, and (3) may simply be called Re- serve or Reserve Fund. Yet the real distinction between them is radical, and the use of the term Reserve in the former sense, while not uncommon in American account- ing, is open to serious criticism. The Depreciation Fund does not represent profits at all ; it does not indicate owner- ship of any net wealth in addition to that represented by the capital stock. On the contrary, it is a Valuation Ac- count indicating that a deduction must be made from the value of assets given on the Debit side of the Balance Sheet. The Reserve for Extension (3) is, however, a part of the profits; it does represent an addition to the orig- inal net wealth shown in the Capital account; it shows that assets have increased. To distinguish between Valu- ation Accounts and Reserves proper is therefore no less important than it is difficult. Item (4), " Reserve for bad debts " is perhaps even more difficult to classify. There has been no wear and tear. No one of the accounts is known to be bad; no single one of them is even suspected. Each is carried on the books at its full value, and perhaps no one of them would b6 sold at a discount of two per cent. Yet ordinary common sense and business experience show that a loss is likely to occur, and a Reserve is provided so that if a loss should take place it need not be charged against the current prof- its. From the outside it is impossible to say whether this SUEPLUS AND EESEEVES 239 is nearer akin to depreciation or to a reservation of prof- its. If under the law of probabilities the loss is practically certain to take place, it is logically a depreciation for an unrealized but existing loss. If the creation of the Reserve was based on a minimum certainty and a maximum of prudence it represents a reservation of profits. The bal- ance left standing to the credit of Undivided Profits is logically and legally a Reserve, even though not techni- cally so called. Profits which might have been distributed were not voted as dividends and are, ipso facto, held as a reserve. The only difference is a psychologic one, and consists in the fact that the directors have apparently not expressed so definite an intention of permanently holding the balance, as they have done in regard to the Reserve for Extensions and Reserve -for Bad Debts. A Surplus, by whatever name it may be called, repre- senting additional capital (normally derived from profits) the purposes for which it is created may be any of those for which capital is needed, or it may be used, as profits ordinarily are used, to provide means for paying divi- dends. More specifically reserves are created: (1) To provide a permanent increase of capital (a) As an additional guaranty to creditors (b) To provide for extension of its fixed or other capital assets. (2) To provide an additional capital which can be used to cover unusual losses or to provide for other emergencies without encroaching on the nominal capital, and (3) To provide for equalizing dividends by retaining part of one year's profit to be used to make up scanty profits for other years. 1. The provision of additional capital as further pro- tection to creditors is frequently specifically required by 240 MODERN ACCOUNTTriSrG statute. In this country the best example is found in the National Bank Act, which requires that one tenth of the annual profits must be retained until a Surplus amount- ing to twenty per cent, of the capital stock is accumulated. More comprehensive are the laws of Germany and Prance, which require all corporations to reserve a percentage of the profits, and in addition certain particular receipts, as, for example, premium on stock. In both these cases the purpose of the law presumably is to furnish additional security to creditors of the corporations concerned. An- other example is the establishment of a Sinking Fund to pay off a bonded debt, which according to current prac- tice in the United States is, as is shown below, a Reserve to protect the creditors. The extension of the business through reserves is of frequent occurrence. A most striking instance is the Chemical National Bank which, with $300,000 capital stock, accumulated a surplus of $6,000,000. But the prac- tice is of much older origin, for the Bank of St. Ambrose, established in Milan in 1593, made a practice of distribu- ting only half its profits and accumulated a large surplus ; and the early trading companies similarly divided only a fraction of their profits. Similarly many railroads and industrial corporations show reserves which make a very appreciable addition to their capital. An instance which has caused considerable discussion is the Wells-Fargo Ex- press Company with $8,000,000 capital and over $16,000,- 000 surplus. In foreign countries the accumulation of permanent reserves is an accepted practice — the average reserve of all Austrian corporations being over 27 per cent, of the capital, while that of the savings banks is over 105 per cent. 2. The second class of Reserves is that created not to provide for a general extension of the enterprise, but to prevent its curtailment by providing a fund to be used in SUEPLUS AND KESEEVES 241 special emergencies. A clear case is a Renewal Fund cre- ated by a steamship company to be used to replace ves- sels lost at sea. But more general aims may be in view, such as the provision against any unseen loss, whether caused by bad debts, by slack business due to hard times, or by any of the countless dangers which beset the course of business enterprise. Because of such a reserve the First National Bank of Chicago some years ago was able to charge off at one stroke a million dollars of its notes and bills, whose ultimate payment was made uncertain as the result of the panic of 1893. Another corporation in 1903 suffered loss to its property by the hurricane in Jamaica, a loss surely not distinctly anticipated, yet one which was most conveniently covered by a previous Surplus. Such provision against unforeseen emergencies may perhaps be construed as one form of a protection for credi- tors, and the legal reserves mentioned above are as a mat- ter of fact generally used to cover exceptional losses. , But this provision inures as well to the benefit of stockholders, and in many cases the establishment of a Reserve for emer- gencies is inspired by regard for the stockholder rather than for the creditor — if indeed the two interests can be separated. Among such emergency reserves may be men- tioned a " Reserve for personal injuries " of a coal com- pany; a " Reserve for accidents " not unreasonably pro- vided by a manufacturer of powder; and an " Accident fund " of a street railway company. 3. The final type of Reserves is that for the purpose of equalizing dividends. Here it is scarcely correct to say, as has been done by some writers, that the Reserve creates an addition to Capital, for Capital does not provide a fund for dividend paying. Here the Reserve preserves rather its original character as profits— profits not distributed during the current year, but to be distributed as dividends in future years, when the annual profits may be scant. 242 MODEEN ACCOUNTING This is a most common practice of which many instances are found in American corporation finance. The different purposes enumerated ahove are not al- together distinct or mutually exclusive, the provision for unusual losses, for instance, being at the same time an ad- ditional guaranty to the creditor and a means for equaliz- ing dividends. The purpose of a surplus may be more or less definitely limited and specialized. Most commonly, indeed, there is only a single Reserve created which is general in its char- acter, and may be used for any of the purposes enumer- ated. On the other hand the purpose may be strictly lim- ited, as for instance a Reserve for erecting a particular building, or for constructing a certain bridge. The United States Steel Corporation, for instance, as shown in its Bal- ance Sheet (Form 29) has in addition to its several Sink- ing Funds no less than eight Reserves, including funds for contemplated appropriations, for authorized appropria- tions and for the specific purpose of building the plant at Gary, Indiana. The Balance Sheet of the Atchison, To- peka and Santa Fe Railway (Form 27) shows almost equal differentiation. But even where the Reserve is a special one there is no assurance that it will be devoted to the purpose for which it was created. The specific labeling of a Reserve is at best merely a declaration of the pres- ent intentions of the existing board of directors. As both intentions and boards are subject to change, there is no guaranty that the Reserve will be used for the indicated purpose. Continuity may, however, in some eases be se- cured by pledging certain funds representing the reserve, as for instance where investments representing a Sinking Fund are given in trust to sinking fund trustees who can use them only for the purpose of retiring specified bonds. A compulsory Reserve is also to a limited extent preserved from division. In Germany the uses to which it may be SURPLUS AND EESEEVES 243 applied are definitely prescribed; in this country the Sur- plus, compulsory for National and for some State banks is presumably safe from being used to pay dividends. But even here the restriction is only a limited one, for a loss which otherwise might have prevented dividends, may be charged to Surplus. Thus a company showing Dr. Form 84. Balance Sheet. Cr. Assets -. $615,000 $615,000 Capital $100,000 Surplus 10,000 Deposits 500,000 Undivided Profits 5,000 $615,000 suffers an unexpected loss of $5,000 and charges this against Undivided Profits. It will then probably not be considered in a position to pay a dividend. But by charg- ing the unusual loss against Surplus, there results the fol- lowing : Dr. Form 85. Balance Sheet. Cr. Assets $610,000 $610,000 Capital $100,000 Surplus 5,000 Deposits 500,000 Undivided Profits 5,000 $610,000 a showing which makes the legitimacy of a dividend un- questionable. Frequently the designation given to a Reserve refers not to the purpose for which it was created, but to the source whence the surplus came. Thus are found the fol- 17 244 MODEEN ACCOUNTmG lowing items: Premium received on old stock, Stock pur- chase surplus, Real estate sales. Royalties, Surplus from redemption of bonds, etc., all of which indicate the source rather than the purpose of the Reserve. A Surplus being a reservation of profits must be rep- resented by equivalent assets. It is the increase of assets that creates all profit, and necessarily that portion of the profits reserved from distribution. To speak of a Surplus without equivalent assets is, therefore, self-contradictory. But with the ambiguous usage of the term Reserve the question often arises as to whether it represents assets or merely signifies the depreciation in value of some of the assets. Some writers have even demanded that the term Reserve should never be used unless it represent not merely the existence of equivalent assets, but that certain specific assets, of a particular character have been set aside to cover the Reserve. Deferring to a subsequent paragraph some distinctions in terminology which have been involved in this contro- versy, it may here be inquired whether the distinction between a Reserve represented by specific assets— a spe- cially covered Reserve or as some term it a Reserve Fiind — and one not so represented is significant. The primary objection to the claim that a Reserve on the Credit side of the Balance Sheet must be represented or covered by certain specific assets, is that it implies a confusion of the two sides of the Balance Sheet, of Goods accounts and Proprietorship accounts. The Debit side of the Balance Sheet lists certain specific Goods, the value of which, less liabilities, equals the sum of the various Proprietorship accounts; but there is ordinarily no spe- cific asset corresponding to specific Credits. Bonds may have been issued to purchase plant, preferred stock to pur- chase present Goodwill, common stock to represent the esti- mated additional earning power of the consolidation, but SUEPLUS AND EESERVES 245 the Balance Sheet does not make a separate equation of these three pairs. It suffices to show that Plant + Good- will = Preferred stock + Common stock + Bonds. It is true that the equating of the various items is in part secured by the double account form of Balance Sheet required of certain English Cpmpanies, where the receipts from Capital Stock and Bonds are balanced against the more permanent investments. There is also a comparison made, though not a definite equation between various sub- heads frequently introduced into modern Balance Sheets, as for instance between Capital Assets and Capital Liabil- ities and between Current Assets and Current Liabilities. But even in such cases there is no real equivalence stated between a given Credit and some other Debit item. The equivalence of the Balance Sheet is that between the sum of the items representing proprietorship and liabilities and the sum of those representing assets. The groups into which these assets are subdivided and the various subdi- visions into which Proprietorship is for convenience divided, are divergent systems of classification and should not be confused. In the varied shifting of form which con- tinually takes place in the assets, an original correspond- ence between certain Credits and Debits becomes lost and the connection can no longer be traced. Undoubtedly every depositor and stockholder in a bank contributed some particular money or other asset equivalent to his de- posit or his subscription; but the identity is lost at once upon the title passing to the bank and there is no specific asset representing the particular claim of A although, for convenience, there may be a comparison, though not a balancing of the items of Deposits and Cash Reserve, or of Deposits and Discounts. Secondly, the. setting aside of a specific asset does not make the Reserve any more secure, any more available. For instance, a Balance Sheet shows: 246 MODERN ACCOUNTING Dr. Form 86. Balance Sheet. Cr. Miscellaneous Assets. . . Investment of Reserve Fund . $120,000 5,000 $125,000 Capital Debts Reserve for Extension. . . $100,000 . 20,000 5,000 $125,000 A debt becomes due, which because of financial stringency cannot be renewed or placed elsewhere. Unless the invest- ments of the Reserve have been specifically placed in trust, they will in such an emergency probably be sold to provide cash to pay the debt. The Balance Sheet becomes: Dr. Form 87. Balance Sheet. Cr. Miscellaneous Assets $120,000 $120,000 Capital $100,000 Debts 15,000 Reserve for Extension. . . 5,000 $120,000 The specific investment has not made the Eeserve for Ex- tension any more available than it otherwise would have been, and the Reserve remains despite the disappearance of the specific investment. On the other hand the Reserve is no more secure because of the specific investment, for supposing that the business of the year following the show- ing of Form 86 results in a net loss of $5,000, the Balance Sheet then becomes: Form 88. Dt. Balance Sheet. Cr. Miscellaneous Assets $11 5,000 Investment 5,000 $120,000 Capital $100,000 Debts 20,000 Reserve for Extension. . . $120,000 SURPLUS AND EESEEVES 247 so that while the specific investment is still intact the Re- serve has disappeared as effectively as possible. It would be illegitimate to show Form 89. Dr. Balance Sheet. , Cr. Miscellaneous Assets $115,000 Investment of Reserve Fund 5,000 Loss 5,000 $125,000 Capital $100,000 Debts 20,000 Reserve for Extensions . . 5,000 $125,000 for the Reserve indicates that there has been a reserva- tion of part of the profits amounting to $5,000 while the Loss item shows there are no profits to be reserved. This is shown even by Pixley who, himself, argues strongly that a Reserve Fund must be specifically invested. 3. And finally, although this pertains to corporation finance rather than to accounting, the identification of Re- serve with specific assets lends itself easily to two false theories : (1) That an outside investment is a better holding for the corporation than an investment in extending its own plant, and (2) that where a fund of cash, or other liquid assets is desirable as a provision for emergencies, such provision need not be made out of capital, but only as profits accumulate. The first of these views is undoubtedly true in certain circumstances, as where provision is being made for an emergency demanding ready funds, but as a general principle it is without validity. The second view is altogether unsound and vicious in principle and in practice. In such matters, where personal opinion and taste have much weight, it may be well to quote two leading authori- ties, one German and the dther English. Says Rehm: 248 MODEKN" ACCOUNTING " A Reserve Fund is not an asset but merely a technical indication of property in such. It signifies that a given value of assets may not be distributed or disbursed; but as it is not assets it cannot be an item on the Asset side of the Balance Sheet, and accordingly it also cannot be transferred into assets and invested in given securities. ' ' ^ Dicksee similarly says: " It cannot be too strongly ad- vanced that the question as to whether or not any given Reserve Fund is represented by assets consisting of mar- ketable securities outside the business or by less readily marketable assets employed in the business as fixed (or working) capital, is comparatively speaking of little im- portance. The most casual perusal of any Balance Sheet will show at a glance, even to the least informed, by which class of assets the Reserve Fund is represented. ' ' ^ On the other hand, Pixley, Dawson, and Whatley object to the use of the term Reserve Fund where there is not a cor- responding specific asset. In the ease of Hoare and Com- pany, before the Court of Appeals, Vaughan "Williams, L. J., implies there is no Reserve Fund unless the assets are specifically set aside, but Romer and Cozens-Hardy, L. JJ., speak of a Reserve Fund where there is no sepa- rate investment. Somewhat more specific is the provision in the revised form of Table A of the English Compa- nies Act. This is a model form of articles of association which applies to all companies unless they specifically adopt other articles. In this it is provided (See. 99) that reserves for any purpose may at the discretion of the di- rectors " either be employed in the business of the com- pany or be invested in such investments (other than shares of the company) as the directors may from time to time think fit." In accounting practice much diversity is found. The * Die BUanzen, 571. See also H. V. Simon: Die Bilanzen derAktievr- aeseUschaften, § 60. ' Auditing, p. 287. SURPLUS AND EESERVES 249 great majority of Reserves shown in Balance Sheets do not show a corresponding special investment. "Where there is such an investment the more approved form is to indi- cate it by using some such title as that recommended by A. Lowes Dickinson, " Fund Assets," as for instance the Illinois Central shows " Assets in Improvement Fund," " Assets in Surplus Dividend Fund," and " Assets in Pension Fund," each of which is equal in amount to a corresponding Fund on the credit side of the Balance Sheet. In other eases the investments shown are not equivalent to the Reserve, only a portion of the Reserve being specifically invested as is seen by reference to the Balance Sheet of the United States Steel Corporation. In France the specific investment of reserves in outside securi- ties is not customary. An attempt is made at times to differentiate between what is called a Reserve and a Reserve Fund. Unfortu- nately there is no uniformity in the distinctions made, as is shown by the various definitions of Reserve Fund given by different authors. 1. " Reserve Fund is an asset item signifying that cer- tain forms of wealth have been specifically set asid!e for a given purpose. This may or may not be the equivalent of a Reserve Account appearing in the credit side of the Balance Sheet." (Keister. Corporation Accounting, p. 71.) 2. " Reserve Fund is a credit item indicating that profits have been reserved and that a special fund of wealth will be found on the debit side of the Balance Sheet representing the reserve, one for which there has been a special investment made, a specially covered re- serve." (Pixley. Duties of Auditors, I, p. 359.) 3. " Reserve Fund is a credit item representing that the reservation is made out of net profits, in eontradistinc- 250 MODERN ACCOUNTING tion to Reserve Account, which indicates a charge to Profit and Loss before net profits are obtained. Reserve Fund indicates actual profits, Reserve Account may be merely a depreciation account." , (Dicksee. Depreciation, Re- serve and Reserve Funds, p. 51.) 4. " Reserve Fund is a Reserve for general purposes, with perhaps no distinct object in view but available for all contingent purposes, in contradistinction to a reserve account provided for a definite and well-known contin- gency." (Eddis. In Thome's Twentieth Century Book- keeping, § 424.) 5. " Reserve Fund is a Reserve which is shown on the Balance Sheet in contradistinction to Secret Reserve." (Rehm. Die Bilanzen, p. 543.) In nomenclature employed in the present treatise the equivalents for several uses of the ' ' Reserve Fund ' ' given above are as follows: 1. Investment of Reserve (or similar title), 2. Specially Covered Reserve. 3. Reserved Profits, or simply Reserve. 4. General Reserve, or Surplus. 5. Open Reserve. iluch of the confusion is caused by the fact that the term Reserve is used in connection with banking and in- surance in an entirely different sense from that in gen- eral bookkeeping practice. Thus the National Bank Act, general banking literature, and at times even the Balance Sheets of the banks use " Reserve " as indicating the en- tire cash on hand or deposits in certain banks deemed by law or custom equivalent to cash. A condensed Balance Sheet, such as is published for advertising purposes, may read SUKPLUS AND EESEKVES 251 Resources. Form 90. Condensed Balance Sheet. Liabilities. Loans and discounts.. .$11,100,000 Bonds 1,600,000 Eeserve 7,000,000 $19,600,000 Capital ■ $2,000,000 Surplus and Undivided Profits 1,100,000 Deposits 16,500,000 $19,600,000 Eeserve in this sense evidently has nothing to do with profits, and its maintenance is in no wise dependent upon the existence of accumulated profits; but in law and in banking practice it is proportionate to the deposits, not to profits. Similarly Reserve in insurance has a specific meaning referring to certain classes of assets which must be kept on hand to cover the actuarial value of outstand- ing risks. Again this is proportionate to a given item of liabilities, not to profits. In both of these cases the items are better listed, not under " Reserve " but under some title appropriate to the asset itself. The " Reserve " of the bank is really " Cash " and " Deposits with approved reserve agents ' ' and is thus correctly stated in the detailed Balance Sheet. The " Reserve " of the Insurance Com- pany is really " Cash," " Bonds," and similar items, while " Reserve," as it appears among the liabilities, is merely an indication that part of the accumulated profits is not to be distributed as dividends. It is not the assets themselves but represents at most a state of mind regard- ing certain assets. The exceptional use of " Reserve " in banking and insurance literature may sometimes be con- fusing but the matter is so simple that it should cause no serious misunderstanding. A Reserve exists when an increment of assets is with- held from distribution to the stockholders or proprietors; that is, whenever the excess of the total value of the net 252 MODERN ACCOUNTING assets over the original capital is retained by the company. It is an ecomonic fact and is independent of whether the accounts show the existence of such a surplus or not. In corporations desiring to be considered conservative, or wishing to escape taxation, or to conceal large profits, it is not uncommon purposely to conceal the existence of such a Reserve. This is done whenever there is an under- valuation of assets, or less frequently when there is an overstatement of liabilities. In such cases there is said to be a Secret Reserve. Thus in a company whose Balance Sheet shows: Form 91. Dr. Balance Sheet. Cr. Plant, ete 890,000 Less Deprecia- tion 5,000 $85,000 Cash 10,000 $95,000 Capital. Profits.. $90,000 5,000 $95,000 if an additional depreciation of $5,000 is reckoned, one not represented by an actual loss or decline in value, the Balance Sheet will read: Dr. Form 92. Balance Sheet. Cr. Plant, etc $90,000 Less Deprecia- tion 10,000 $80,000 Cash 10,000 $90,000 Capital $90,000 $90,000 Despite the statement here made the ne^ value of the assets is really $95,000, which exceeds the capital by SUEPLUS AND EESEEVES 253 $5,000. As no profits appear in the Balance Sheet, no divi- dends can be declared, and the $5,000 cash, which might otherwise have been distributed, is perforce reserved as an addition to the working capital of the concern. Such a condition may also be produced by treating as expenses, or by charging direct to Profit and Loss account, pay- ments which really represent the purchase of new assets. If $5,000 is spent in making some unquestioned improve- ment or addition to the plant, the normal entry is to charge the amount to " Plant " or to some synonymous account. A change in the form of assets held from Cash to Plant does not affect Profits, or Surplus. But if the payment is treated as though it were a mere expense, the total assets are apparently diminished when the Cash is paid, and no showing is made of the new asset gained by purchase. Whether the charge is made originally to Exr pense and thus indirectly diminishes profit, or whether the charge is made direct against Profit and Loss, or against some special or general Reserve, the effect is the same. In one way or another the assets held are understated and to an equivalent amount the showing of accumulated profits is less than the correct amount. Banks are especially given to this practice doiibtless with the purpose of being able to cover losses without dis- closing them to the public. Thus the First National Bank of New York City is said to have covered a defalcation of $690,000 because it had so large a Secret Reserve. This could be done by bringing into the Balance Sheet enough of the assets representing the Secret Reserve to cover the unusual loss. Railroads, too, especially those desiring a reputation for conservatism have acted similarly either by violently marking down the value of the road, as was done by the Chicago and Northwestern Railway in 1893 ; or by charg- ing to operation and maintenance sums representing very 254 MODERN ACCOUNTING material additions to the physical property, as' was done by the same road to the extent of nearly $5,000,000 a year for the seven successive years from 1900 to 1906. An even more striking charge, one of $13,000,000, part of the expense of constructing its tunnel, was made by the Pennsylvania against a special Surplus in 1906. Again appears a case of justifying a practice abhorrent to accounting principles, yet not without certain practical merits. In the anxiety to escape the prevalent temptation to exaggerate the value of the assets, which in many eases has led to such disgraceful results, conservative financiers applaud an equally erroneous, but perhaps less dangerous tendency to understatement. But the creation of a Secret Reserve is not without its dangers. It may be used as a means of refusing to pay dividends really earned, which so far as it applies to holders of income bonds or non- cumulative preferred stock, may work an irreparable loss. Even where there are no such divisions of interests it may lead ignorant stockholders, thinking the Balance Sheet cor- rect, to dispose of their stock at less than its real value. The position which the Interstate Commerce Commis- sion has taken against the practice of charging to operat- ing expenses payments really of the nature of betterments is decidedly healthful. This has already been attacked by the technical press, and has been spoken of as " casting to the winds the whole system of conservative finance which has been the boast of many American railroad com- panies. ' ' ^ This is curious as coming from the organ of the Chartered Accountants, whose council had previously taken ground that the existence of Secret Reserves makes the Balance Sheet criminally false. To identify conserva- tive finance with incorrect statements is a dangerous prece- dent, for the use of untruth in a good cause is likely to induce an attitude of mind in which untruthfulness be- ' Accountant, July 20, 1907. SUEPLUS AND EESEEVES 255 comes chronic and ineradicable. It is hard to believe that so good a cause as financial conservatism needs such unholy allies as misrepresentation and deception. An extreme type of a Secret Eeserve, one which the directors were authorized to expend without accounting to the stockholders therefor, was brought to notice in connec- tion with the Birmingham Small Arms Company. The articles of the company authorized the directors to set aside, out of the profits, an " Internal Eeserve Fund " which need not be disclosed by the Balance Sheet, the directors to use the Eeserve Fund in any way which they think will promote the interests of the company without giving any information to the shareholders regarding the amount or application of this Eeserve. In discussing this provision Justice Buckley said: " The special resolutions in the present case provide that the Balance Sheet shall not disclose the internal Eeserve Fund; it must, therefore, omit on the assets' side of the Balance Sheet the assets which make up the amount standing to the credit of that fund and the contra item — namely, the credit balance of the fund — on the liability side. The result will be to show the financial position of the company to be not as good as in fact it is. If the Balance Sheet be so worded as to show that there is an undisclosed asset, the existence of which makes the JBnancial position better than shown such a Bal- ance Sheet will not, in my judgment, be necessarily incon- sistent with the Act of Parliament. Assets are often by reason of prudence estimated, and stated to be estimated, at less than their real value. The purpose of the Balance Sheet is primarily to show that the financial position of the company is at least as good as there stated, not to show that it is not, or may not be better." ( [1906] 2 Ch. 378.) A Surplus being nothing but accumulated profits, its disbursement is secured in any way in which profits are disbursed save where some particular statute or by-law 256 MODERN ACCOUNTING prevents. More strictly speaking there occurs a cancella- tion rather than a disbursement of Surplus, for a Surplus in the sense of an account on the Credit side of the Balance Sheet cannot itself be disbursed. Certain tangible assets may be paid out and this may work a cancellation of the Credit. The bookkeeping entries in connection with such cancellation remain for consideration. A Reserve created to provide against some unusual loss logically remains intact until such loss occurs. This may be a loss by fire or other accident, a loss due to default by trade debtors or on securities held, a loss due to unfavor- able results in business operations. Such a loss would otherwise be charged to Profit and Loss, or to Capital, but where a Reserve is held the unusual loss may appropri- ately be charged against such Reserve, leaving the current profits from ordinary business still available for dividends. Similarly, where the Reserve is used to pay a dividend, otherwise unearned, there results a cancellation of some part of the Reserve, just as a dividend paid in ordinary circumstances works a cancellation of the credit balance to Net Profits. Whether the charge for dividend is made direct to the Reserve account, or whether part of the Re- serve is transferred back to the Profit and Loss account from which it originated is immaterial so far as the final showing is concerned. The Reserve being a reservation of profits, may either be used to cancel any loss, as current profits would be used ; or at any time may be canceled by retransference to Profit and Loss, which simply signifies that profits for a while reserved are no longer so, but are to be treated in the usual way. But it has been shown that sometimes— and frequently —a Reserve is created not to cover a loss or make possible a dividend but to provide additional plant, to cover an Exchange, not a Profit and Loss transaction. Thus in the following case: SUKPLUS AND EESEE.VES 257 2>. Form 93. Balance Sheet. Or. Plant Cash $90,000 20,000 $110,000 Capital Reserve for Extensions . . $100,000 . 10,000 $110,000 the Reserve may have been created for the specific purpose of purchasing an additional machine. The time has come when it is needed, and the Reserve is just sufficient to cover the cost. Cash is lessened by $10,000 when the ma- chine, is purchased but this expenditure is no loss, as a machine of equal value is received in exchange. Conse- quently the Balance Sheet should show: Dr. Form 94. Balance Sheet. Cr. Plant Additions . . . $90,000 ... 10,000 Capital Reserve for Extensions . . $100,000 . 10,000 Cash 10,000 $110,000 $110,000 In many eases, however, Cash is credited and Reserve is debited showing merely: Form 95. Dr. Balance Sheet. Cr. Plant $90,000 Cash 10,000 $100,000 Capital $100,000 $100,000 But this is a case of creating a Secret Reseirve, which has already been criticised. There is no justification in charg- ing to Reserve anything which could not legitimately be 258 MODEEF ACCOUNTIIsrG charged against profits. The purchase of a machine, an Exchange transaction, should not thus be charged. It may, however, be desirable to make some change in the Reserve item. It seems somewhat absurd to have a Reserve to pro- vide for something already secured. Consequently the credit to Reserve for Extension may be canceled and a corresponding credit made either to the general Profit and Loss account, or to the general Surplus account. Or if it is desired to be more specific there can appear the cum- brous but minutely accurate phrase : ' ' Reserve created by purchasing machinery out of profits. ' ' Any of these book- ings is entirely correct. Crediting the Reserve back to Profit and Loss is legitimate but it indicates a change in policy, for if credited to profits dividends of that amount can then be paid and the machine is no longer paid for out of reserved profits but from capital. Doubtless a simple transfer to Surplus, or general Reserve most recommends itself. The payment of debt, like the purchase of assets, is not a loss transaction, and similarly is not a logical charge against a Reserve. The treatment of a Reserve provided for the payment of debts, should, therefore, be identical with that of a Reserve for Extensions described above. It is to be noted that the booking is identical whether the Reserve is specifically covered or not. Where specific investments are held, presumably they will be sold to pro- vide cash with which to cover the payment. Thus with a Balance Sheet showing: FoKM 96. Dr. Balance Sheet. Cr. Plant, etc $90,000 Investments 10,000 Cash 10,000 $110,000 Capital $100,000 Reserve for Extensions. . 10,000 $110,000 SURPLUS AND EESERVES 259 the company may make the addition to its plant contem- plated when the Reserve for Extension was established. Whether the payment is made from the cash on hand or from $10,000 realized from the sale of the investments, is immaterial so far as it affects the rest of the Balance Sheet. In either case the item " Plant " is increased by $10,000, and the treatment of the Reserve is the same. The amount of the latter remains' unaltered although the term used in the Balance Sheet may be changed as suggested in the preceding paragraph. Even when specific investments are held to cover the Reserve it may be that a flurry in the investment market makes it undesirable to sell them, and the purchase is made with cash already in hand or even by credit. In the last named case the Balance Sheet becomes : Dr. Form 97. Balance Sheet. Cr. Plant, etc $100,000 Investments 10,000 Oish 10,000 $120,000 Capital $100,000 Bills payable 10,000 Reserve 10,000 $120,000 This again emphasizes the fact that the booking of Reserves is practically independent of the existence of specific assets. The item Reserve for Insurance is frequently found in Balance Sheets. It generally occurs where a company, whose, plant is so widely scattered that there is little likeli- hood of large loss by a single fire, decides not to carry any insurance but to stand its own loss should one occur. In such circumstances it is assumed that the insurance pre- miums saved will more than cover losses as they occur. To carry out this policy an annual charge, perhaps equivalent to regular insurance premiums, is made against earnings, and an equivalent amount is credited to Reserve for Insur- ance. There m'ay, or may not be a specific investment 13 260 MODERN ACCOUNTESTG made to cover the reserve. It is somewhat difficult to deter- mine whether such a reserve is really a part of profits. Were the company to go into liquidation, or to change its policy and provide for future losses by carrying regu- lar insurance the balance then standing to the credit of the Insurance Reserve would unquestionably represent an addition to profits which could be distributed as dividends. But so long as the company maintains its business and refrains from insuring, the Reserve is clostely allied to a Depreciation account or a provision for bad debts. If the plant is sufficiently large and scattered the law of proba- bilities makes certain that a loss will some time occur. If an accurate estimate shows that there wiU be an average loss of $20,000 each ten years, it is clear that the account- ant should charge $2,000 (ignoring the compounding of interest) as the share of such loss properly to be allocated to each year's business. And the accumulation of such charges is not so much a part of net profits as a represen- tation of a loss logically anticipated but fis yet unrealized. BIBLIOGRAPHICAL NOTE TO CHAPTER XIII Dawson, S. S. Reserves and Reserve Funds. Article in Encyclo- psedia of Accounting, V, p. 482. DiCKSEB, L. R. Depreciation) Reserves, and Reserve Funds. London, 1903. Meade, E. S. The Management of the Surplus Reserve. Publica-^ tions of the American Economic Association. 3rd series. V. p. 245. Nbukamp, E. Der Reservefonds der Aktiengesellschaften. Gold~ Schmidt's Zeitsehrift f. d. gesamte Handdsrecht. XXXVIII, 10. Das Dogma von der "Bilanzwahrheit" Ihid., XLVIII, 450. [A strong argument in favor of secret reserves.] PrxLBY, F.W. Auditors, their Duties and Responsibilities. I. 358- 361. Ninth edition. London, 1906. Rehm, H. Loc. eit., 542-642. [Emphasizes the distinction between a real and a fictitious reserve.] Simon, H. V. Loc. at., 227-283. CHAPTER XIV SINKING FUNDS A Sinking Fund in the strict sense is a fund raised by annual contributions for the purpose of providing means for paying off a funded debt. The term is of very fre- quent occurrence in accounting, especially in the Balance Sheets of American railways. Its use is however not uni- form, and an examination of a number of railroad reports will disclose some in whicli it appears only on the Liability side, others where it is found only among the Assets, and still others in which Sinking Fund appears both as a Debit and a Credit. The vari )us methods in which this is done and the forms in which the transactions are booked are as follows : 1. A given sum of money is annually paid to Sinking Fund trustees or otlerwise set aside to accumulate at com- pound interest until the time when the bonds mature. The payment is not regarded as a loss or an expense, which indeed it is not, for the payment of debt not being an expense certainly the preliminary setting aside of a fund with which to pay the debt is no more so. Assuming a road whose Balance Sheet shows: Dr. Form 98. Balance Sheet. Cr. Cost of road, etc. . Cash .. $99,000,000 . . 2,000,000 Capital Stock $50,000,000 Funded Debt 50,000,000 Balance of Income Account 1 ,000,000 $101,000,000 $101,000,000 m 262 MODEEIf ACCOUNTING the payment to the Sinking Fund trustees of an install- ment of $500,000 produces the following condition: Dt. Form 99. Balance Sheet. Cr. Cost of road, etc $99,000,000 Cash in hands of Sink- ing Fund Trustees . 500,000 Cash 1,500,000 $101,000,000 Capital Stock $50,000,000 Funded Debt 50,000,000 Balance of Income Account 1 ,000,000 $101,000,000 In this ease cash has been taken out of the general funds and put aside to provide means for the future payment of the bonds. There is no indication as to its relation to profits. The legal requirement by contract with the bond- holders is that funds be thus set aside and separately held. So long as this is done it is immaterial to the bondholders whether the cash is obtained from the stockholders, from loans obtained elsewhere, or from accumulated profits. The Sinking Fund here is a fund of assets, analogous to a " bank reserve " and not a Reserve in the sense of re- served profits. This form is used, for instance, by the Chicago, Rock Island and Pacific. 2. Other roads are accustomed to charge the amount of the Sinking Fund installment to the Income or Profit and Loss account. In this case a distinct reserve is created by withholding part of the accumulated profits. Where this is done the Balance Sheet becomes: Dr. Form 100. Balance Sheet. Cr. Cost of road, etc $99,000,000 Cash iu hand of Sink- ing Fund Trustees. 500,000 Cash 1,500,000 $101,000,000 Capital Stock $50,000,000 Funded Debt 50,000,000 Sinking Fund 500,000 Balance of Income Account 500,000 $101,000,00C SINKING FUNDS 263 which is the form used by the Chicago and Northwestern Railway, and many other corporations. The name given to the account varies somewhat in the different reports, but the essential thing is to note that a Reserve Fund, specially covered by cash in the hands of the trustees, has been established, and that both sides of the Balance Sheet show the amount of the Sinking Fund. 3. The other forms are variations of the two just given, and depend on the method of employing the funds paid to the trustees, and of booking the transactions. The pur- pose of the Sinking Fund being to provide means which shall serve to wipe out a given issue of bonds at a certain time, this end can be gained either by leaving the cash on deposit in a trust company, by investing it in outside securities, or by buying up some of the Company's own bonds. The first plan is objectionable because of the small rate of interest received, the second involves the possibility of risk, the danger of misappropriation of the large sums of securities held by trustees, and a relative low rate of interest, for the trustees will prefer bonds whose greater security means lower returns. Investment in the Com- pany's own securities is therefore the most desirable as well as the customary method, and so far as practicable the bonds purchased are part of the very issue to be cov- ered by the Sinking Fund. Here the question of security cannot arise, for the purchase of the bonds in itself sectires the desired end; misappropriation can be prevented by canceling or by rendering the bonds otherwise non-nego- tiable ; and the interest will be higher than could be gained by any investment of approximately equal security. Where outside investments are made the securities held must appear in the Balance Sheet as part of the assets of the company, under the heading ' ' Cash and securities held by Sinking Fund Trustees " or an equivalent phrase ; but where bonds of the company are purchased different meth- 264 MODERN ACCOUNTING ods of booking the transaction are employed. Sometimes they too are included among the assets embraced in the heading just given, but in other companies bonds so held are not counted as assets, and are therefore necessarily canceled from the bonds listed among the liabilities. This is treating the bonds purchased for the Sinking Fund as a payment of a debt, and a debt paid as a rule no longer appears in the accounts. Assuming that the sinking fund has been invested in the company's bonds, and that these bonds are canceled, the Balance Sheets given above in forms 99 and 100 become respectively FOHM 101. Dr. Balance Sheet. Cr. Cost of road, etc $99,000,000 Cash 1,500,000 $100,500,000 Capital Stock $50,000,000 Funded Debt. 49,500,000 Balance of income account 1,000,000 $100,500,000 Dr. Form 102. Balance Sheet. Cr. Cost of road, etc $99,000,000 Cash 1,500,000 $100,500,000 Capital Stock $50,000,000 Funded Debt 49,500,000 Sinking Fund 500,000 Balance of income account 500,000 $100,500,000 Illustrations of the above are found in the reports of the Louisville and Nashville Railway, which uses the form 101 so far as it concerns the bulk^of its sinking fund pay- ments, the uninvested balance appearing as a debit with no corresponding credit; and in the balance sheet of the United States Steel Corporation, given in Form 29, which shows a credit but no debit for the bulk of its sinking fund operations. SINKING FUNDS 265 A comparison of the four methods shows that an item representing the sinking fund appears in the first form only among the debits, in the second in both debits and credits, in the third in neither debit nor credit, and in the fourth in the credit side alone. The creditors are given the security, in the first case, of certain segregated assets, but no assurance that the total assets of the company will be increased. In the second case the reserved assets at the same time constitute an increase in the total assets of the company, gained by a reservation of profits, or at least there is the guaranty that the stockholders take no divi- dends unless profits are first withheld sufficient to provide for repayment of the debt. In the third method no specific assets are withheld and the gross assets may even decline, but the outstanding claims are reduced so that the margin of security is increased. In the fourth there is a similar reduction in liabilities, but in this instance accompanied by a guaranty, not found in the third method, that the gross assets will at least be constant while the net assets are being increased by paying debts with profits. The theory of the Sinking Fund involves the com- pounding of interest on the invested installments. Where outside investments are made this is simply done by leav- ing in the hands of the trustees the interest received. Where the company's own bonds are purchased it involves the payment of interest on the entire issue of bonds, in- eluding those held by the sinking fund, and regardless of whether these bonds are canceled and subtracted from the liabilities or not. This interest in either case is credited not to the general income of the company but to the Sink- ing Fund, from the investments of which the interest is derived. Thus assuming that the installment of $500,000 in the illustrations given above is promptly invested at five per cent., the Balance Sheet at the end of the year — ignoring other changes— is : 266 MODEEF ACCOUNTING Dr. Form 103. Balance Sheet. Ct. Cost of road, etc . . . . 899,000,000 Cash and securities in hands of Sinking Fund Trustees 525,000 Cash 1,500,000 $101,025,000 Capital 850,000,000 Bonded debt 50,000,000 Sinking Fund and Accretions thereto . 525,000 Balance of income' account 500,000 $101,025,000 As the years pass the credit to " Sinking Fund and accre- tions thereto " and the " Cash and securities in hands of Sinking Fund Trustees " increase pari passu by the accu- mulation of compound interest on the several installments paid. Much discussion has occurred in the field of both public and private finance as to the economic effects of adopting a sinking fund policy. "Whether this indirect and rather cumbersome method of -retiring debt is advantageous or not has been argued with great vigor, but with this dis- cussion the present treatise is not concerned. Some purely accounting aspects of the subject are, however, of interest. Sinking fund installments being in most cases compul- sory under the mortgage, they are frequently treated as fixed charges, together with interest payments. An illus- tration is found in the reports of the Chicago and North- western Eailway Company, which shows: Form 104. Gross earnings ". $55 . 7 Operating expenses and taxes 38 . 6 Net earnings $17.1 Other charges: Interest $7.0 Sinking Funds .2^ 7.2 $979 Add other income .5 $loTi SINKING rUNDS 267 On the other hand the Pennsylvania R. R. Company, obtaining its earnings in the customary way, subtracts interest, but not Sinking Fund installments, to obtain the Net Income, and from the Net Income are subtracted Con- tributions to Sinking Funds, Special Reserve, and Divi- dends, all three being treated as homologous items, each being an appropriation of Net Income, not a charge against Earnings. From a theoretical view point the latter method is cor- rect, the former erroneous. Payment of debt not being in any sense an expense or loss, it may be left entirely out of the Income Account as has been shown to be a recog- nized method of treatment; but it is also legitimate to provide for making such payments out of profits, just as provision for extending a fixed plant may legitimately be made by creating a Reserve; but in neither case is the essential nature of the transaction altered, and this is cor- rectly reported m the accounts by showing it as a dispo- sition of profits. On the other hand may be cited the authority of M. M. Kirkman, Vice-President of the Chicago and Northwestern Railway, who says: " Sinking fund is unrepresented capital. It is not chargeable against income account any more than any other capital expenditure. The reason why we so often find it included in the income account is because of the conservatism of proprietors. It is another way they have of strengthening their properties. It is similar in effect to making improvements with net earnings. The fact that it is done by sagacious and practical business men is, in itself, sufficient evidence that it is proper. ' ' ^ But the analogy here given is not quite correct. In charging improvements to net earnings the item disap- pears entirely from the Balance Sheet and constitutes a » Science of Railways, III, p. 104. 268 MODEEN ACCOUNTING Secret Reserve. This is apparently never done in regard to the Sinking Fund. The payment does not disappear but is either held among the assets or what is equivalent is deducted from outstanding debt. The alternative, so far as the showing in the Balance Sheet is concerned, is between retaining an unappropriated Balance to Income and a Special Reserve, not between creating a secret and an open reserve. Charging to income reduces the unap- propriated balance and doubtless lessens the clamor for extra dividends which might appear as that balance is augmented, but which would be less insistent where the amount appears as Sinking Fund. To charge to gross rather than to net income affects only the showing in cur- rent income accounts, not at all the cumulative sum in the Balance Sheet, but even the showing of the annual profits at a sum larger than can advisedly be distributed is at times embarrassing. Wliile the net profits of the Chicago and Northwestern Railway were unquestionably larger than the amount shown, the amount of ' ' Net profits avail- able for dividends " were not larger. The compulsory nature of the Sinking Fund has some Clearing, it is true, but neither national banks nor foreign corporations con- sider the compulsory establishment of a surplus a reason for understating the annual net profits, and they do not charge the required percentage of their profits as if it were an expense, but show it properly as an appropriation of profits. So the compulsory nature of the Sinking Fund, while lessening the amount which may be available for dividends, should not diminish the net profits shown. Even the decisions of the courts, that profits are ascer- tained after the payment of Sinking Funds (Belfast & Moosehead Lake Ry. t^. Belfast, 71 Me. 445 (1885), Ex- celsior Water & Mining Co. v. Pierce, 90 Cal. 131 (1891)) like the similar decisions regarding the payment of the principal of the debt, are, as is shown in Chapter XII, to SINKING FUNDS 269 be explained as a ruling against forcing dividends rather than as a scientific definition of the nature of profits. The customary treatment of interest received on Sinking Fund investments is similarly inexact. The interest thus received is part of the income of the company. That it is immediately appropriated to a special purpose, does not alter its nature as income of the company. As such it might with propriety, indeed it logically should, appear in the Income account. But in practice, where the Sinking Fund appears as a special reserve, the income derived from its investment is not shown in the Income account but is credited direct to the fund or to some subordinate account as for instance " Sinking Fund Accretions." Thus again the showing of annual profits is too low, although the Bal- ance Sheet does show in full the reserved profits held in the Sinking Fund. In the normal course, when the time comes for the re- tirement of the bonds covered by the Sinking Fund, the credit to that account should equal the amount of bonds. Where the specific investment of the funds is shown, the Balance Sheet becomes: Dr. Form 105. Balance Sheet. Cr. Cost of road, etc $99,000,000 Cash, etc., in hands of Sinking Fund Trus- tees 50,000,000 Cash 1,500,000 $150,500,000 Capital Stock $50,000,000 Funded Debt 50,000,000 Sinking Fund 50,000,000 Balance of Income Account 500,000 $150,500,000 At this point the bonds are presented to the trustees of the Sinking Fund and paid by them. The Balance Sheet then becomes: 270 MODEEK ACCOUNTING Dr. Form 106. Balance Sheet. Cr. Cost of road, etc. . Cash .. $99,000,000 . . 1,500,000 Capital Stock $50,000,000 Sinking Fund (?).... 50,000,000 Balance of Income Account 500,000 $100,500,000 $100,500,000 V It perhaps seems unreasonable to continue the Sinking Fund under that title, now that the debt has been re- deemed and canceled. The entire sum could with pro- priety be credited back to Income Account, whence it all originally came. To most accountants, however, it appears better to continue it as a special reserve, perhaps un(Jer some such descriptive title as that proposed by Dicksee " Accumulations of Revenue which have provided the wherewithal to Redeem Loans," or so far as accounting is concerned, it can legitimately be capitalized, and a stock dividend issued for it to the stockholders. Economically it means that by a period of prolonged abstinence the stockholders, formerly having only a half interest in the economic capital, have bought out the bondholders' inter- est of $50,000,000, making payment out of their accumu- lated profits or savings. Where the Sinking Fund is invested in the bonds of the company and such bonds are canceled and disappear from the Balance Sheet (the method shown is Form 102 above), the final condition will be the same as that in Form 106. "Where no special Sinking Fund is shown among the liabilities the final payment of the debt does not require any further alteration of the Balance Sheet, for the pay- ment of bonds, either gradually or in mass has not been charged against income, and there is no need for reestab- lishing that depleted account. SINKING FUNDS 271 The calculation of the amount required for a Sinking Fund is as follows. The problem being the amount pay- able at the end of each year, which invested at a given rate of interest (i) will be sufficient to pay off the prin- cipal (P) in (n) years. In this calculation the interest annually paid on the bonds is neglected, that being a regu- lar charge against the earnings of the company, the Sink- ing Fund installment being separately handled. A payment of $1 invested at the end of the first year will accumulate at compound interest until the end of the sinking fund period of n years. Its accumulated value will therefore be (l + i)°— ^, the second installment will accumulate for one less year and so on, for a series, the next to the last 'installment drawing interest for only one year, the last installment made at the time when the bonds mature, not having any time for investment. The series then becomes (l + i)n-l+(14.i)n-2. . . (l+i)+l, which may be simplified to (l-|-i)°— 1. Dividing the i total amount of bonds to be retired (P) by this sum, the amount of the annual sinking fund installment is obtained, and iP Sinking Fund Installment = -^— - (l + i)»-l In these calculations the accountant and the investor must have in mind that there is bound to be some delay in reinvestment and that the rate to be obtained is almost certain to decline through any protracted period. It is however by no means necessary that the Sinking Fund should equal the entire principal to be retired." A provision which amounted to eighty, sixty, or any other considerable proportion of the funded debt would in the 272 MODEEN ACCOUNTING ease of a perpetual enterprise, such as a railroad, offer security sufficient to satisfy the creditor ; for if to-day the road can borrow $100,000,000, the presumption is that twenty years hence it will have no difficulty in borrowing half that sum, if it should prove necessary to refund the debt not covered by the Sinking Fund. "Where the enter- prise is not perpetual, as where it is dependent on a lim- ited franchise, the adequacy of the Sinking Fund pro- vision is more important and the failure to realize the calculated interest may be a decided injury to the bond- holder. The relation of the Sinking Fund to Depreciation has led to protracted discussion, especially in connection with the legal restrictions on municipal borrowing. The Eng- lish requirement is that the municipality, desiring to bor- row for public service utilities must provide out of the revenue both for a Sinking Fund with which to retire the bonds at maturity, and also for a Depreciation Fund with which the plant can be replaced when worn out. But assuming th^t the life of the plant and the duration of the bonds are the same this leads to an exact doubling of the proper charges against revenue. "Whatever good effect this may have in preventing reckless undertaking of municipal enterprises, it clearly does not lead to a correct showirlg of the profitableness of the undertaking. The relation between Sinking Fund and Depreciation is better understood by accountants. Thus for instance the certifi- cate of the Public Accountants attached to the Balance Sheet of the American Hide and Leather Company con- tains the following : ' ' The appropriation out of profits for the purposes of the Sinking Fund is in our opinion, suffi- cient to take the place of provision for Depreciation." SINKING FUNDS 273 BIBLIOGRAPHICAL NOTE TO CHAPTER XIV Dickinson, A. L. Interest and Sinking Funds. Accountant, XVII, p. 715. DicKSBE, L. R. Depreciation, Reserves and Reserve Funds, pp. 57-65. London, 1903. SpraguBjC.E. The Accountancy of Investment. New York, 1904. Turner, S. H. Depreciation and Sinking Funds in Municipal Undertakings. Economic Journal, XIV, pp. 47-56. Walton, S. Sinking Funds and Reserve Accounts. Journal of Accountancy, VI, p. 394. CHAPTER XV TRADING, MANUFACTURING AND INCOME ACCOUNTS The profits of a year can be accurately shown without an elaborate set of books, all that is necessary being a care- fully prepared annual inventory. The herdsman telling the tale of his sheep, the miser counting over his hoard, compares the figures of a preceding period and learns what has been his annual increase. The contribution which double entry bookkeeping has made to accounting science is largely that it has introduced a separate Profit and Loss account which, though it may not show the net results any more accurately, does present them in greater detail. Even the simpler forms of the Profit and Loss account exhibit such details as the gain from merchandise, the amount of expenses, the interest paid or received, wages, rent, and other sources of profit and lines of expense. "With greater complexity of business organization there comes a demand for a more logical, or at least a more practical classification of Profit and Loss items. Account- ing practice of to-day subdivides the old Profit and Loss account into several sections or even into separate ledger accounts which not merely show the total profits, but group the items so as to exhibit the results of each of the parts or processes which are embraced in the operations of the busi- ness. The Trading Account, the Manufacturing Account and the highly developed Income or Revenue account of railroads are differentiations of the simple Profit and Loss account and are appropriately discussed in this place. The Trading account, as the term is ordinarily used, is ■Z74 TRADING AND INCOME ACCOUNTS 275 a technical device whereby it is sought to differentiate the elements of gain caused directly by trafficking, from that which a mercantile establishment derives from other sources. At the outset the student is confronted With the difficulty that here, as elsewhere in accounting, terminol- ogy is but partly crystallized and the words are used loosely and with divergent connotation. Even yet it is difficult to say whether the Profit and Loss account is a compre- hensive statement of which the Trading account is one part, or whether they are separate accounts, or whether one should rather speak of a Trading Section and a Profit and Loss Section of a not definitely named, all-embracing statement of the results of the business. Furthermore while there is general agreement that the Trading Section — if so it be called — should logically be separated from other exhibits of Profit and Loss, there is no agreement as to just what items should be included in that exhibit. These confusing differences are best illustrated by discuss- ing a sample form, that given by Lisle in his " Account- ing ' ' being particularly elaborate may be used as the basis of comparison. The form with only a few verbal changes is given on pages 276-277. It should be noted first, that while the statement as a whole is called the Profit and Loss account, yet the second, third and fourth sections are specifically Profit and Loss accounts in contradistinction to the first section called Trading Account. Other accountants make a wider sepa- ration between the first and the subsequent sections, and apply Profit and Loss account only to the latter group. Again variance is found in the subdivisions made after the Trading Account. Lisle gives three subdivisions, one showing business transactions, with a balance " Profits on ordinary business "; the second containing those entries which relate to the investment of capital, with a balance " Net Profits "; the last giving the allocation of profits. 19 276 MODEEN ACCOUNTING Dr. Form 107. Profit and Loss Account. 1st section TRADING ACCX)UNT. Ck To Cost of goods used (in- ' eluding freight inward and after deducting purely trade discounts) . . " Expenditure directly con- nected with sales or which reduces the price realized for the goods such as: Commission and sala- ries of travelers and travelers' expenses. . Wages of salesmen .... Wages of porters Outgoing freight Cash discount allowed on sales " Balance carried down being gross profits By Sales (after deducting purely trade discounts) 2D SECTION ORDINARY BUSINESS PROFIT AND LOSS ACCOUNT. To Fixed Charges notdireotly By .Balance brought down connected with sales and being Gross Profits .... not varj'ing much with " Income not directly con- the turnover such as: nected with sales such as Rents, taxes, etc Rent of stores dr prem- Repairs and other ises let to tenants . . . office expenses. . . . Revenue from royal- Salaries of office staff ties and management. . . Depreciation ; :' Business losses such as : Bad debts Defalcations ' Balance carried down being Profit on ordi- nary business TEADING AND INCOME ACCOUNTS 277 3D SECTION — THE NET PROFIT ACCOUNT. To Expenses connected with By Balance brought down Capital, such as: being Profit on ordinary nterest on loans business " Balance carried down, " Income connected with being Net Profit capital such as ; Revenue from invest- ments Interest earned Cash discounts , ob^ tained which depend on the amount of capital in the busi- 4TH SECTION THE PROFIT AND LOSS APPROPRIATION ACCOUNT. To Allocation of Profit: Interest on capital. . . . Profit allocated to cap- ital " Profit unappropriated, carried forward By Balance brought down being Net Profit So minute a subdivision of the Profit and Loss account as that shown above is rarely found in accounting practice. "Frequently there is no distinct separation into parts. A grouping of the items in an inner column, and the intro- duction of subtotals in the main column enable one to pick out the facts which by Lisle are more formally pre- sented by the actual balancing of the various sections. It cannot be said that there is any universally recognized form ; indeed there should not be, for a system of account- ing must be flexible, not tied down to any set formula, if it is most clearly to present the facts essential to the under- 278 MODERN ACCOUNTING standing of a particular establishment. This is well recog- nized by accountants, for not only do the forms used by other authors differ from the one presented above, but a glance through Lisle 's most valuable book shows that of the dozen forms of Trading and Profit and Loss accounts which he gives, no two are identical in nomenclature, sub- division and grouping of individual items. FOHM 108. Gross earnings (whether sales of products, transportation earnings, professional earnings, etc.) $ Deduct — Cost of Manufacture or Operation: (a) Manufacture (for a manufacturing con- cern) $ Labor Material General Manufacturing Expenses (b) Cost of Operation (for concerns not manufacturing) (Under suitable headings according to the nature of the business) $ $ Gross Profits $ Other Earnings Deduct — Expenses of sale (manufacturing business only) $ Expenses of management (if distinct from operation) $ Net Profits from Operation $ Deduct — Interest on Bonds $ Other Fixed Charges $ Surplus for year $ Extraordinary Profits (detailed) Surplus brought forward from preceding year Deduct — Extraordinary charges not applicable to the operations of the year $ Interest and Dividends on Stocks _$. Surplus carried forward $ . TEADING AND INCOME ACCOUNTS 279 A simpler form, suitable for general application is that suggested by Mr. A. Lowes Dickinson at the Congress of Accountants, and given on the preceding page. The Manufacturing account is a further amplification of the Trading account of concerns which manufacture, rather than purchase, part or all of their stock in trade. The Trading account includes as its first item the cost of purchased merchandise; where merchandise is manufac- tured the manufacturing account gives a detailed exhibit of the manufacturing cost of the commodities, which are then entered iu the Trading account and subsequently treated just as if they had been purchased. Difficulties exist in determining what items belong in the Manufac- turing Account similar to those confronting one who forms a Trading Account. In both eases divergencies in practice rightfully occur. An example of a manufacturing account is as follows: Form 109. Manufacturing Accounts All direct cost of Manu- All reductions in cost of facturing such as: manufacturing such as: Raw materials Discounts on Purchases. Labor Inventories Superintendence Balance to Trading Account, Packing materials representing Manufactur- Heat and Power ing Cost of goods sold. . . . Factory expenses Freight (inward) Cartage (inward) Insurance on Plant .... Depreciation, Machinery Reserve for Taxes on plant » For the above form the author is indebted to Mr. E. P. Moxey, Jr., C.P.A. 280 MODEEN ACCOUNTESTG The Income or Revenue Account of a railroad is iden- tical with the expanded profit and loss statements already described, so far as the difference in the business transacted permits. Two forms for such an account are given below : Form 110. Income Account. Gross earnings from operation Less operating expenses Income from operation Deficit Dividends on stocks owned Interest on bonds owned Miscellaneous income Income from other sources Total income Deficit Deductions from income: Interest on funded debt accrued Interest on interest-bearing current liabilities, etc. Interest on real estate mortgages Bents paid for lease of road Taxes Permanent improvements Other deductions Total deductions from income Net income. Deficit Dividends, per cent, common stock Dividends, per cent, preferred stock Other payments from net income Total Surplus from operations of year ending June 30, 1907.. . . ~ Deficit from operations of year ending June 30, 1907 Surplus on Jime 30, 1906 [from "General balance sheet," 1906 Report] Deficit on J\ine 30, 1906 [from "General balance sheet," 1906 Report] Additions for year Deductions for year Surplus on June 30, 1907 [for entry on "General balance sheet"] Deficit on June 30, 1907 [for entry on "General balance sheet"] TRADING AND INCOME ACCOUNTS 281 Form 111 Income Account (Abridged) Operating Income: Railway operating revenues $102,358,892.95 Railway operating expenses 61,713,161 .02 Net revenue from railway opera- tions $40,645,731.93 Railway tax accruals $4,449,290.83 Uncollectible railway revenues 9,547 . 58 4,458,838 . 41 Total operating income $36,186,893 .52 Nonoperating Income: Rent $1,300,396.92 Dividend income 10,554.05 Income from funded securities 39,520 . 88 Income from unfunded securities. . . . 1,029,259 .92 Income from sinking fund 2,900 . 10 Miscellaneous income 11,519 .97 Total nonoperating income 2,394, 151 . 84 Gross income $38,581,045 .36 Deductions fbom Gross Income: Rents $1,585,311 .43 Miscellaneous tax accruals 13, 165 . 26 Separately operated properties — ^Loss 41,887 .85 Interest on funded debt 7 038,490 . 72 Amortization of discount on funded debt 55,163.52 Miscellaneous income charges 756 .60 Total deductions from gross in- come 8,734,775.38 Net income $29,846,269.98 Disposition op Net Income; Income applied to sinking funds. . . . $1,817,679.41 Dividend appropriations of income . . 8,867, 128 . 00 Income appropriated for investment in physical property 4,431,359.81 Fund for accrued taxes — not yet due . 2,400,000 . 00 Miscellaneous appropriations of in- come 6,000,000.00 Total appropriations 23,516,167.22 Income balance transferred to credit of Profit and Loss $6,330, 102 . 7ft 282 MODERN ACCOUNTING • Profit and Loss Account. Ceedits: Credit balance at beginning of fiscal period Credit balance transferred from income Profit on road and equipment sold Delayed income credits Unrefundable overcharges Donations Miscellaneous credits Total credits Debits: Debit balance at beginning of fiscal period Debit balance transferred from income Surplus applied to sinking and other reserve funds Dividend appropriations of surplus Surplus appropriated for investment in physical property Stock discount extinguished through surplus. . . . Debt discount extinguished through surplus Miscellaneous appropriations of surplus Loss on retired road and equipment Delayed income debits Miscellaneous debits Total debits $ Balance carried to Balance Sheet $ The first of the above forms is one formerly much used by American railroads, the second is in accordance with the improved form established by the Interstate Commerce Commission. In discussing the variations in practice one ruling prin- ciple is to be kept constantly in mind. The form of the Profit and Loss statement should be adapted to the needs of the individual establishment and cannot be prescribed by any hard and fast rules. Its purpose being to give a better insight into the operations of the establishment to TEADING AND INCOME ACCOUNTS 283 the end of enabling the managers to limit waste and pre- vent unprofitable ventures, the subdivisions to be made and the decision as to the particular section into which any one item should appear, turn largely on the particular information which the management desires to secure, and on the business and physical organization of the plant itself. Thus, for instance, of two manufacturing estab- lishments one may be considering the relative desirability of increasing its plant or of purchasing, from other manu- facturers, part of the goods it sells. The other, having no opportunity to purchase the finished commodities, might, however, consider whether it is better to continue its sales department or to turn its entire product over to some job- bing or commission house. In the first case it is desirable to show the exact cost of manufacture, to compare it with the price at which goods can be purchased elsewhere; in the other the point of emphasis is the cost connected with selling. It is quite conceivable that the system of account- ing which best brought out one set of figures would not most economically give the information desired in the sec- ond establishment. Again, the nature of the organization itself is a factor in determining the form of accounting. The separation or juxtaposition of the factory and the office, the location of the warehouses at one, or the other place, the degree to which the labor of employees is specialized, and the num- ber of branch establishments are all examples of facts which enter into the question of the proper grouping of items. What is desired is to be able to put the finger on some point and say, " Here there is relative inefficiency." If manufacturing is distinct from trading, the separation of the two in the accounts seems to facilitate the localiza- tion of responsibility; if the two are combined, but there are separate plants each manufacturing and selling, the line of cleavage is evidently different. As in all account- 284 MODEKISr ACCOUNTING ing matters, while certain general principles hold good, the main difficulty is their application to a particular problem which must be individual and perhaps unique. Keeping clearly in mind the limitations of the preced- ing section the points of more general interest may still be discussed. 1. The first problem relates to the valuation at which manufactured goods are to be carried down to the Trading section, where these sections are kept separate. Two distinct principles are advanced on this point. The first is that the manufactured goods should be carried down to the Trading Account at the net manufacturing cost. This is shown in Form 109. The other is that goods should be transferred from the Manufacturing Account to the Trading Account, not at the actual cost but at a fair market price, that is, at the figure which would have been paid had the goods been bought from some other manu- facturer instead of being produced within the establish- ment. In favor of the latter view it is urged that by so doing a distinct showing is made of the profits which result from efficient manufacturing, as distinguished from the profits which arise from skillful trading. Form 112. Dr. Manufacturing AccounL Cr. To Costs $100,000 By Trading Account . . $110,000 " Maaufacturing Profits 10,000 $110,000 $110,000 Dr. Trading Account. Cr To Merchandise at Trade Price $110,000 ''Expenses 15,000 • Trading Profits 20,000 $145,000 By Sales $145,000 $145,000 TRADING AND INCOME ACCOUNTS 285 This may be illustrated by assuming a manufactory which produces, at a net cost of $100,000, goods for which the current wholesale price is $110,000; and that these goods are sold at $145,000, with trading expenses of $15,000. If the manufactured goods are carried to the Trading Account at the market rather than at the cost price, the accounts appear as on the preceding page. This exhibits Manufacturing Profits of $10,000 and Trading Profits of $20,000, while if the merchandise had been brought down at the cost of manufacture there would be shown only a single item of profit of $30,000. The advantage of distinguishing between the two ele- ments of profit is indisputable, especially where the con- cern purchases part and manufactures part of the mer- chandise which it sells. But in so far as the goods are not all sold during the year in which they are manufactured, there is the great objection that there is introduced into the accounts an unrealized and perhaps fictitious profit on Dr. Form 113. Manufacturing Account. Cr. To Cost of manufacture.. $100,000 " Manufacturing Profits 10,000 $110,000 By Trading Account at market price $110,000 $110,000 Dr. Trading Account. Cr. To Manufacturing Ac- count $110,000 Less stock on hand . . . 55,000 " Cost of goods sold $55,000 " Expenses 15,000 " Trading Profits. 2,500 $72,500 BySales $72,500 $72,500 286 MODERN ACCOUNTING the unsold portion of manufactured goods. This is illus- trated hy assuming that only one half of the manufactured goods are sold for $72,500. Where goods are carried down to the Trading Account at cost there will be shown Net Profits of $7,500. But where goods are brought down at the market price the accounts will appear as in Form 113, giving a total profit of $12,500 instead of only $7,500. The difEerence, of course, is due to taking credit in the latter method for $5,000 profits on the unsold half of the product. The problem here is the same one that arises when in- ventorying any merchandise, namely : Shall stock on hand be taken at cost or at market price ? As has been shown in Chapter V, the taking of a higher market price is gener- ally condemned as opening the doors to imaginary profits. The criticism applies to the taking of an assumed manu- facturing profit as well as to the profit taken on still un- sold merchandise purchased. But there is a real advan- tage in showing the manufacturing as distinct from the trading profits, in that it gives information which serves as a guide for future management. And the objection to showing the unrealized profit may not be conclusive, for it is possible to put the profits thus shown into a special reserve, thus removing them from the sum available for dividends and lessening the danger of overvaluation. As has been shown, valuation at the present market price is in reality the logical course in accounting, but in ordinary cases logical consistency is sacrificed as a practical expe- dient to prevent overvaluation. In treating the Manufac- turing Account, the real advantage of distinguishing the part of the profits derived from manufacturing is so great as to lead many accountants to return to the logical scheme of valuation, elsewhere abandoned from motives of con- servative prudence. This is recommended by both Dicksee and the " Encyclopedia of Accounting." It is a case TEADING AND INCOME ACCOUNTS 287 where advantages are to be weighed against dangers, with the additional complication of logical principles pulling against consistency of treatment. 2. A second problem relates to the items to be included in the Trading Account. Ignoring variations in mere de- tail, two divergent customs are found. One includes in the Trading Account all the expenses connected with traf- ficking as distinct from the general expenses of manage- ment. This is the principle applied in Lisle 's form given above, Form 107, where commissions and salaries of trav- eling salesmen, wages of salesmen, wages of porters, etc., are charged to the Trading Section. The second more rigid method excludes from the Trading Account all items except those representing the direct cost price and the net selling price of the goods handled. The balance then carried down is generally called Gross Trading Profits, although, strictly speaking, the term is incorrect and the balance itself is of no great logical significance. Properly it is not profits, but merely the sales less some, but not all, of the cost or expense of making the sales. Nevertheless there are advantages in making a comparison of cost and selling price as these figures lend themselves conveniently to statistical results. A merchant generally bases his sell- ing price on the cost price, either adding a given percent- age, or by fixing it so that difference between cost and selling price is a percentage of the latter. Thus, where merchandise is bought at $1.20 a yard, the price may be fixed so as to yield, say, 25 per cent. " profit," or other- wise expressed so that 20 per cent, of the selling price will be gross profit, that is, at $1.50. Basing the selling price thus on the prime cost is almost a necessity, for the trad- ing expenses are not known when the price is fixed, while the cost is easily ascertained through the invoices. The keeping of the accounts thus somewhat parallel with actual business processes has practical advantages. But a glance 288 MODERN ACCOUNTING at the various forms used by accountants shows at once that practice is far from uniform. If items other than the direct costs are to be included in the Trading Account the criterion by which selection is to be made offers new difficulty. The one frequently followed is to include only those expenses which are at least roughly proportionate to the amount of goods sold. But this line of division is most vague, and custom, while including wages of salesmen and commissions to travelers, excludes the wages of bookkeepers, which equally may vary with the amount of business transacted. 3. What constitutes selling ■ price is another problem, for at times* it is difficult to determine whether a given charge is a deduction from the selling price or a part either of the selling or of the general administrative ex- penses. The discounts allowed on sales come under this class of doubtful items. Custom seems to favor deducting from the sales the trade discounts, that is, those deduc- tions conventionally allowed to dealers from the nominal selling price. On the other hand, the discount allowed for an early payment of the account, according to Lisle, should not be deducted from sales, but be treated as is interest and discount paid the bank, that is, as a cost of obtaining the needed working capital. Thus it results that the difference between the nominal selling price and that actually received may appear in either one of three sections of the Profit and Loss statement; in the first as a deduc- tion from sales, in the second as a selling expense, or in a subsequent one as the cost of borrowed capital. 4. Of greater theoretical, but of less practical interest is the location of taxes. This is shown clearly in the case of railroads. Some roads, as for instance the Southern Railway and the Illinois Central, treat taxes as being co- ordinate with Operating Expenses and deduct them from Gross Earnings. Others treat them as fixed charges, simi- TRADnSTG AND INCOME ACCOUNTS 289 lar to interest, and deduct them from the Net rather than from the Gross Earnings. The revised form proposed by the Interstate Commerce Commission makes a special divi- sion for taxes, as is shown in form 111, and still other accountants argue that taxes should be treated as part of the Net Profits. It is impossible to say that any one of these views is absolute and exclusive. Perhaps even the system of taxa- tion may influence the decision as to the proper treatment of taxes in accounts. A strong argument can be made in favor of the view that taxes are really a part of profits and not a deduction from earnings to be made before determining profits. In so far as the stockholder is con- cerned it turns on two facts: whether the taxation of the road exempts the stockholders from other taxation; and whether the capitalist would escape taxation on other in- vestments. If the stockholder has his dividends lessened by the taxes paid, but in all probability would pay no taxes were his funds invested, say, in bonds or mortgages, the taxes are, from his point of view, in no sense a distri- bution of profits. But where there is an income tax uni- formly enforced, and the payment of taxes by the road works merely as a stoppage of that part of the income, it is not illogical to consider the tax as a distribution of part of the Net Profits derived from operating the road. 5. Of much greater importance is the treatment of depreciation. In a preceding chapter it was shown that depreciation, despite conflicting usage and authority, is a charge which should invariably be made. Here the ques- tion is as to the. section of the Profit and Loss Account- using the title in its broadest sense— in which depreciation shofild appear. Almost all possible combinations are found even in the relatively few accounts in which depreciation shows at all. In some few eases it is subtracted from Gross Earnings, and thus, like expenses, is prior to the 290 MODEEK ACCOUNTIN^G determination of Net Earnings. This is done for instance by the National Biscuit Company. By some, for instance the Chicago City Railway Company, it is even distinctly included among the expenses. Much more frequently it is subtracted from Net Earnings, in whieh place it may rank along with dividends or may be regarded as one of the fixed charges; since in many accounts fixed charges, depreciation, dividends, and reserves tire ail together sub- tracted from " Net Earnings " without any intermediate balancing to indicate how much of the net earnings are at the same time " Net Profits." An example of this treat- ment is found in the accounts of the International Mercan- tile Marine Company. In still other companies the deduc- tion is clearly made from what is called Net Profits, that is, it is deducted, together with dividends, from the balance remaining after fixed charges have been met. This is done by the Republic Iron and Steel Company. And finally the Diamond Match and numerous other companies sub- tract depreciation from the surplus after the dividends have been paid. Depreciatiorf charges are thus variously regarded as partaking of the nature of expense, of fixed charges, of profits reserved or placed in a surplus. In railroads depreciation has almost never been specifically allowed. The recent ruling of the Interstate Commerce Committee referred to above demands, however, that it be included, at least so far as equipment is concerned, among the operating expenses. Those who have followed the argument of this treatise will agree that it is a radical error to treat depreciation as anything else than a deduction to be made before profits are ascertained, and that, allowing for variations in the use of terms, it must inexorably appear in the Income Ac- count before the balance called Net Income is reached. But so far as shown by the published accounts only about one third of the corporations making any allowance for de- TEADING AND INCOME ACCOUNTS 291 preciation deduct it before obtaining the sum which— by whatever name it is called— is apparently available for dividends. The strong position taken by the Interstate Commerce Commission is theoretically correct, for depre- ciation is really ah expense. In the formal statements of manufacturing coilcerns depreciation of the plant should appear in the Manufacturing Account, the depreciation of office and store equipment in the Trading Account rather than among the fixed charges as a deduction from Net Earnings. Even to treat depreciation as a fixed charge, though that is a great improvement over regarding it as an optioiial disposition of profits, is illogical. Depreciation represents an expense not only preceding profit to the stockholders as such, but prior also to the earnings on the invested capital as a whole, whether that capital is represented by bonds or stock. Whether a road costing $100,000,000 is financed by issuing $100,000,000 stock, or by issuing only half that sum in stock and an equal amount in bonds, the invested capital (using capital in the eco- nomic, not in the accounting, sense) is the same, and the earnings of that investment should appear the same in the Income Account. No change of form of capitalization affects these earnings. Interest charges may increase, but the earnings ceteris paribus remain unchanged. But not so with depreciation. A smaller charge shows indeed larger apparent earnings, but such a showing is false and decep- tive. Depreciation, therefore, is not logically to be treated as coordinate with interest charges. It is even more erroneous to treat the fixed charges as superior to depreciation. Unquestionably there is an insistence about interest charges which appeals to the directors in a way in which a charge erroneously called a " mere bookkeeping charge " is not regarded. But the compulsion to make a payment has nothing to say regard- 292 MODEEN ACCOUNTING ing the position of the charge in the Income Account. Needed repairs may, perhaps, be deferred for years, while the payment of a collateral note is imperative and un- avoidable. But the inclusion of repairs among expenses is never even questioned, vrhile the payment of a note has no place whatever in the Income Account, does not in the least affect the determination of profits. A sound system of accounting will therefore not make depreciation subse- quent to fixed charges merely because of the imperative nature of the latter payments. Finally placing depreciation charges after net profits is not only incorrect in theory, but tends to the vicious policy of making the amount of depreciation depend on the amount of profits and of omitting it altogether when thefe are no net profits against which it may be charged. BIBLIOGRAPHICAL NOTE TO CHAPTER XV Bkoakee, F. and Chapman, R. M. The American Accountants' Manual, I, pp. 131-148. New York, 1897. Champness, C. H. Form and Arrangement of Profit and Loss Accounts. AccouTitant, XXIII, 1904. Lisle, G. Accounting in Theory and Practice, pp. 55-63. Edin- burgh, 1906. Manufacturers' Accounts. Article in Encyclopedia of Account- ing, V, pp. 1-5. Profit and Loss Account. Article, Ibid., V, p. 366. Revenue Accounts and Balance Sheets. Encyclopedia of Account- ing, VIII, pp. 249-326. [Contains an interesting collection of Revenue Accounts of British companies.] CHAPTER XVI COST ACCOUNTS The desire to distinguish between the elements of profit due to industrial and commercial activities respectively led to the formulation of the Manufacturing and Trading Ac- counts. The stress of modern business and the keenness of competition make necessary a more minute analysis and a closer estimate. Not only must it be known what are the manufacturing costs as a whole, but these must be so ana- lyzed as to indicate the cost of each commodity, of each process employed in production, even of each part, minute though it be, of which the commodity is composed. Sys- tems designed to secure such information are known as Cost Accounts. The attention given to such investigations is of recent origin. The first reference to its desirability is said to be that of Charles Babbage in his " Economy of Manufac- ture," published in 1832, but half a century elapsed be- fore factory managers began on any extended scale to introduce systems of Cost Accounts. Since then increased attention has been given to the subject, particularly under the influence of engineers, to whom, rather than to pro- fessional accountants, the credit of inaugurating and de- veloping cost accounting is perhaps due. More specifically the purposes of cost accounting are as follows: 1. To indicate the probable actual cost of production so as to enable the manufacturer to determine the price at which he can profitably sell. This is particularly impor- 293 294 MODERN" ACCOUNTrKrG tant in engineering work where so much is done on con- tracts rather than by producing stock goods for the open market. Thus, for instance, a system of cost accounts, accurately kept, should enable a shipbuilder to give an estimate of the cost of constructing a vessel which would be something more than guesswork. 2. Identical in principle is the value of cost accounts in indicating whether the manufacturer shall produce goods for the open market where the price is already fixed by competition. Without such information manu- facturers have undoubtedly continued to produce and sell certain lines of goods which, at least to them, were un- remunerative and a source of loss. Perhaps the market price is fixed by some competitor whose peculiar advantage in production gives profits at prices unremunerative to less favored rivals; or perhaps the price is due to ignorance on the part of the competitors who are themselves selling at a loss while fancying that they are making profits. A clear understanding as to whether the manufacturer can produce so as to realize a fair profit at current prices is of advantage not merely to the individual, but also to society, as it serves to prevent the misdirection of capital and the great loss which occurs when readjustment be- comes necessary. 3. Cost Accounts have a further advantage in deter- mining the advisability of introducing a new process, or of substituting machine for hand labor. They have shown, for instance, that it is profitable to run a drill so rapidly as to wear it out in a single day, although at a slower speed it would have drilled twice as many holes before de- struction. They show at what prices of machinery and of skilled labor it is profitable to substitute an automatic machine in a process which can interchangeably be per- formed by a skilled laborer on a less costly machine. Thus throughout the industrial process Cost Accounts substitute COST ACCOUNTS 295 facts and intelligence for the rule of thumb and blind guessing. 4. Finally, Cost Accounts furnish a convenient method for checking the efficiency of factory management. If it appears that the cost of producing a given form of pinion has increased, it enables the manager at once to locate the cause. It may be that the change is unavoidable, due to higher cost of raw material or higher wages. But, on the other hand, investigation may show carelessness on the part of the foreman, and ill-advised redisposition of labor, or wastefulness in the handling of material — evils which are already far on the way toward correction when once their existence is shown. Slight losses of this kind may well escape attention if only general results are studied ; or the losses in one department may easily be offset — but by no means canceled— by a new economy elsewhere. The sub- division of accounts makes it more easy to detect changes, and gives a constant incentive to foremen and superin- tendents to reduce costs. The discussion of Cost Accounting is rendered more difficult by the rather vague and varying terminology em- ployed. There are many different costs depending on the point of view. The terms used to designate these differing costs— Prime Cost, Factory Cost, Total Cost, etc.— are not uniformly defined either by economists or accountants. This may be illustrated by the case of a factory which desires to learn the cost of producing, say, a pair of shoes. To pro- duce this the following factors are involved: (1) The raw material used. (2) The wages of the laborers directly em. ployed in making the shoes. (3) The expenses of operating the factory as a whole which are not. particularly assigned to this pair of shoes, as for instance the wages of watchmen, the repairs on the building, the cost of the "power used for various purposes, etc. (4) The expenses of the establish- ment outside of the factory. (5) More questionably the 296 MODERX ACCOUNTING normal rate of profit, whetlier separated or not from the normal rate of interest on invested capital. In a broad sense profit is a necessary cost of the permanent continu- ance of the industry ; for, if normal profits are not secured, new factories will not be started, and an adjustment of prices will be ultimately secured whereby profits as well as wages wiU be covered by the selling price. By some writers the first and second items mentioned above are collectively called Prime Cost, while the first three items together make up Factory Cost. Other writers vise Prime Cost to indicate the same as Factory Cost just defined, and these employ no specific term to indicate the sum of the cost of material and labor directly employed. The sum of the first four items is sometimes called Total Cost, sometimes " Cost to make and sell." Accountants universally exclude profits from cost, but use as a compre- hensive term, including all five items enumerated above, the phrase " Selling Price." In addition to these differ- ences in terminology there is divergence in regard to the treatment of certain particular items, such as interest, rent, taxes, etc., involving the principles discussed in Chapters IV and XV. Without attempting to decide between the various usages, each of which has the support of high authority, and no one of which therefore can be declared Wrong, the real problem may be faced, namely: "What share of the total expenses, covering as they do the production of vari- ous commodities, is to be assigned to the cost of some one commodity, or to some single process? As to the first two items, wages and material, there is no doubt as to the prin- ciple and little difiiculty in practice. The material actu- ally used and the wages of laborers directly employed in producing the given commodity are obviously an integral part of the cost of producing that article. The connection is so clear that the use of the phrase Prime Cost seems in COST ACCOUNTS 297 a measure to be justified in describing these two funda- mental and easily ascertainable elements of cost. The first point of difficulty comes in attempting to dis- tribute the indirect factory costs among the various com- modities produced. Various principles are used, among which may be mentioned the following: 1. The indirect factory expenses, which include such items as wages of workmen employed in general labor such as watchmen, cleaners, firemen, etc., the wages of foremen and superintendents, light, heat, rent, and repairs of fac- tory and its equipment, depreciation, etc., are apportioned among the various jobs or processes in the proportion which in some particular exists between the given job and the total operations of the factory. But the basis on which the comparison is made is variously chosen, and it may rest either on a. The direct wages paid. h. The hours of labor spent. c. The material used. d. The direct wages paid plus the cost of material, (Prime Cost.) e. The units of product. Other bases may also be taken, and one of them, the Machine Rate, is reserved for further discussion, but the five mentioned above are those most generally used. Taking, as purely arbitrary figures, those given below in Form 114, it is seen that each of the methods may pro» duce quite different results, the figure in the last column indicating the amount of the total indirect factory ex- penses of $12,000 to be apportioned to the particular job on each of the five bases of distribution mentioned. Doubtless in actual practice, the divergence in results reached by the different methods would not be so great, as in the figures given below. But it is clear that unless all work is of a practically uniform character the costs 298 MODEEN ACCOUNTING obtained must vary according to the basis of distribution selected. Unfortunately for scientific accuracy it is impos- sible to pick out any, one of the methods named as being logically correct or uniformly accurate. The first one, which distributes factory expenses in proportion to direct wages paid, is probably more frequently used than any of the others. It is, however, obviously incorrect where there is great divergence in rates of wages paid, or where there is a difEerenee in the degree in which automatic machinery is used in the various processes. But it is simple of appli- cation, and this fact in itself probably explains its more general use. Form 114. Basis Used In Entire Factory On this Job Apportion- ment (a) Wasres Daid $24,000 60,000 16,000 40,000 400,000 $100 400 50 ISO 4,000 $50 00 80.00 (c) Material used 37.50 (d) Wages plus Material 45.00 120.00 Distribution in proportion to hours rather than to cost of labor is favored on the ground that much of the indi- rect cost, such as foremen's wages, light, heat, etc., is de- pendent on the hours of work, and that other general charges, such as rent, depreciation, etc., have a direct rela- tion to time. But its critics point out the fact that it makes the same charge upon the labor of a boy running a fifty-dollar machine that it does on that of a man with a thousand-dollar machine, " the grotesqueness of which procedure will not be enlarged upon." Apportionment of indirect factory expenses on the basis either of material or of the sum of wages plus material has the obvious ob- jection that there does not seem to be any logical connec- tion between an increase in the cost of material used and COST ACCOUNTS 299 an added charge for indirect factory costs. Apportion- ment in proportion to the units of product may be most convenient of application in certain kinds of production, and is frequently used in foundry practice, the ease with which this system is used being held to more than offset any theoretical objection on the ground of the absence of strict logical accuracy. The foregoing methods have all considered wages and material as the only charges directly apportionable to the particular product or operation, and have made all the indirect charges a function of labor or material. A dif- ferent conception is one which recognizes to a greater or less degree that in modern factory production there is a third element of cost, namely, that of the machinery em- ployed. This theory has had various applications. In some it has merely determined the direct cost of the ma- chinery, including depreciation, repairs, and interest, and from this obtained an hour-rate by dividing the total of such costs by the assumed number of hours which the machine runs. This method, of course, merely gives an apportionment of part of the indirect expenses of the fac- tory and leaves probably the larger part still to be allo- cated. Furthermore, it does not give correct results where the machinery is idle for part of the time, for the rate charged is on the basis of the machine running the assumed number of hours. Sometimes the method has involved dividing all the indirect expenses by the total number of hours which the machines run, or are supposed to run, thus obtaining a uniform hour-rate without differentiation between different classes of machines. This is similar to dividing the indirect expenses according to the hours of labor spent on the particular operation, the difference being that in one case the hours of labor, in the other the hours of machine operation, are taken as the basis of dis- tribution. 300 MODERN" ACCOUNTING The obvious objection here is that many of the indirect expenses have no more to do with the cost of running the machines than they have to do with wages or the cost of material. For instance, in a factory in which all the work was done by hand there would still be indirect charges covering the cost of the factory itself, the watchmen, light and fuel necessary for keeping the building warm in win- ter. These certainly cannot be machine costs, where no machinery is used, and part of similar expenses in a niod- ern factory equally relate to labor rather than to machin- ery. Or again some of the indirect expenses relate to the material used, as, for instance, the additional watchmen required where the material is costly and portable and hence easily stolen. Probably the indirect expenses of an establishment for polishing diamonds have no great rela- tionship to the use of machinery. In the more improved methods of obtaining machine rates the attempt is to determine not merely part, but all of the charges which attach to the running of a given machine, and to make an hour-rate which correctly dis- tributes all such expenses. In other words it is an exten- sion of the costing system to the operation of the individual machines themselves, so as to determine scientifically what is the real cost of running each one of them for an hour. This system has been strongly advocated by A. Hamil- ton Church, who outlines it as follows: " First we consider each machine as an independent production center, allocating to such centers all the ex- penses and charges which can on reasonable analysis be considered as chargeable as a composite rent or machine rate for all the factox-s of production therein concerned. Second, we charge to a monthly shop-charges account all charges whatever incurred by that shop, including all the items specifically represented in fractional detail by the machine rates, and also including, of course, such general COST ACCOUNTS 301 items as cannot be represented in the machine rates, of /which the most obvious item is the supervision of a head or foreman. " Then as each machine is occupied on jobs, the latter are debited vpith so much per hour as machine rate, and at the end of the month the total amount so earned by the machines is deducted from the total shop expenses, leaving a balance which is distributed over the same jobs as a supplementary rate. The ratio of the supplementary rate to the amount distributed by the machine rates forms a varying barometer whose fluctuation is an index of the efficiency of the shop. " It will of course be obvious that when the machines are all running full time the supplementary rate will con- sist of the general charges alone, such as the foreman's wages, which have not any individual connection with the particular machines. This will be the condition of maxi- mum efficiency in the shop. In proportion as all machines are not kept full of work all the time, this ratio of the supplementary rate to the amount distributed by the ma- chine rates will begin to rise. The same effect will occur if any general kind of expenditure is increased." ^ In determining the special hour-rate to be applied to a given machine the following method is advocated by Church. First the costs of the factory building as such are determined. These include interest, insurance, depre- ciation and repairs on the building, ground rent, if any, and taxes on the real estate. All these expenses are appor- tioned between the various machines on the basis of the floor space occupied. This rate may be further varied by distinguishing between space occupied in one or another part of the building. Second, the cost of lighting is de- termined, which is also distributed according to floor space where there is general overhead lighting, with spe- ' Engineering Magazine, XXI, 909. 302 MODEEN ACCOUNTING cial charges for individual lights for a particular machine. Third, the cost of power, which includes fuel, boiler and engine costs, wages of firemen and engineers, etc., all of which is reduced to a rate per horse-power hour, which is then charged to each machine on the basis of the esti- mated power used by each machine. Fourth, the cost of the machine itself, which as before stated includes interest, depreciation, etc., and all of which is apportioned accord- ing to the estimated annual working hours.^ The several factors just enumerated give a machine-hour rate, differ- ent for each type of machine, which is supposed with some degree of accuracy to cover all the costs of operating that machine, assuming that the machine is fully occupied. But it still leaves two elements of indirect cost not yet apportioned. One of these covers the general expenses of the factory which cannot with any show of reason be con- sidered part of the cost of operating the machine, and the other that element of expense which remains unappor- tioned because the machines are not run to their full esti- mated capacity. It is apparent, therefore, that even the elaborate scheme of machine costs proposed by Church does not entirely remove the problem as to the distribution of indirect fac- tory costs. It has, however, made that problem of much less practical importance, for instead of considering all the expenses over and aboVe the wages and cost of material as indirect expenses, the apportionment of which must be largely by a crude and unscientific ratio, the bulk of the general factory expenses are found to be directly attrib- utable to particular jobs through the machine rate, and there remains as unallocated expenses only the two items mentioned in the last paragraph— those by nature not as- signable to a machine rate, and those due to idle plant. The treatment of the unassignable expenses is relatively i Engineering Magazine, XXII, 31 ff. COST ACCOUNTS 303 unimportant, for it cannot constitute a very large propor- tion of the total expenses. Church suggests that the appor- tionment be on the basis of the hours spent on the various jobs. But where there is a considerable margin due to idle plant the apportionment of this sum is of some theoretic interest. The illustration given by Church assumes a factory with four machines on which the machine rate was based on the assumption that they would each work 200 hours, the rate charged to each machine being 40, 30, 20 and 10 cents respectively. Had each of the machines been used for the full assumed time the charges would have covered the total indirect expenses of $200, but because of idleness there remains a balance of unassigned charges amounting to $58, the charges to each machine being as shown below : Form 115. Machine Time used Rate per Hour Amount Charged A 120 134 169 200 $0.40 0.30 0.20 0.10 $48 00 B : 40 20 c 33.80 D 20.00 623 $142.00 In this ease, the author argues, the $58 may either be apportioned on the basis of the hours employed, making a supplementary rate of 9^ cents per hour, or on the basis of the amount of the machine charges, making a supple- mentary rate of 40.8 per cent, (ibid., xxii, 910). Which- ever method is used, the result is that the cost of produc- tion is increased because of the idle machines. To this some critics vigorously object. If the costs are taken as the basis for making estimates, or bids, it leads to the illogical result that at the very time when, because 304 MODEKlSr ACCOUNTING of an idle factory, it is most desirable to get new work, the accounts will show that the work cannot profitably be done except at a price higher than normal. Whit- more, writing in the Journal of Accountancy, therefore urges that these costs representing idle time should not be charged up against the goods produced. In his opinion they should be put in a separate account which would be treated as a general expense of the establishment, not as part of the immediate cost of manufacturing. But the practical results are the same whether supplementary charges are treated as "Whitmore suggests or are all dis- tributed over the goods produced. So long as the elements representing idle machines are shown in a supplementary rate, attention is clearly drawn to the loss that comes from idle plant. There is the same incentive to try for new business whether that loss appears among the manufac- turing costs or is separately shown as one of the general expenses of the establishment. A vital difference in method of estimating cost turns on the point whether the indirect factory expenses which are apportioned to different jobs are the actual expenses incurred during the period in which the operations are performed, or whether they are to be based on the experi- ences of past operations. For instance, in a given factory it may be desirable to treat the indirect costs as a per- centage to be added to the prime cost. This may be done by taking account, say, at the end of each month of all such expenses and accurately apportioning them to the work then in progress. But others, as for instance Oberlin Smith and Nisbet, recommend that the added charge be based on the experience of a preceding year, or series of years, so that the charge can at any time be made without waiting for the results of the current period. To some it seems that by taking the current figures a greater degree of accuracy is obtained. But it should be COST ACCOUNTS 305 remembered that for certain purposes what is desired is not so much the actual amount which it cost to produce a certain commodity, as an estimate of what it will cost to produce more of the same kind of goods. This is particu- larly true where special contracts are undertaken. Just what experience will give the best indication of future costs may be debatable. It does not necessarily follow that the experience of the present month is any better criterion than that of last year. The distribution of general establishment charges offers somewhat similar difficulties. These expenses include the office expenses, the expenses of selling, and the general expenses of financing and managing the whole enterprise. Alternative methods of dividing these expenses among the products are to apportion them in proportion to: 1. The Wages Cost. 2. The Factory cost, i. e., the cost of wages, material and the indirect factory expenses, or 3. The hours consumed in manufacturing the product. 4. The selling price. The second method seems the most logical, for it appar- ently covers all the elements for whieh the establishment exists. Church, however, advocates employing the hours as the basis, making, however, certain modifications in the rates charged to different classes of commodities. In the preceding pages have been discussed the prob- lems concerning the distribution of indirect charges in gen- eral. Further difficulties arise in reference to the appor- tionment of certain special costs. One of these, relating to the cost of patterns, requires particular mention. Not only is there the general question as to how far the costs of designing and making patterns should be charged to expense, and how far the patterns should be considered an asset, but there is a further difficulty. After having decided that a given amount is really an expense, is it to 306 MODEEIv" ACCOTJNTIlirG be allocated to the particular products made from the pattern or treated as a general expense of the factory? This is particularly clear where unsuccessful patterns or designs are made. Are these all to be charged against the cost of the article made from a later satisfactory model, or do the preliminary attempts represent merely general expenses of the factory as such? Somewhat similarly: is the cost of making a special pattern for an article made on contract to be considered as cost of completing the contract or is there a residual value representing the serviceability of that same pattern for future possible contracts ? Three points of uncertainty arise even in regard to the best system of cost accounting. 1. The first is whether the information acquired is after all worth the expense of acquiring it. This is more than doubtful in some of the more elaborate and expensive systems of cost keeping that are occasionally introduced. To take a flagrant and noto- rious case the cost system introduced into the Government Printing Office seems to have cost decidedly more than it was worth. In this instance the committee investigating the system reported that it " is principally to be criticised upon the score that in an attempt to secure all classes of detail, the amount of labor entailed upon each employee for the purpose of recording necessary facts, and the amount of labor required for subsequent tabulation, were so great as to make the system almost prohibitive. ' ' '^ 2. The second point of doubt is as to the degree of accuracy which may be obtained and the danger which arises from treating as actual what is merely hypothetical. It has been shown that even the division between the Manu- facturing Account and the other portions of the Profit and Loss Account is with difficulty drawn and can never be regarded as of absolute value. Much more is it true ' LX Cong. 1. Seas. H. Doc. 974, p. 11. COST ACCOUNTS 307 that the detailed apportionment of expenses among the dif- ferent processes or the various commodities is to some ex- tent a matter of estimate. To be sure accounts can be prepared, though with great difficulty and much expense, in which every cent expended will be allocated to some unit of product. But it must be remembered that this rests on estimates which can never be exact. To illustrate: It is difficult to determine the exact cost of power in a fac- tory. Coal and wages may be known, but depreciation of plant is an estimate merely. But granting a substantial accuracy as to the cost of the total power this can be divided to the last cent by some system of machine rates. But much of this ostensible accuracy is specious. It is a rough estimate at best which attempts to divide the horse power among the diflFerent machines, and the degree of accuracy obtained in the final results can never surmount this fundamental defect. And the whole system of fixing the machine rate depends on an incorrect estimate of the hours during which the machine will be at work. As Bur- ton said, " Cost accounts based on separate charges for each machine employed must be generally hypothetical, and in many if not the majority of cases they must be delusively hypothetical. ' ' 3. A third point bears on the application which is to be made of the result. Are they to be used in determining whether capital shall go into a given industry? If so, it is evident that what is wanted is a correct estimate of the net income after deducting all interest on capital and other items frequently, indeed generally, excluded from the cost accounts themselves. The information necessary to show whether an enterprise is ultimately successful is very dif- ferent from that which shows whether an enterprise once established should be continued. Cost accounts as they are frequently prepared confuse these two points of view. Thus "Whitmore criticises the inclusion of idle-machine cost 21 308 MODEEN ACCOUNTING f as not showing whether to a new concern it is desirable to undertake certain work. The idle-machine cost, says he, is incidental to the establishment of a new concern and should not be included in an estimate which shows whether goods can be produced profitably at a certain price. But the same author includes interest on the cost of machines and buildings in his estimate of machine costs, while these have nothing to do with the cost of producing further goods by a factory already established. As is well known in railroad practice, when a road is once permanently con- stiucted it is better to carry freight at a price not cover- ing interest than to refuse traffic. The same principle, of course, ap|)lies to a factory. If, as seems to be the opinion in discussing idle-plant costs, the purpose of the cost ac- count is to show the figure at which the established factory can afford to produce, it is clearly illogical to include in this figure interest, which indeed bears on the ultimate profitableness of the enterprise, but not on the desirability of undertaking a given contract. As to the technic of cost accounting little can here be said. It is impossible to frame a system of cost accounting applicable to establishments of different character. Iron works producing a single form of staple commodity, a fac- tory making a few standard grades of cloth, each involving a succession of separate processes, works manufacturing special machines where it is desirable to learn the cost of the entire machine and of each of its parts, and a shipyard undertaking special contracts, each needs an entirely dif- ferent system of keeping its cost accounts. No general scheme of forms can be outlined which will apply to all of them. Nor can a scheme be outlined which will apply in detail to the different individual establishments of a single class of undertakings. As Dioksee has said: " It need hardly be pointed out that the requirements of undertakings carrying on a similar business are by no COST ACCOUNTS 309 means uniform. Special and local considerations have to be taken into account, and the most desirable system for any particular undertaking can only be ascertained after a full and detailed inquiry has been made into its peculiar circumstances and conditions. ' ' ^ Even to describe a system serviceable to a particular establishment, while it might have illustrative and suggest- ive value, would require so extended a treatment as to exclude it from a treatise on the general principles of modern accounting. The best that can be done is to call attention to some of the most elementary matters of the technic of cost account- ing, referring the reader to the more extended treatises on cost accounting, as indicated in the bibliographical note appended to this chapter, for more detailed' information, or better still to emphasize the necessity of employing a technical expert to arrange a system of cost accounting adapted to the particular needs of a given establishment. Cost accounting, as shown above, requires (1) an accu- rate recording of the wages directly paid, (2) of the ma- terial consumed, and (3) a systematic allocation of the indirect factory and establishment charges incurred in con- nection with each contract, process or product. To keep track of the direct wages it is evidently necessary to have a daily record kept showing the exact nature of the work on which each laborer is employed. Only by such an elab- orate system can the proper amount be charged to the separate accounts representing the direct wages cost of the particular contract or process. From these daily individ- ual slips can be prepared a summary of wages showing by individuals or departments the total direct wages charge. Sheets ruled in columns representing the various subdi- visions will most conveniently serve for such records. The material consumed needs similar treatment. Here, 1 Advanced Accounting, p. 232. SIO MODEEN" ACCOtnSTTIKG however, it is well to emphasize the need for careful rec- ords, as the keeping track of materials used is generally not so accurately done as in the case of wages paid. Strangely enough accountants who require the pay roll to balance to the last cent pay little attention to the accuracy of the accounts representing material consumed. A discrepancy in the cash drawer excites immediate attention while valu- able material and finished parts are often treated with carelessness and no exact balancing is expected of the store- keeper. The first requisite is, therefore, a more careful accounting for the materials as well as for the cash in the drawer, an accuracy regarding amount of material used not dissiipilar to that required in regard to wages paid. "Where the materials are directly purchased for a par- ticular contract this is simply done, and probably with greater accuracy than where material on hand is taken from the warehouse for a similar purpose. Again the fic- tion that the cash directly paid out is more important than a similar value of other assets is seen to affect accounting methods. It is in the treatment of ftores that the greatest im- provements have been introduced. In any system of ade- quate cost accounting it is now recognized that it is neces- sary to keep accurate track of all goods coming into the stores, of all goods issued for different jobs, or all returned goods not needed for the job for which they were originally issued. In this way it is possible (1) to verify the amount of goods on hand at any time and so prevent peculation and waste, and (2) to keep account of the material actu- ally used in each job. Model forms of a stores record sheet, and a requisition are given on pages 311 and 312. From the slips regarding the wages and materials con- sumed, and from similar records showing the machine rates, the proper entries can be made in a ledger account opened for each job. These ledger accounts are most con- H H W W 02 a o o H « O s T3 oa S > w c O c d 3 c 3 ■^ > ■^ -< a V ■ o^ « OS P li 3 t> « -a PL< > d) K C s a -firSc £5^ g! OS O Ld 1^ o 1 ■*3 3 O a (U 312 MODEEN ACCOUNTING O i-i g as Q s o o o ^: o I b L. •oS o J2 •a t" u, jQ :^; CQ > ^3 p 13 T3 o ^ C3 (3 o Ph 1 >-• • 1 a s: >. ^ a COST ACCOUNTS 313 •E O o .03 c3 CO TT.n O ,o Q O o 1^ S J3 o s s T3 O a O o S 0) 314 MODEEN ACCOUNTING venielitly kept in loose leaf ledgers, ruled somewhat as in Form 118. On the same sheet may be entered the sup- plementary charges and such other information as may be desired. The forms given above apply particularly to an estab- lishment where it is desired to ascertain the cost of special contracts. Where machines, for instance, are being made for stock, or where merchandise such as cloth is being simi- larly made, the items, for which columns are to be ruled, in the Cost Ledger Accounts would of course vary. The cost account of the finished machine would probably indi- cate not the labor, and material and machine rates as a whole, but rather the total cost of the several parts mak- ing up the machine. The cost of the cloth would not be divided into wages and material but into the costs of the several processes involved in making the finished product. In each case the elements must be combined so as to give most easily the information wanted in the particular factory. In many of the forms used great economy i§ secured by the use of duplicating devices, so that, for instance, the filling out in triplicate of an order for stores will provide an order to the storekeeper, a memorandum for the fore- man issuing the order, and a memorandum for the cost accountant whereby the proper entry can be made in his records. BIBLIOGRAPHICAL NOTE TO CHAPTER XVI Arnold, H. L. The Factory Manager and Accountant. New York, 1903. [Gives description of systems of cost accounting used in various factories.] The Complete Cost-Keeper. New York, 1900. Bean, B. C. The Cost of Production. New York, 1905. Burton, F. G. Engineers' and Shipbuilders' Accounts. London, 1902. COST ACCOrnSTTS 315 Chukch, a. H. The Proper Distribution of Expense Burden. New York, 1908. [An elaborate presentation of the "improved machine cost " system and a criticism of other systems of cost accounting.] Day, C. M. Accounting Practice. New York, 1908. [A valuable technical treatise, containing numerous forms.] Eddis, W. C. and Tindall, W. B. Manufacturers' Accounts. Toronto, 1904. Gahcke, E. and Fells, J. M. Factory accounts. Fifth edition. London, 1902. [A pioneer work on the subject and still standard.] Hall, H. L. C. Manufacturing Cost. Detroit, 1904. Hawkins, L. W. Cost Accounts. London, 1905. Webner, F. E. 'Obtaining Actual Knowledge of the Cost of Pro- duction. Engineering Magazine, XXXV-XXXVI. Whitmore, J. Factory Accounting as Applied to Machine Shops. Journal of Accountancy, II, pp. 248, 345, 430, III, p. 20, 106, 211. Fob FtTRTHER Bibliography, See: Encyclopedia of Accounting, II, p. 299. Engineering Magazine, XXVII, p. 645. The Accountants' Library, London, a series of some forty volumes treating of special branches of accounting gives many forms applicable to the particular needs of various classes of estab- lishments. CHAPTER XVII PARTNERSHIP ACCOUNTS Partnership accounts constitute no separate system of accounting. Whether the proprietorship is vested in one or more persons the general principle of double entry bookkeeping, that there is an equation between the sum of the Proprietorship accounts and the suin of the Goods accounts, holds true. The mere subdivision of the pro- prietorship into various accounts introduces no new prin- ciple. The essential problems of partnership are those which bear upon the essential character of the partnership rela- tion and refer to the proper division to be made of profits and losses, of assets and liabilities. If it is clearly under- stood in each case just what contract has been made there is ordinarily little difficulty in formulating the accounts. But, unfortunately, the terms of partnership agreements are at times vague, and even the courts have not always agreed on their interpretation. Some of the cases in which difficulties arise are therefore of importance to the account- ant even though there may be no really vital accounting principle at stake. The first class of difficulties arises in connection with the establishment of the firm. When an individual first opens a set of books', there either is no difficulty in know- ing how much capital he contributes, or if there be a doubt it is of no particular moment so far as it concerns ultimate distribution of wealth. If A begins business with $5,000 cash and certain real estate he should, of course, attempt 316 PAETNEESHIP ACCOIHSTTS 317 to place correct valuation on the latter in estimating his net wealth. But if he fails to do so it evidently does him- self no injury. But if two persons join in a partnership, one furnishing cash and the other real estate, it is neces- sary to know what value is placed on the latter. To be sure the original entry is the same whether it be in the books of a single trader or those of a partnership, as in either ease Eeal Estate is debited and the Capital account of the one contributing it is credited. This may be illus- trated by assuming the following opening: Form 119. Dr. Balance Sheet. Cr. Cash 85,000 5,000 A, Capital Account. . . $5,000 Re?,! Estate. B, Capital Account. . . . . 5,000 $10,000 $10,000 in which the cash is contributed by A and the real estate by B. Any other valuation of the real estate would not, in itself affect the credit of A's Capital account; nor would it, in the absence of special agreement, affect the division of profits, B being entitled to half of the profits whatever the value of his contribution. But the value at which the contributed property is adniitted is, neverthe- less, of vital importance in a partnership for having once been accepted by the firm any subsequent shrinkage in the value of the real estate is a loss to be divided between the two partners, and not one to be borne by the contributing partner alone. Conversely a sale of the real estate for $10,- 000 gives to A as well as to B one half of the appreciation, $2,500. It is evident then that it is essential in account- ing to understand the nature of the contribution which each partner makes, to interpret accurately the terms of the partnership agreement, for " in the absence of special 318 MODERN ACCOUNTnsTG agreement the rise or fall in the value of fixed plant or real estate belonging to a partnership is as much profit or loss of the partnership as anything else." (Robinson v. Ashton, L. R. 20 Eq. 28 (1875)). In this connection it is necessary to distinguish between the division of profits and a share in the partnership. This may be illustrated by the case where a single trader whose Balance Sheet shows: Dr. Form 120. BaZance Sheet. Cr. Merchandise $5,000 Capital Account $5,000 and who agrees to admit B and give him one half of the profits if he contributes $6,000. This done the Balance Sheet shows: Form 121. Dr. Balance Sheet of A and B. Cr. Merchandise $5,000 Cash 6,000 $11,000 A, Capital Account $5,000 B, Capital Account 6,000 $11,000 The basis of the division of the profits here differs from the proportion of capital contributed by each, which is legal and not uncommon in practice. But had the agree- ment been that the contribution of $6,000 by B entitled him to a half interest in the business the accounts would need different treatment. The half interest being secured by a contribution of $6,000 it implies that A too has a similar interest of $6,000 and consequently, accepting the valuation of the goods at $5,000 as correct, that he is con- strued as contributing Goodwill of $1,000 as well as the merchandise, thus giving: PAETNEESHIP ACCOUNTS 319 Dr. Form 122. Balance Sheet of A and B. Cr. Merchandise 85,000 Goodwill 1,000 Cash 6,000 $12,000 A, Capital Account $6,000 B, Capital Account 6,000 $12,000 If desired the same relationship can be represented with Goodwill eliminated as follows : Form 123. Dr. Balance Sheet of A and B. Cr. Merchandise. S-S-OOO A, Capital Account... B, Capital Account. . . . . . $5,500 Cash 6,000 $11,000 . . . 5,500 $11,000 Similarly if the arrangement specifies that B's contribu- tion of $6,000 gives him a three fifths interest in the busi- ness, not merely three fifths of the profits, and the mer- chandise still being accepted as worth $5,000, B must be construed as bringing into the firm business connections, or other elements of Goodwill, to such a value that his total contribution represents one and a half times the value of A's merchandise, or: Form 124. Dr. Balance Sheet of A and B. Cr. $5,000 A, Capital Account. . . B, Capital Account. . . .. $5,000 GoodwilL Cash ....... 1,500 6,000 812,500 . . . 7,500 $12,500 or again eliminating the Goodwill: 320 MODERN ACCOUNTING Form 125. Dr. Balance Sheet of A and B. Cr.. Merchandise Cash $5,000 6,000 $11,000 A, Capital Account...- B, Capital Account. . . .. $4,400 . . 6,600 $11,000 The first point in partnership accounting to be ascertained is then what is the exact nature of the partnership agree- ment ; what is actually contributed ; what is the division of interests between the partners. It is also necessary to distinguish between one who buys, say, a third interest in a firm from the members of the firm and one who enters the partnership with a third interest. Thus if A and B are in business together with the following showing: Form 126. Dr. Balance Sheet of A and B. Cr^ Miscellaneous assets. . . . . $60,000 A, Capital Account. . . B, Capital Account. . . . . . $20,000 ... 40,000 $60,000 $60,000 C might, if it were mutually agreed on, buy a third inter- est in the firm from B, paying therefor $20,000, which would give as the Balance Sheet of the new firm: Dr. Form 127. Balance Sheet of A, B, and C. Cr. Miscellaneous assets $60,000 $60,000 A, Capital Account $20,000 B, Capital Account 20,000 C, Capital Account 20,000 $60,000 But if be were admitted to the firm with a one third inter- PAKTNEESHIP ACCOUNTS 321 est the showing, provided he contributed the book value of his share in the business, would have to be as follows: Dr. Form 128. Balance Sheet of A, B, and C. Cr. Miscellaneous Assets $60,000 Cash 30,000 $90,000 A, Capital Account $20,000 B, Capital Account 40,000 C, Capital Account 30,000 $90,000 This important distinction has not always been observed by writers, as may be seen even in Dicksee's work on Goodwill. The allowance of interest on partners' capital furnishes opportunity for disagreement, principally when the exact nature of the allowance is not definitely stated in the arti- cles. If interest is to be allowed on the entire capital the matter is simple. Thus assuming partners who contribute as follows : A $100,000, B $60,000 and C $50,000, interest at 5 per cent, to be allowed and profits shared equally, the several accounts concerned will be as in Form 129. The same net results, so far as the partners' balances are concerned, may be secured by crediting or debiting interest on the excess or deficit which each partner's con- tribution shows in relation to the average capital. ' The three partners have together furnished $210,000, of which the average is one third or $70,000. A receives interest on an excess of $30,000, B is charged on a deficit of $10,000 and C on $20,000, which gives the same balances to the credit of the several partners as those in Form 129, but without passing the charge through the interest or profit and loss account. The correct booking in this case could be secured by the following journal entry: B $500 C. 1,000 ToA $1,500 322 MODERN ACCOUNTING Form 129. Dr. A, Capital Account. Or. J of interest allowed. . . Balance . . $3,500 .. 101,500 Cash $100,000 Interest on $100,000 at 5% 5,000 $105,000 $105,000 Balance $101,500 Dr. B, Capital Account. Cr. J of interest allowed $3,500 Balance 59,500 $63,000 Cash $60,000 Interest on $60,000 at 5% 3,000 $63,000 Balance $59,500 Dr. C, Capital Account. Cr. 1 of interest allowed. . . . $3,500 . 49,000 Cash $50,000 Interest on $50,000 at 5% 2,500 $52,500 $52,500 Balance $49,000 Dr. ' Interest Account. Cr. Allowed on partners' capital: A $5,000 B . 3 000 By A " B " C $3,500 3,500 3,500 C 2,500 $10,500 $10,500 $10,500 Note. — ^As these accounts are to show only the effect of the interest transactions the Interest Account has been closed directly into the Capital Accounts instead of being carried to the Profit and Loss account and appearing indirectly in the balance of Profit and Loss carried to the partners. PARTNEESHIP ACCOUNTS 323 It is to be noted that had the basis of profit sharing not been one third to each but in some other proportion, say, 2:1:1, the basis of comparison, by which excess con- tributions are measured, would be correspondingly modi- fied. Thus A's contribution being compared with two fourths of $210,000 or $105,000 he is charged with interest on $5,000 or $250; B showing an excess of $7,500 over $52,500 (i. e., one fourth of $210,000) receives $375; and C pays $125. These entries produce the same results as though the entire capital had been credited with interest and the total interest, $10,500, had been divided in the proportion last named. If profits are divided in proportion to capital contrib- uted by the several partners, interest may be reckoned for the purpose of distinguishing the business profits from those derived from invested capital, but the amounts cred- ited to each partner is not thereby altered. Hence, while it may be desirable to make allowance for interest even though profits are proportionate to capital, this is useless unless put through the interest account in full. It is seen therefore that interest on the partners' cap- ital may be estimated either on the whole contributed capital, in which ease the entries must go through the Interest Account, or by figuring it merely on deficiencies and excesses (relative to the proportion in which profits are divided). In the former case the entries must go through the Interest Account; in the latter the entries are made direct to the proprietors' Capital accounts and do not appear in the Interest Account. The former method not only serves to adjust differences between the partners, but at the same time serves to distinguish between the profits supposedly arising from investment of capital at the normal rate of interest and the profits of the business operations. The second method merely adjusts differences between partners. 22 324 MODEKN ACCOUNTING Where the agreement does not call for interest on the ■whole capital but only on excesses and deficits relative to the amount agreed on the treatment is quite similar. Tlius if the partners had agreed to contribute as follows: A $100,000, B $60,000, and C $50,000, but in fact paid $70,000, $73,000 and $25,000 respectively, profits to be shared equally, the Interest Account would show: Dr. Form 130. A, Capital Account. Cr. Interest on $30,000 $1 ,600 Balance 69,200 $70,700 Cash $70,000 J of interest received 700 $70,700 Balance $69,200 Dr. B, Capital Account. Cr Balance $74,350 $74,350 Cash $73,000 Interest on $13,000 650 § of interest received 700 $74,350 Balance $74,350 Dr. C, Capital Account. Cr. Interest on $25.000 . . . $1,250 Cash § of interest received . . Balance.; . . $25 000 Balance ... 24,450 $25,700 700 $25,700 . . $24,450 Dr. Interest Account. Cr. To B on $13,000 '. . . . $650 2,100 $2,750 On A's deficit On C's deficit $1,500 1,250 Balance to partners : A $700 B 700 G 700 $2,750 PAETNEESHIP ACCOUNTS 325 Had profits been shared in proportion to i;he agreed on contributions of capital (i.e., in ratio of 10:6:5 in this example) the accounts would show: Form 131. Dr. A, Capita I Account. Cr. Interest on $30,000 deficit $1,500 Balance 69,500 $71,000 Cash ^ of interest received.. . Balance . $70,000 . 1,000 $71,000 . $69,500 Dr. B, Capital Account. Cr. Balance $74,250 Cash $73,000 Interest on $13,000 excess 650 ^ of interest received. . . . 600 $74,250 $74,250 Balance $74,250 Dr. C, CapiUd Account. Cr. Interest on $25,000 deficit $1 ,250 Balance 24,250 Cash ^ of interest received . . Pftlance ..$25,000 500 $25,500 $25,500 . . $24,250 Dr. Interest Account. Cr. ToBonSlS.OOO $650 On A's deficit On C's deficit $1,500 1,250 Balance to partners : A, if. $1,000 B,^ 600 G. A. 500 2,100 $2,750 $2,750 326 MODERN ACCOUNTING But in the latter ease the adjustment could have been more simply made by entries made directly in the Capital Accounts, without passing through the Interest Account. But where this shorter method is usfed, the amount, on which interest is charged or credited to each partner, again is not determined by comparing his contribution with the amount which he agreed to furnish ; but the amount which he contributes is compared with the proportion of the total contributed capital corresponding to his share in the profits. Thus in the above example A's actual contribu- tion of $70,000 is compared, not with the amount agreed on, namely, $100,000, but with ^ (the ratio in which he shares profits) of the total contributed capital, $168,000, i. e., with $80,000, showing a deficit of $10,000. B's actual Dr. Form 132. A, Capital Account. Cr. Interest on $10,000 deficit $500 Balance 69,500 $70,000 Cash $70,000 $70,000 Balance $69,500 Dr. B, Capital Account. Cr. Balance $74,250 $74,250 Cash $73,000 Interest on $25,000 excess 1,250 $74,250 Balance $74,250 Dr. C, Capital Account. Cr. Interest on $15,000 deficit $750 Balance 24,250 $25,000 Cash $25,000 $25,000 Balance $24,250 PAKTNEESHIP ACCOUNTS 327 contribution is compared with ^^ of $168,000 or $48,000, showing an excess of $25,000, and C's with -^ or $40,000, showing a deficit of $15,000. The accounts would there- fore appear as in Form 132. To sum up : "When interest is allowed on the total cap- ital, entries may be through the Interest Account, or the adjustment may be made directly between the Capital Ac- counts by allowing interest on excesses and deficits relative to the proportion of total contributed capital correspond- ing to the individual partner's share of profits. But where interest is allowed only on excesses and deficits, the shorter method can be used only where profits and assumed capital contributions are proportionate. Otherwise the adjust- ment of excesses must be made by the longer form of put- ting entries through the interest or other similar account. A third problem relates to the final distribution of as- sets in case of liquidation. Here great confusion exists, even in the decisions of courts. To illustrate, there may be taken a partnership between A and B in which A fur nishes $2,000 and B $500, profits to be shared equally. But losses having been suffered, the total assets amount to only $1,000, the balance sheet showing: Form 133. Dr. Balance Sheet. Cr. Cash Deficit $1,000 1,500 $2,500 A, Capital Account B, Capital Account. . . . . . . $2,000 500 $2,500 It has been variously claimed that in such a case the avail- able cash is to be divided either on the basis of the divi- sion of the profits, i. e., $500 to each ; or on the basis of con- tributed capital, i. e., $800 to A and $200 to B. Neither of these is correct from the accounting viewpoint. The loss 328 MODEEN ACCOTJNTriSrG of $1,500 by the terms of the agreement being divisible equally, the accounts should show : Dr. FoKM 134. Balance Sheet. Cr. Cash $1,000 A, Capital Account. . . . . . $1,250 B, deficit 250 $1,250 $1,250 so that A is entitled not only to the cash but has a valid claim against B for $250. A moment's glance will show that in no other way can losses be shared equally, and this is the doctrine of Nowell v. Nowell (L. R. 7 Bq. 538 (1869)). Somewhat more complicated, but similar in principle is a case where three partners whose statement is: Form 135. Dr. Balance Sheet i >f A, B, and C. Cr. Cash $2,200 A, Capital Account. . . . B, Capital Account. . . . C, Capital Account.. . . . . . . $2,000 Deficit 4,800 ... 500 ... 4,500 $7,000 $7,000 Dividing the deficit gives : Form 136, Dr. Balance Sheet. Cr. Cash B deficit $2,200 1,100 A, Capital Account C, Capital Account . . . $400 . . . 2,900 $3,300 $3,300 If now, B is found to be insolvent and the claim against him worthless, a great variety of opinions are given as to PAKTNEESHIP ACCOUNTS 329 the proper division of the remaining assets between A and C. Thus it has been claimed that A is entitled to one half of the cash, or $1,000, others say to || or 676.92, and still other claims, whose reasoning need not be given here, but which may perhaps be worked out by the curious reader, give him $1,661.54, $2,113.04, and $266.66. To the accountant the solution is simple and clear. There being only $2,200 cash with which to pay the $3,300 due to A and C, the two together are to suffer a further loss of $1,100 which according to the terms of the agree- ment is to be borne equally. Hence, charging the worth- less claim against B equally to A and C gives: FoEM 137. Dr. Balance Sheet. Or. Cash A, deficit $2,200 150 C $2,350 $2,350 $2,350 whereby A, instead of receiving anywhere from $676.92 to $2,113.04, is compelled to pay C $150. While the correctness of the principle involved in this solution is recognized by accountants, the courts have not been so uniform. However, it is most fully set forth, with illustrative examples in the case of Raymond v. Putnam (44 N. H. 160 (1862) ), and has been more recently vouched for in "Whitcomb v. Converse (119 Mass. 38 (1875)) and confirmed in "Woelfel v. Thompson (173 Mass. 301 (1899)). Unfortunately a recent English ease (Garner v. Murray [1904] 1 Ch. 57), relying on the phraseology of the statute, sanctions another solution.^ ' The decision in Gamer v. Murray has been much discussed by accountants. A series of interesting communications on the subject may be found in the Accountant for 1904. It is also discussed in 330 MODEEN ACCOUNTmG The foregoing discussion shows the futility of the ques- tion frequently raised as to the basis on which assets are to be divided, the ratio in which losses are shared being already given. Such a question involves a misconception or else is purely gratuitous. If all losses are shared accord- ing to the agreed proportion, the capital accounts of the several partners show the amounts which they are sev- erally to receive or pay. Evidently a firm starting with an equality of assets and capital will, by the most elementary principle of bookkeeping, have assets still equaling the balances of the Capital Accounts if all shrinkages are de- ducted from the original credits. One needs not estimate proportions, the absolute amounts must appear in the Capi- tal Accounts themselves. To determine the final distribu- tion of assets it is necessary only to determine profits and losses, to divide these in the agreed proportion, and to discharge the remaining capital balances, collecting from the debtor^ and paying to the creditor partners. In one set of circumstances there is, however, a problem of division of assets apparently distinct from that of appor- tionment of losses. This occurs where a liquidation takes place and it is desired to distribute the assets in install- ments as quickly as they are realized, and hence before the net loss is ascertained. The aim is to distribute the assets in such proportions that in any contingency no one part- Dicksee's " Advanced Accounting," 2d ed., p. 66. Dicksee favors the solution here given, but in attempting to work out a solution corre- sponding to the decision of the court he seems to have misunderstood the latter. The court records furnish many other interesting illustrations of the difficulty which the legal mind finds in solving problems requiring ac- counting knowledge. Aside from mere arithmetical errors, which are surprisingly common, many of the decisions involve errors in principle. Cases in point are: Gunnell v. Bird, 10 Wall. 304; Oakley v. Cokalete, 41 N. Y. Supp. 1124; Schulte v. Anderson, 13 Jones & Sp. 489; Butler V. Ballard, 43 N. Y. Sup. Ct. 191. The last named is quoted anrf criticised by W. C. Jaudon in Banking Law Journal, XI, 342. PAETNEESHIP ACCOUNTS 331 ner will be paid more than his share. This may be illus- trated by taking the ease of a partnership in which the profits and losses are to be divided as follows : 50 per cent, to A, 30 per cent, to B, and 20 per cent, to C, the balance sheet before liquidation begins being: Dr. Form 138. Balance Sheet of A, B, and C. Cr. Assets $25,000 Deficit 5,000 $30,000 A, Capital Account $10,000 B, Capital Account 10,000 C, Capital Account 10,000 $30,000 On the principle already discussed the deficit is appor- tioned among the partners, leaving the claims of A, B, and C at $7,500, $8,500, and $9,000 respectively. If the assets were all in ready cash the problem of distribution would be removed. But assuming that the assets are only grad- ually sold and converted into cash, the yield in successive installments being $10,000, $8,000, and $6,000, after which nothing remains, there is a real problem as to the proper distribution of each installment. When the first installment of $10,000 is received how should it be divided ? It should not be divided in proportion to the original contributions of capital, that is, in thirds ; nor in the same proportion as profits were divisible, that is, in the ratio of 5:3:2; nor in proportion to the capital then standing on the books, that is, in the ratio of 75 : 85 : 90. The correct method is as follows: It being impossible to know beforehand how much the remaining assets will yield, it is necessary to equalize the status of the partners so that if no more cash is received the actual losses will be in the predetermined ratio. If nothing had been realized the net loss of each of the partners would have been $7,500, $8,500, and $9,000 332 MODEEN ACCOUNTING respectively. But if A loses $7,500, B should, by tlie part- nership agreement, lose only $4,500 and C only $3,000. Before paying anything more to A $4,000 should therefore be paid to B and $6,000 to C. The $10,000 cash should accordingly be divided on this basis. The illustration is here made simple by assuming a first installment just suf- ficient to equalize the status of the three partners and by omitting all consideration of expenses and interest. But similar reasoning would determine the distribution had some smaller sum been available for dividends. The adjustment between partners having once been made, all further installments are to be divided in propor- tion to the division of losses. This is not because the divi- sion of assets is at all the same as the division of profits or of losses, but because this method of treating all un- realized assets as potential losses prevents any one of the partners being overpaid. After the distribution of the three installments the accounts will appear ' as in Form 139. If the assets fail to produce more the losses are still properly divided according to the agreed ratio.^ The discussion in the present chapter does not profess to treat any problems save those which seem peculiar to the status of partnership. While in the keeping of part- nership accounts questions will arise as to the most con- venient method of booking certain transactions, these are ordinarily mere questions of general bookkeeping technic and not peculiar to partnership. Or problems may arise such as the amount of profits to be divided, but these are all matters of accounting principles elsewhere discussed, say under valuation, depreciation, or profits; questions all ' The problems involving the principle discussed above are given in Dicksee's " Advanced Accounting " (p. 69) and in Breaker and Chap- man's "American Accountants' Manual." The solution given in the former is correct, but in the latter, the authors, while apparently recognizing the correct method, fail rigorously to apply it so that the results are in part wrong. PAETNERSHIP ACCOUNTS 333 Form 139. Dt. a, Capital Account. Cr. Deficit $2,500 Cash 50% of 2d install- ment 4,000 Cash 50% of 3d install- ment 3,000 Balance 600 Original capital Balance $10,000 $10,000 $10,000 $500 Dr. B, Gapital Account. Cr. Leficit ^ $1,500 4,000 2,400 1,800 300 $10,000 Original capital Balance $10,000 Cash 40% 1st installment. Cash 30% 2d installment . Cash 30% 3d installment . Balance . $10,000 .... $300 Dr. C, Capital Account. Cr. Deficit Cash 60% 1st installment. Cash 20% 2d installment. Cash 20% 3d installment. Balance $1,000 6,000 1,600 1,200 200 $10,000 Original capital Balance $10,000 $10,000 .... $200 of which refer to corporation and individual accounts as well as to those of partnership. The partnership problems, as such, are generally involved in the correct interpreta- tion of the partnership agreements, perhaps ambiguously drawn up or even resting on a vague oral agreement, and have to do primarily with the essential relationship of the individual partners, the terms on which they unite, the 334 MODEElSr ACCOUNTING division of profits, the adjustment of unpaid capital con- tributions through allowances for interest, and the final distribution of assets, all of which transactions must con- form to the rules of the partnership agreement. BIBLIOGRAPHICAL NOTE TO CHAPTER XVII Child, P. Partnership Accounts. Third edition. London, 1904. DiCKSEE, L. R. Advanced Accounting. Chapter XIII. Third edition. London, 1908. LiNDLEY, N. A Treatise on the Law of Partnership. II, pp. 396-403. American edition. Jersey City, 1888. Lisle, G. Interest on Capital in Partnership. Article in En- cyclopedia of Accounting, III, pp. 432-438. CHAPTER XVIII THE STATEMENT OF AFFAIRS AND DEFICIENCY ACCOUNT These statements, while somewhat outside of the regu- lar scheme of accounts, are sufSciently important to de- serve some notice. The Statement of Affairs is a statement drawn up when a concern becomes insolvent, and designed to indicate to creditors the probable amount which will be realized in liquidation. The Deficiency Account is a sup- plement to the Statement of Affairs and serves to explain how the deficiency shown by the Statement of Affairs has been caused. The use of these forms is of* English origin and depends on the provisions of the Companies Acts which prescribes the form in which they shall be made out. In the United States the laws are less exact regarding bookkeeping forms, and the statements submitted to the courts are generally not in strict accounting form. But despite the absence of legal authorization, the advantage which results from a clear and formal presentation of the status of the involved concern is so great that American accountants are also frequently making use of the Statement of Affairs and Deficiency Account. The use of these forms may be illustrated by presenting an example applying to a typical problem but one which contains only a few items and is free from complications. The firm of A & B finding itself financially embar- rassed is forced to go into liquidation November 30, 1908. A statement drawn from the books at that date shows the Trial Balance exhibited on the following page. 33S 336 MODERN ACCOUNTING Dr. Trial Balance. Cr. Real estate $70,000 Investments 140,000 Merchandise 100,000 Bills Receivable 21,250 Accounts Receivable.... 14,250 Drawings A 12,000 Drawings B 10,000 Bad debts charged off .. . . 1 5,000 Expenses 10,670 Cash 1,330 $394,500 A, Capital $35,000 B, Capital 30,000 Bills Payable 204,500 Accounts Payable 125,000 $394,500 A further examination of the condition of the firm dis- closes the following facts : Of the Investments, all of which are good, $100,000 are pledged to secure a note of $85,000 and $15,000 are pledged with the holder of a note of $20,000. Of the Accounts Receivable $5,000 are recognized as bad, $3,000 are doubtful with an estimated value of $1,000, the remainder are good. The Bills Receivable are estimated as worth $15,000. The Merchandise is estimated as worth $60,000, and the Real Estate as worth $50,000. In addition to the liabilities shown on the books, $2,500 is due for wages, $1,000 for salaries, and $250 for taxes, all of which are preferential claims against the assets. "With these facts and estimates the Statement of Affaira and Deficiency Account would be as follows: 6 r-1 S CS s o « In ^ ^ lo ooc coco CRcrT Ol «» w TftC IC t^ toio IN I-H C0 >0 ooo !^ m (M rq ooo > .-H ■^■" rt oob .M S© .-1 IN -* OI> o o P5 O OO ■O o : •> g »o o o o o (N 0,0 o o C3 3 o CO o3 C<1 IN 00 •^ c^ as • oo o oo o s • oo O OOIO •oo O, "OO^iM s .■o«o "5 t3 c^'"i-r e fS (Nr-< c» s s. les ^ : SI- : Ml 2 ■a cured. . . assets as -Wages. Salaries Taxes.. assets as (u :3 -3 >> t, a >, ed cr span ecuri sfuU Jtedf dclai Jtedf 5 5 ^ o 3 £ 5 g^ to ^T3 C -o si % v,& s 337 338 MODEEN ACCOUNTING Form 141. Dr. Deficiency Account. Cr. To Capital on Jan. 1, 190- $65,000 " Deficiency as per statement of affairs. 59,670 By sundry trade losses $29,420 " Shrinkage as per statement of affairs, viz.: Book Accounts . $7,000 Bills Receivable. 6,250 Merchandise 40,000 Real Estate.... 20,000 73,250 " Drawings of partners.. . . 22,000 $124,670 $124,670 Considerable variation is, however, found in the ar- rangement of such statements. In the form given above it is noticed that the Liabilities are given on the left hand, just as they appear on that side in English Balance Sheets. By some accountants this order is reversed. Similarly there is a disagreement in practice regarding the arrangement of the sides of the Deficiency Account, some placing the Deficiency and Capital items on the Debit side, and the items showing how the losses occurred on the Credit side of the account, as is done above, while others reverse this order. There are, accordingly, four different combinations, all of which have the support of authorities of repute. These may be scheduled as follows : Variations in Arrangement of Statement of Affairs and Deficiency Account Statement of Affairs. Deficiency Account. Left Column. Right Column. Left Column. Right Column. la. lb. Ila. lib. Liabilities. tt Assets. ti Assets. <( Liabilities. (1 Capital and Deficiency. Shrinkages, etc. Capital and Deficiency. Shrinkages, etc. Shrinkages, etc. j Capital and ) ( Deficiency. J Shrinkages, etc. \ Capital and ) / Deficiency. J STATEMENT OF AFFAIES 339 Of these various forms la corresponds to the schedules of the English Companies Acts, is most generally used in England, and in this country is used, for instance, in Broaker and Chapman's " American Accountants' Man- ual," and in W. H. Dennis's " Practical Accounting." The second arrangement (lb) is the one approved by Lisle. The third (Ila) is favored by P. S. Tipson in his " Theory of Accounting " and in the model form given by Leo G-reendlinger in the Journal of Accountancy. The last form bears the approval of A. G. Piatt as shown in the appendix to Rahill's " Corporation Accounting." Some of the authors mentioned above have argued at some length in favor of one or the other arrangement. Some ingenuity has been exhibited in showing that the arrangement, Liabilities — Assets, has some particular logi- cal justification when used in the Statement of Affairs. But historically it doubtless arose as the result of that arrangement in the Balance Sheet, which has not been fol- lowed elsewhere than in England. It may furthermore be noted that in forms la and lib the deficiency shown in the Statement of Affairs is carried to the opposite side of the Deficiency Account, just as a balance of any account is thus transferred to another account. But in forms lb and Ila the deficiency item appears on the same side of the two accounts. Probably the preponderance of custom is in favor of the form given above (la), although in view of the divergences noted it cannot be said that this form is at all binding. One may accept the prevalent custom with- out agreeing with the arguments given to show that the arrangement is logical as well as customary. The purpose of these statements being to present to the general creditors a succinct view of the status of the con- cern, the best arrangement is to eliminate all secured claims and the property by which they are protected from the figures showing the net assets and the ranking lia- 23 340 MODEEN ACCOUNTrNG bilities. A comparison of the resulting totals gives the per- centage on general claims which may be expected, without allowing for expenses of liquidation. Where a claim is secured by some specific collateral the two items should be canceled against each other as is shown in the treat- ment of the " Creditors fully secured " above. But where the claim is not secured by a specific security it is deducted, from the total assets, as in case of the Wages and Taxes in the illustration given. Some accountants object to thus subtracting claims not secured by specific collateral, but the general practice favors so doing. In the Deficiency Account given above the business had been run at a loss, as shown by the item of Sundry Trade Losses. It is desirable to make the showing in the de. ficieney account as complete as possible, and therefore it may cover the operations of several years, showing on one side the original capital and the profits made in certain years, on the other side of the account the net losses of other years, separately displayed. If the concern is a corporation, dividends paid should be disclosed just as withdrawals by the partners are shown in the present illustration. BIBLIOGRAPHICAL NOTE TO CHAPTER XVHI Broaker, F. and Chapman, R. M. The American Accountants' Manual. I, pp. 109-130. New York, 1897. DicKSEE, L. R. Advanced Accounting. Chapters XIV-XV. Third edition. London, 1908. GoTTSBERGER, F. Accountant's Gtiide for Executors, Administra- tors, Assignees, Receivers, and Trustees. New York, 1902. CHAPTER XIX TECHNICAli IMPROVEMENTS IN ACCOUNTING PRACTICE While bookkeeping has preserved unaltered the essen- tial principles involved in Paeiolo's treatise, yet the prac- tice of the art has not been stationary during the past four centuries. Two lines of development may be mentioned. One has been in the direction of technical devices, of one kind and another, designed to lessen the routine drudgery of the bookkeeper — labor-saving devices which either elimi- nate part of the work not essential to securing the neces- sary results, or assist the accountant in performing the un- avoidable operations. The second line of development is one in which the operations of bookkeeping and the results obtained are made to correspond with the changing ■ eco- nomic conditions and the resulting modifications of busi- ness activities. The more technical improvements which have taken place may be grouped as affecting 1. The relation between the chronological and classified records of business transactions. 2. The form and arrangement of the ledger. 3. The performance of the necessary mathematical cal- culations by substituting machine labor in such operations. 1. It has been seen that the significant feature of double entry bookkeeping is a classified outline of all business operations, which is kept in what is called a ledger. The ledger is thus the essential book, at least so far as account- ing theory is concerned. Indeed, it has occasionally been 341 342 MODERlSr ACCOUNTING the only book kept, as for instance by the earlier Venetian accountants, or as advocated — as though it were a distinct invention of his own— by Lizet in 1660; yet it has been well-nigh universally recognized that it is practically neces- sary to have a chronological as well as a classified record of business transactions. But the form in which this chronological record is kept, and the method by which the record is transcribed from the original record into the ledger have been greatly modi- fied, always with a view to eliminate needless repetition and to save unnecessary labor. Paciolo considered it de- sirable to have a threefold series of records. The first called Memorial, a term still used in Germany, contained a mere description of the transaction, generally expressed in un- teehnical language. The second, or Journal, repeated the record but expressed it in technical terms, with values re- duced to the current money of account, and with a clear indication of which ledger account was to be debited and which was to be credited. From the Journal the proper postings were made into the Ledger. This complicated process was perhaps originally neces- sary. As Row-Fogo has pointed out, in the beginnings of modern commerce, when there was no uniform coinage, it was frequently a difiicult task to translate the transaction into terms suitable for posting into the Ledger. Yet it was desirable to make the first record at once, leaving the pro- prietor to determine later the form in which it should ulti- mately appear in the Ledger. This was perhaps all the more necessary as it was customary to use the books of account not merely as a record of the transaction but as well as legal evidence of the contract, with the signatures of the verifying witnesses. Such an entry may be shown by quoting from an account book kept more than five hun- dred years ago by a merchant of Hamburg : ' ' Bertold Scroder and Herr Johann, his son, the Pres- TECHNICAL IMPEOVEMENTS 343 byter, are together indebted for 24 marks for two pieces of Oldenard cloth viz: 1 red and 1 blue which they bought on the day after the feast of St. Peters Chains, to be paid at the beginning of Past time. In presence of Herren Johann Stuveke and Luke and Albert Albecke." But the elaborateness of entry became needless and un- desirable as commerce became better systematized. Evi- dences of contract were more conveniently kept elsewhere, instead of crowding them into the record of transactions; the use of uniform currency made a definite entry no lon- ger difficult; and the conventional threefold series of Me- morial, Journal, and Ledger, if not altogether abandoned, is at least obsolescent. Especially in American practice has there been a tend- ency to simplify and abridge. The Memorial, called in English the Day Book, a most inappropriate term to be used in contradistinction to Journal, both having the same root meaning, has largely disappeared as a separate book. "Where detailed description of the transaction is still re- quired it is written directly in the Journal itself. But not content with the felimination of the Memorial or Day Book, modern bookkeeping has gone farther and has to a con- siderable extent dispensed with the Journal, at least in the sense of the formal and somewhait stately record in which the bookkeepers of the last generation thought necessary to make the entry before it could appear in the Ledger, and from which each item was separately transcribed. This has been brought about by using a columnar rec- ord, in which items of a similar nature, as, for instance. Cash, Discount, and Merchandise, are placed in separate columns and the footings of these columns, not the indi- vidual items, are posted into the Ledger. ' This device, which appears in myriad forms, may be illustrated by a Columnar Journal-Cash Book, as shown in Form 142. 344 MODEEIST ACCOUNTING O o K m I < Iz; P O -B >-s £ rt I 3 8 i 1 a i . i 6 S • 1 i 1 1 1 Xto 1 s & - 5 1 1 - M 1 ! TECHNICAL IMPROVEMENTS 346 Here only the footings of the sevetal columns, Accounts Receivable, Accounts Payable, etc., are posted into the Ledger. Items occurring too infrequently to need a spe- cial column can, however, be entered in the last column, with the name of the account to which the special entry is to be posted. Carried to a logical extreme the columnar system be- comes at once Journal and Ledger, the column for the descriptive text furnishing the chronological record, while the distribution of amounts into various columns— a sepa- rate coliimn being provided for each account— serves for the classified record or Ledger. This is what was done in Form 1 on page 5. In that example the perfect com- bination of Journal and Ledger was easily accomplished because the scheme of accounts consisted of only three ac- counts. With a large number of accounts it is easily seen that such a system is impossible. Even where there is no attempt to dispense with the Ledger and the columnar Journal is used only as a means of obtaining footings for posting, the increase in the number of such columns soon becomes objectionable. The book itself becomes unwieldy, it is uneconomical of paper, and the danger of making the entry in the wrong column becomes increasingly great. While the columnar system thus has clear limitations, its acceptance has become very widespread, especially in the United States. It is less common in Europe, where the term American Bookkeeping is applied to a system using books so ruled. Parallel with the abolition of the unnecessary duplica- tion of Memorial and Journal, there has been an increase in the number .of books from which postings are made into the ledger. In Paciolo's scheme all entries came into the Ledger through the Journal, in modern accounting there may be a dozen books from which postings, generally of footings, are made into the Ledger. This is rendered neces- 346 MODEEN ACCOUNTING sary by the increase in the amount of business transacted, which makes it impossible for one person to make all the entries of current transactions. By dividing the books of original entry, so that transactions of different classes are made in separate books, an indefinite number of clerks can be simultaneously engaged in making entries, while the posting into the Ledger can be done later, by totals. The first division of this kind to be made was the separation of all transactions in which a cash payment is involved. The separate Cash Book was not known to Paciolo and did not appear until about the middle of the sixteenth century. At present not only cash, but many other transactions, pur- chases, sales, discounts, loans, etc., are entered indepen- dently in separate books and posted thence into the Ledger, generally without passing at all through the Journal, al- though by some an entry of the totals is passed through that book. In these coordinate books of original entry, as well as in the Journal, the principle of columnar ruling is applied. It is interesting to note that this device was presented in the first American text-book on bookkeeping published by William Mitchell in 1796. In this valuable but little- known work each side of the Cash Book is provided with columns for Merchandise, Bills Receivable (or Payable), und Sundries. It is thus seen that there has been a steady line of de- irelopment in bookkeeping teehnic in connection with the relation between the chronological and the classified rec- ords, whereby the Ledger has been brought closer to the original entries, duplications have been avoided, totals have been entered instead of needlessly minute details, and facilities have been created for attending to a greater amount of business than could have been accomplished by the older forms. But in all this nothing has been done at all opposed to the principles of double entry bookkeeping. TECHNICAL IMPKOVEMENTS 347 and everywhere the equation between Goods and Proprie- torship is maintained as carefully as ever. 2. The second line of improvements has been in the form and arrangement of the Ledger itself. In general the traditional ruling of the Ledger has been preserved, and there are stiU two columns for the Debit and Credit items respectively. Some little variation exists in the position of these two columns relative to each other and to the col- umn for descriptive text, and at times a third column is added to contain the balance. This latter device means some additional writing, but it has the advantage of mak- ing immediately available the desired information concern- ing the state of the account. It is especially valuable in connection with personal accounts, particularly those kept by a bank with its customers, where immediate information is essential. Such rulings have a further advantage in doing away with some of the rather cumbersome forms of ruling off and balancing an account, the saving in time and space in this regard offsetting to some extent the ad- ditional labor of indicating the new balance after each transaction. There is also a tendency to eliminate unnecessary detail from the Ledger entries, it being more economical to make an occasional reference to some other record than to tran- scribe all the details, most of which serve no purpose, in the Ledger. The regulation on which the older writers insisted that each Ledger entry should give the name of the other account— religiously preceded by the formula " To " or " By "—in which the counter entry appeared, became impossible so far as totals only were posted. It is now recognized as altogether needless. The custom was doubtless once useful. The older bookkeeping technic verified the accuracy of the Ledger, not by taking a trial balance but by checking each Debit against its correspond- ing Credit. When this was done it was of great assistance 348 MODEEN ACCOUNTING to have easy reference from one account to the other, and this was conveniently given by including in each Ledger entry both the name and the folio number of the account in which the corresponding entry appeared. Bookkeepers long since found it was more useful to refer to the Journal page containing the original entry than to the page con- taining the balancing Ledger entry. But the entry of the name of the Ledger account long persisted, and is even now inculcated in some text-books. The absurdity of cling- ing to this convention is greatest when the corresponding entry is not found in a single account but in several, when convention demanded that the Ledger should bear the meaningless reference to " Sundries." But while refer- ence to the corresponding account is still general in Con- tinental practice, and is doubtless frequently found even in this country, it is no longer considered necessary by American accountants. In this respect, as in the avoidance of the needless' labor of actually closing out all ledger accounts into a Balance Account, American practice shows good sense in lessening the drudgery of bookkeeping with- out making its record of business transactions less valuable to the proprietor. A more important improvement in the form of the Ledger has been the substitution of cards or loose leaves in the place of a bound book. The advantages of this are : The elimination of dead accounts. The ease of reference, the accounts being self-indexing. The nice adjustment to accounts of varying lengths, without overcrowding or wasting of blank pages. The ease of expansion with a growing business. The facility with which the accounts may be divided up so that many clerks can work simultaneously. Unfortunately some prejudice has existed against the innovation on the ground that it makes fraud more easy. Indeed, the careful prescription of some laws, such as the TECHNICAL IMPROVEMENTS 345 Code de Commerce of France, to the effect that legal valid- ity can attach only to accounts kept in bound books with serially numbered pages certified by a public official, have been a positive bar to the introduction of card ledgers, which elsewhere have been less absolutely opposed by con- servatism and prejudice. While the advocates, and especially the manufacturers of loose-leaf systems, vehemently deny that a bound ledger is any more secure, their claims seem somewhat exagger- ated. It is true that the Ledger at best is not the authori- tative record, yet the falsification of the Ledger is not an unusual method of concealing fraud. Even the keeping of Ledgers, duplicate except in some doctored accounts, has been resorted to by those wishing to hide their frauds. Cer- tainly such manipulation can be more easily accomplished where each account is on a separate sheet or card. But on the other hand the same precautions which should be observed to prevent fraudulent manipulation of bound books would also prevent fraud in handling a loose-leaf system. In either case there is no security without a care- ful system of auditing, and where this is provided frauds will be prevented because of the certainty that they 'Will be discovered. Certainly the use of Card Ledgers has made great advances since they were first introduced in 1889 by Mr. J. A. Langstroth, the accomplished accountant of the San Francisco Savings Union. The advantages far out- weigh any possible objections to the system. There has been considerable controversy as to the rela- tive merits of cards and loose leaves temporarily bound in a holder. Universal preference should be given neither to one nor the other. "Where there are a vast number of ac- counts with infrequent entries in each, as for instance in a great savings bank, separate cards seem to have the advan- tage. In otlier eases the Loose-Leaf Ledger is more easy to handle, less time being consumed in turning pages thau 3S0 MODEElSr ACCOUNTING in taking out and returning the card. Thus a savings bank may wisely keep its depositors' accounts on cards while its General Ledger accounts are kept in a Loose-Leaf Ledger. The relative merits of competing devices for holding the loose leaves need not be discussed here. The interested reader can easily obtain unlimited advertising matter on the subject. The use of cards has been of great service in other lines of accounting than as a ledger. Particularly true is this in keeping track of maturing notes, interest payments, insur- ance, contracts on hand, unfilled orders, etc. They serve also to keep a continuous record or inventory of merchan- dise or material on hand, each class of article being listed on a separate card. This furnishes a record of quantities of stock, parallel with the ledger accounts showing values, and constitutes a most valuable check on the accuracy of the inventory, and on the pilfering tendency of employees. For use in such subsidiary records, outside of the account- ing system in the strict sense, cards have proved indis- pensable. 3. So much of the labor of accounting consists in the performance of arithmetical calculations that the intro- duction of mechanical devices for doing this work is one of the marked improvements in bookkeeping technic. The more important instruments of this kind fall into three groups: (1) adding machines, (2) " calculating " ma- chines, designed primarily for multiplying and dividing, and (3) the mechanical tabulator. Foremost among these are the mechanical devices for adding. Of these three groups may be mentioned: (1) Those in which the addition is performed by the operator moving a part of the instrument for each digit to be added, the distance through which the moving part passes corre- sponding to the value of the digit; (2) those in which the addition is performed by pressing a key indicating the de- TECHNICAL IMPEOVEMENTS 351 sired digit; and (3) machines similarly operated by keys but listing the items at the same time that they are added. The first class of instruments have' considerable vogue, due to their portability and cheapness. To accomplish the result various mechanical devices are used, such as the rota- tion of wheels, the revolving of endless chains bearing num- bered links, and the sliding of bars. In these instruments the carrying of tens to the next higher order of digits is automatically performed. Many such adding machines are in the market, costing from one to twenty-five dollars, each of which has its own advocates. But all of these are rela- tively inefiicient as compared with key-operated machines. In the key-adding machines the pressing of a separate key bearing the appropriate digit serves to make the proper addition, with, of course, great increase in both speed of operation and price of machine as compared with the sim- pler type of adding machine. The use of such key machines is rapidly increasing. In some large establishments special operators are provided whose duty it is to go from desk to desk as occasion requires, and perform the additions demanded in the several departments. While the speed of adding figures already listed in a column may not be much greater when performed by an operator on an adding ma- chine than when done by a highly skilled bookkeeper, the cost of having the work done is much less because of the lower grade labor that can operate the machine. The listing machine is arranged on practically the same line as the nonlisting key machine, but is accompanied with a device for printing the item at the same time that it is added. Many machines of this type, differing in detail but very similar in form and operation, are on the market. Considerable rivalry exists between the advocates of listing and nonlisting adding machines. As a matter of fact they are not truly rivals, each being appropriate for its particular service. The nonlisting machine performs 352 MODERN ACCOUNTHSTG the adding operations much more rapidly than can be done on the listing machine. "Where the figures to be added are already listed it is, therefore, best adapted. The only ob- jection to be made is the supposedly greater ease in detect- ing errors where a listing machine is used, as the items can be checked off from the list. But with' a little practice mis- takes in either type of machine are infrequently made, and it is but little slower to verify additions by repeating the op- eration on a nonlisting machine than it is to check off the printed list agaiinst the original items. But where a list of items needs to be made, it is evident that the listing machine has no fear of rivalry from the nonlisting machine. The nonlisting machine has, however, an advantage for certain kinds of work in that it lends itself readily to sim- ple operations of multiplication, and less readily to divi- sion, operations which are similarly performed on a listing machine but with a relative disadvantage in speed greater than that in adding. The second type of mechanical aids is the calculating machine or, more concretely, a device for performing mul- tiplication and division. Earliest of these is the slide rule, a device long since introduced into engineering but rather slowly adopted by accountants. The slide rule, in its vari- ous forms, whether a simple rule, or in the circular, spiral, or cylindrical forms is a logarithmic scale, that is, a scale so ruled that addition is substituted for multiplication. Thus, for instance, on a given scale 3 is indicated at a point one inch from the left-hand end of the rule. But the value in- dicated at a point one inch further along is not 6, but 9 ; the addition of the second inch on the scale not adding 3 but multiplying by that number. Similarly, division is per- formed by simple subtraction. The application of this prin- ciple is very wide. It is especially serviceable in working • out percentages. The slide rule is the most convenient of all instruments for working out values where one factor is TECHNICAL IMPROVEMENTS 353 a constant, as for instance in translating a table of prices from one currency into another. Here only one setting of the machine is needed, the various values being read off without further manipulation of the slide. In this there is an advantage even over the more mechanical calculating machines. The chief objection is that there is required some little practice in taking off accurate readings, and at best these are not accurate beyond the fifth significant fig- ure. To accountants, who are accustomed to have their additions prove to the last cent, that is, to show accuracy say to the tenth figure, this seems at first objectionable. It should, however, be borne in mind that the original data on which calculations are made rarely are accurate beyond the third figure, so that for most purposes the slide rule is sufiiciently exact. Multiplication being only addition on a larger scale, the key machines, designed primarily for addition, prove most serviceable for multiplication, with certain limita- tions. If, for instance, 123 is to be multiplied by 321, it can probably be done more quickly on the key-adding ma- chine than on any other mechanical device. All that is necessary is to press the keys indicating 123 once, then moving the fingers one place to the left to press the keys twice (that is, multiply 1230 by 2, which is equivalent to multiplying 123 by 20), and so on. This requires no set. ting up of a machine, and no skill in reading results. The drawback comes when the two factors are large, as the dif- ficulty of manipulating the larger number of keys more than offsets the time required to set up the factors on a calculating machine proper. Of the latter there are several models, principally of foreign manufacture. In the most advanced type the mul- tiplicand is set up by moving sliding indexes, and the multiplication is performed by moving an indicator to each of the successive figures of the multiplier and turning the 354 MODEE]Sr ACCOUNTING handle once for each digit. These machines are made with a capacity of eight digits in both multiplier and multipli- cand, and sixteen figures in the quotient. After the opera- tion is performed the dials exhibit multiplier and mul- tiplicand, as well as product — thus cheeking against errors. Division can also be performed, but less conveniently. The advantage of this type of calculating machine is that it is accurate to the last figure, even when applied to factors containing so many digits. Such minute accuracy is more demanded in astronomical calculations, for instance, than in commercial accounting, but nevertheless such machines are being increasingly used in large establishments, such as railroads and factories, principally for working out per- centages. The last type of mechanical aid to be mentioned is the mechanical tabulator. This is a device first introduced intc the United States Census Office for tabulating census re- turns. The method used is that of punching holes in cards, the location of the hole indicating certain statistical facts, as for instance the number of the job, the number of the workman, the terms on which the work is done, the time con- sumed, etc. By running the cards thus punched through an electrical machine, a device, which works by an elec- trical connection being made wherever the hole is punched, indicates the various charges made for each job or each part of the operation. This system has been used by some of the railroads, for instance, the New York Central, and by some of the larger manufacturing. plants. So far have been described some of the more important technical improvements by which the labor of bookkeeping has been lessened. Parallel with these improvements, and in part logically implied in the improvements themselves, there has been a continuous progress by which accounting practice is brought into closer coordination with the chang- ing economic conditions. Indeed, it is no mere accident TECHNICAL IMPEOVEMENTS 355 that systematic bookkeeping first appeared in the Italian republics and during the period of their commercial su- premacy. It was not until commerce began to assume importance that systematic accounting became important, and hence it naturally appeared at the time and in the place where commerce, in any modern sense, first began. Some of the minor technical improvements described in this chapter are seen to be conditioned on the change in economic environment, as for instance when the establish- ment of uniform currency made obsolete the forms which were used when the coinage was in a state of chaos. The greatest impetus to formal accounting has, how- ever, been due to more recent economic changes, two fac- tors of which, distinct yet closely connected being especially important. These are the introduction of machine produc- tion, due to the great inventions centering around iron and steam, and the development of the corporate form of industry. Taken together these two factors have Hiade exact ac- counting necessary, for three reasons: (1) Ownership has been separated to a large extent from management of in- dustry and there has been an imperative need for a scheme of accounting which would disclose to the stockholders the status of the business entrusted by them to the directors; (2) the large scale on which business has been conducted has made accounting more complicated and hence has led to greater systematization in its methods; and (3) the use of fixed capital, assuming unheard of proportions since the great inventions, has made necessary accounting methods which would regard changes covering long periods ot time, a marked contrast to the simple enterprises of the middle age when capital changes were disregarded. Of less importance may be mentioned the effect of the general growth of the credit system, necessitating a closer scrutiny of business transactions ; and the disappearance of 24 356 MODERN ACCOUNTING the old prejudice against interest, with the consequent rec- ognition of interest calculations in inventory taking and in cost accounting. The accounting problems of to-day as discussed in this book may be seen to be closely dependent on the economic changes mentioned above. Most of the debated questions Jiave had to do with the Balance Sheets of corporations, and the problems concerning Capital Stock. The most puzzling question concerning Profits has related to the treatment of changes in the value of invested capital and the recognition of depreciation in machinery. And the new problem of Cost Accounting, the most recent contribution to accounting literature, is entirely an outgrowth of the factory system of production. It is apparent, therefore, that accounting never has beer a stationary art, but has changed with changing conditions, Altogether wrong is the quaint panegyric of North, written in 1714: ' ' I do not know, that any Art practiced among Men is come up to a positive ne plus ultra, but that of Accompting, . . . No Limit of Invention is known, thro' which they [the other Arts] may be improved. But the Art of Regular Accompting, or Book-keeping, altho' useful beyond any, and of infinite Variety, and of which not a few, able enough in other things, are utterly incapable; yet in Rule and Method is so contracted and circumscribed, that without a Fault, nothing can be rescinded from, or added to it." While accounting does, indeed, rest on a few simple principles enunciated while Columbus was still on his voy- ages of discovery, yet much needed to be added to the sim- ple rules laid down by the " humble professor of sacred theology ' ' before the art could reach the present advanced but still incomplete stage of Modern Accounting. TECHNICAL IMPEOVEMENTS 357 BIBLIOGRAPHICAL NOTE TO CHAPTER XIX DiCKSEE, L. R. Bookkeeping: Its Adaptability to the Require- ments of Every Class of Undertaking. Article in Encyclopaedia of Accounting, I, pp. 496-301. ^ Gaines, M. W. Tabulating Machine Cost Accounting for Factories of Diversified Product. Engineering Magazine, XXX, pp. 364-374. Kekr, W. H. Calculating Machines. Article in Encyclopaedia of Accounting, II, pp. 1-14. .Risque, F. W. Loose Leaf Books and Systems for General Busi- ness. St. Louis, 1907. Row Fogg, J. History of Bookkeeping. In "A History of Ac- counting and Accountants," edited by R. Brown. Edinburgh, 1905. Seward, G. H. Card System and Mechanical Aids in Accounting. Series of articles in Business World, 1902-1903. Spragtje, C. E. The Philosophy of Accounts. New York, 1908, pp. 82-129. SwEETLAND, C. A. Loosc Leaf Bookkeeping and Accounting. Fourth edition. New York, 1905. Thompson, E. W. Bookkeeping by Machinery. New York, 1906. Thorne, W. W. The AboUtion of the Trial Balance. Detroit, 1 906. Twentieth Century Bookkeeping and Business Practice. Detroit, 1904. [The two books last named contain many prac- tical suggestions as to forms and methods.] INDEX Abstainers & General Insurance Co., in re, 78. Acceptances, 192. Accounts, capital, 144; differenti- ation of, 5, 7, 9; mixed, 10, 22; negative goods, 14, 24; negative proprietorship, 24, 27; positive and negative items in, 19; two sets of, 9. See, also, titles of particular accounts. Accuracy, 55, 83, 170, 306. Active, 44. Adding machines, 350. Adjustment accounts, 119, 123. Allis-Chalmers Co., 136. American bookkeeping, 345. American District Telegraph Co., 48. Anticipation accounts, 119; rela- tion to depreciation, 123. Appraisal, 83. See, also. Inven- tory. Appreciation of assets, 223. Assets, appreciation of, 223; capi- tal, 46; deferred, 46, 118, 123; diflBculty in distinguishing, 70; distribution of, in insol- vency, 327, 330; immaterial ch. vi, 75, 141; purchased with securities, 79. Assets, wasting, 214; legal deci- sions, 205; treatment in ac- counts, 203, Assets accounts, 19. Atchison, Topeka & Santa Fe Ry., 49, 60, 67, 150, 184, 242. Atlantic Coast Line, 228. Austria, accounting rules in, 92, 102, 124, 149, 159, 224, 240. Babbage, C, 293. Badham v. Williams, 225. Balance, 18. Balance account, 41. Balance sheet, ch. iii ; accuracy in, 55, 83; of Atchison, Topeka & Santa F6 Ry., 60, 184; and balance account. 41; classes of items in, 50; double account, 48, 184, 202; English form, 42; history of, 40; mar- shaling items in, 46; misrep- resentations in, 55; model forms of, 59-66; purposes of, 54; subdivisions in, 45; and trial balance, 37; two sides of, 43. Balancing, 29. Bank of England, 84. Bank of France, 92. Barrow Hsematite Steel Co., in re, 109°, 219. Belfast & Moosehead Lake Ry. Co. V. Belfast, 229, 268. Bills rediscounted, 32. Birmingham Small Arms Co., 255. 359 360 INDEX Bolton V. Natal Land & Coloniza- tion Co., 86. Bond V. Barrow Haematite Steel Co., 124, 206°, 210, 214. Bonds, discount on, 77, 96, 188; formula for value of, 94; pre- mium on, 93, 187, 222; repay- able at a premium, 190; re- purchased, 191; in sinking fund, 269; unissued, 190; val- uation of, 90. Bookkeeping, "American," 345; double entry, 9; equation, 1, 28; single entry, 7, 10. British East India Co., 41. Broaker and Chapman, 332°, 339. Buildings, valuation of, 88. Burton, F. G., 307. Butler V. Ballard, 330°. Calculating machines, 352. Caldicott, O. H., 116. Camden v. Stuart, 115, 157. Capital, chs. viii-ix; circulating, 208, 210, 214, 218; fixed, 116, 208, 210, 214; interest on, 321;' and revenue, 72; wast- ing, 206. Capital account, of corporation, 145; of individual, 144; in partnership, 144, 317. Capital assets, 46; appreciation of, 223. Capital losses, 199; in American courts, 211; booking of, 218; and dividends, 214-221 ; in English courts, 205-211 ; when not to be shown, 221. Capital stock, canceled, 151; in consolidations, 179; discount on, 158; donated, 176; issued for property, 79, 161-171; market value of, 163; nomi- nal value of, 165; premium on, 155, 221, 222; reacquired, 151; reduction of, 159; sale below par, 157; subscriptions to, 147; uncalled subscriptions to, 153; unissued, 147. Capital stock issued below par, 157, 161 ; in American balance sheets, 168; booking of, 158, 167; in England, 158; legal decisions, 157, 165; for prop- erty, 163; unnecessary, 163. Cash account, 5, 19°; position in balance sheet, 46. Cash book, 343, 346. Chemical National Bank, 63, 64, 68, 240. Chicago & Alton Ry., 46. Chicago & Northwestern Ry., 32", 253, 266; sinking fund, 263, 266, 268; treasury stock of, 152; unissued bonds of, 191. Chicago City Railway, 290. Chicago, Rock Island & Pacific Ry., 262. Child, P., 116. Chronological record, 341-345. Church, A. H., 300, 302; 303, 305. Circulating assets, 81, 210. Circulating capital, 208, 214, 218. Clearwater v. Meredith, 216. Coats, J. & P., 55. Colorado Fuel & Iron Co., 221. Columbia Straw Paper Co., 112, 170. Columnar journal cash book, 344. Columnar records, 343, 345. Companies Acts, Great Britain, 42, 55, 66, 68, 77, 153, 158, 171, 248, 335, 339; Quebec, 149. Connecticut corporation law, 80. INDEX 361 CJonsolidations, 179. Construction account, 72, 75, 77, 78, 118, 189. Contingent liabilities, 32, 192. Controlling account, 119. Conville v. Shook, 125. Cooper, E., 116, 228. Corporate organization, effect on accounting, 355. Corry v. Londonderry & Ennis- killen Ry., 228. Cost, factory, 296; prime, 296; total, 296. Cost accounts, ch. xvi, 293; ac- curacy of, 306; application of results, 307; cost ledger, 313; expense of, 306; in Govern- ment Printing Office, 306; materials, 309; purpose of, 293; records needed, 309; req- uisitions, 312; stores record, 311; technic of, 308; terminol- ogy, 295; wages, 309. Cost price, 90; actual or construc- tive, 103; as basis of valua^ tion, 75, 102, 108; what constitutes, 75; of property purchased with securities, 79. Cotting V. New York & New Eng- land R.R. Co., 213°. Courts, attitude regarding over- valuation, 162; regarding profits, 231. Cox V. Edinburgh & District Tramways Co., 73. Credit, 19, 20. Credit system, effect of account- ing, 355. Crich ton's Oil Co., in re, 209. Davis V. Flagstaff Silver Mining Co., 229. Davison v. Gillies, 124, 201°. Dawson, S. S., 248. Day book, 343. Debit, 19, 20. Debits and credits, equation of, 23, 28; personification of, 21; scheme of, 27. Debts, 13, 24, 101 ; bad and doubt- ful, 99, 238; paid out of re- serve, 258; reserve for doubt- ful, 100; unpaid, and profits, 228. See also Liabilities. Deferred assets, 118, 123. Deficiency account, 126, 335, 338. Delkredere account, 68. Dennis, W. H., 339. Depreciation, ch. vii, 83; by Amer- ican corporations, 290; an- nuity method, 131; booking of, 67, 126; comparison of methods, 133; economic sig- nificance, 121; excessive, 137; as fixed charge, 291; formulas for, 128, 129, 132; of imma^ terial assets, 141; Interstate Commerce Commission on, 125, 127, 135, 142, 290; irreg- ular, 136; legal provisions, ,124, 134; methods of appor- tionment, 128; and net in- come, 290; percentage of cost, 128; percentage of diminish- ing value, 129; where no prof- its, 136; prior to profits, 121; in profit and loss account, 289 ; rates of, 141; relation to an- ticipation accounts, 123; re- lation to total cost, 134; and replacement, 137; and reserve for insurance, 260; and sink- ing fund, 272; in addition to wear and tear, 140. 362 INDEX Depreciation account, 51. Depreciation fund, 238. Dickinson, A. L., 171, 249, 279. Dicksee, L. R., on balance sheet, 65; on cost accounts, 308; on depreciation, 134, 142; on distribution of assets, 332° on Garner v. Murray, 330° on good will, 113, 116, 117 on manufacturing account, 286; on partnerships, 321; on reserve funds, 248, 249; on sinking funds, 270. Discount, on bonds, 77, 96, 188 on capital stock, 158, 167 due to deficient credit, 189 on mercantile credits, 98; on sales, 288; trade, 288. Dividends, from borrowed funds, 229; during construction, 77; when Iqss of capital, 214; when loss of fixed capital, 217; not paid in cash, 228; on pre- ferred stock, 193; stock, 172; unpaid, 193. Donald v. American Smelting & Refining Co., 161, 166. Donated stock, 176. Double-account balance sheet, 48, 67, 184, 202. Double entry bookkeeping, chs. i-ii, 1, 9, 15; imperfections of, 30. Doubtful debts, 100. Douglass V. Ireland, 178. Dovey v. Cory, 201°, 209, 210. Dupin, 227. Dutch Bast India Co., 228. Eddis, W. C, 250. Edgerton v. Electric Improvement Co., 166. Emery v. Wilson, 125*. Encyclopaedia of Accounting, 286. Equation, bookkeeping, 1, 28. Excelsior Water & Mining Co. v. Pierce, 206°, 213"', 230, 268. Exchange transactions, 2. Expense account, 24, 27. Expenses of experimentation, 77. Eyster v. Centennial Board of Fi- nance, 211, 226. Factory cost, 296. Factory expenses, indirect, 297, 304. Fairchild, C. S., 114. First National Bank, Chicago, 241. First National Bank, New York, 253. Fixed assets, 81. Fixed capital, 116, 207, 210, 217. Fluctuations, 82. Formulas, for depreciation, 128, 129, 132; for sinking fund, 271. France, accounting rules in, 41, 124, 151, 152, 154, 240, 349; Bank of, 92. Franchise account, 169. Freight charges, 102. Fund assets, 249. Garcke and Fells, 116. Garner v. Murray, 329. General establishment charges, 305. Germany, accounting practice in, 55, 65, 68, 79, 84, 134, 152, 164, 178, 237. Germany, legal provision in, on balance sheet, 41, 55; on com- pulsory Reserves, 240, 242; on depreciation, 124, 127, 134, INDEX 363 136; on interest, 77, 87; on inventory, 92, 102; on pre- mium on stock, 155, 234, 240 on repurchased stock, 151 on uncalled subscriptions, 154 on unrealized profits, 224 on unsubscribed capital, 149 Goethe, J. W., 30. Going concern, 81, 91, 101. Goods, 1. Goods accounts, 7. Goodwill, an asset, 75; in the bal- ance sheet; 117; basis of, 110; definition of, 107; determina- tion of cost, 109; Dicksee's rule for valuing, 113; duration of surplus, 112; fictitious, 115, 169; instances of, 110, 111, 112, 113, 117; method of cap- italizing; 111; in partnership, 318; period for averaging sur- plus, 111; rate of capitalizing, 113; transferabiUty of, 112; value limited to cost, 108; writing off of, 116. Government Printing Office, 306. Gratz V. Redd, 76, 223. Greendlinger, L., 339. Greene, T. L., 172, 189. Gross trading profits, 287. Gunnell v. Bird, 330°. Guthrie, E., 108, 116. Handley v. Stutz, 157, 165. Hoare & Co., in re, 209, 221, 234, 248. Hubbard v. Weare, 73, 213". Hiiffcut, E. W., 157. Hugh, F., 22. Illinois Central Railway, 101, 184, 249, 288. Immaterial assets, ch. vi, 75; amortization of, 141. Income, net, 267, 290; in probate law, 201. Income account, 195, 280, 281. Indirect factory expenses, 297, 304. Indorsements, 192. lunes & Co., in re, 178. Insolvency, distribution of assets in, 327, 330; statement of af- fairs in, 335. Insolvent partners, claims against, 328. Insurance, reserve for, 259. Interest, accrued, 97; adjustments, 321, 324; :->n debts, 186; dur- ing construction, 76; on ex- cess capital, 324; paid in advance, 118; on partners' capital, 321; on purchase mortgage, 86; on sinking fund investments, 265, 269. International Mercantile Marine Co., 290. Interstate Commerce Commission, on balance sheet, 41, 59; on construction account, 74, 79, 254; on depreciation, 125, 127, 134, 135, 136, 142, 290; on discount, 77, 190; on in- come account, 282; on secret reserves, 254; on taxes, 289. Inventory, 13, 23, 31; items to be included, 75; problems of, 74. Investments, fluctuations in, 90; interest accrued, 97; premium on, 93; as stock in trade, 92; valuation of, 90, 92. James, A. A., 116. Jaudon, W. C, 330-. 364 INDEX Jones, T., 9, 21. Jones V. Davis, 226. Journal, 342. Journal-cash book, 343. Keister, D. A., 169, 249. Kingston Cotton Mill Co., in re, 208. Kirkmann, M. M., 267. Lackawanna Steel Co., 188. Land, valuation of, 86. Langstroth, J. A., 349. ■ Leake, P. D., 136. Ledger, 17, 341, 347-350; cost, 313; loose leaf, 348. Lee V. Neuchatel Asphalte Co., 205, 213, 214, 223. Liabilities, ch. x; in balance sheet, 184; capital, 46; classification of, 186; contingent, 32, 192; current, 46; marshaling of, 47 ; as negative assets, 184 ; in statement of affairs, 338. See also Debts. Liquidation, distribution of as- sets in, 327, 330. Liquidation value, 80. Lisle, G., 42, 275, 278, 287, 288, 339. Lizet, A., 342. London & Westminster Bank, 62. Losses, of circulating capital, 218; of fixed capital, 207, 214; prior, 208; shown in balance sheet, 120. Louisville & Nashville R.R., 264. Lubbock V. British Bank, etc., 223. Machine production, effect on ac- counting, 355. Machine rate, 297, 299; improved, 300. Machinery, valuation of, 89. Mackintosh v. Flint & Pere Mar^ quette Ry., 73, 124. Main v. Mills, 212. Maine Savings Bank law, 93. Manufactured goods, valuation of, 104, 284, 286. Manufacturing account, 274, 279, 284, 289. Manufacturing profits, 285. Market price, 90, 102. Massachusetts business corpora- tion law, 41, 171. Materials, 309. Mechanical devices, 350. Memorial, 342. Memoriter accounts, 68. Mercantile credits, 98. Merchandise, valuation of, 101- 105. Meserve v. Andrews, 102, 224. Mills V. Northern Ry. of Buenoa Ayres Co., 229, 230°. MitcheU, W., 346. Mixed accounts, 10, 22. Mixed transactions, 2, 10. Mobile, etc., Ry. ■!;. Tijnnessee, 229. More, F., 114. Moseley v. Koffyfonteiu Mines. 167. Moxey, E. P., Jr., 279°. National Bank of Wales, in re, 201°, 208, 209. Negative goods, 14, 184; accounts, 24. Negative proprietorship accounts, 24, 27. Newton v. Birmingham Small Arms Co., 84, 255. Nisbet, A. G., 304 INDEX 365 North, R., 356. Nowell V. Nowell, 328. Oakley v. Cokalete, 330°. Ooregum Gold Mining Co., etc., v. Roper, 158. Operating expenses, 72, 288. Organization expenses, 76, 78. Overvaluation, 162, 170. Oxford Benefit Building & Invest- ment Co., in re, 100. Paciolo, L., 1, 40, 341, 342, 345, 346. Palmer, F. B., 206, 209°, 218, 220. Partnership, ch. xvii; admission to, 316; capital account, 316; claims against insolvent part- ner, 328; distribution of as- sets, 327; formation of, 316; goodwill, 318; interest on cap- ital, 321; interest on excess capital, 324; problems, 316; purchase of interest, 320; share in, 318. Passive, 44. Patents, 77, 110, 117. Patterns, 89, 306. Pennsylvania R.R. Co., 254, 267. Pensions, provisions for, 194. People V. San Francisco Savings Union, 226. Personification theory, 21. Pixley, F. W., 86, 116, 193, 214, 247, 248, 249. Piatt, A. G., 339. Premium, on bonds, 93, 187, 222; on capital stock, 155, 221, 234; fictitious, 156; on for- feited stock, 222; redemption at a, 190. Price, cost, 75, 79, 90, 103, 108; market, 90, 102; selling, 288, 296. Prime cost, 296. Profit and loss account, ch. xv, 195; and assets, 197; and capital losses, 199; deprecia/- tion shown in, 289; forms, 276, 278, 282; problems of, 198; purpose, 196; subdivisions, 277, 282; and taxes, 288; variations in, 282. Profit and loss appropriation ac- count, 277. Profits, chs. xi-xii; available for dividends, 226; in balance sheet, 54; in cash, 224; and debts, 228; gross trading, 287; and loss of capital, 202; and loss of fixed capital, 207; net, 203, 212, 275; and previous losses, 208; undivided, 237; unrealized, 224; and wasting assets, 203. Property purchased with stock, 79, 161. ' Proprietorship, 1. Proprietorship accoimts, 9, 19. Proprietorship transactions, 2-4. Providence Rubber Co. v. Good- year, 100, 104. Quebec Company Act, 149. Quoted price, 90, 102. Raymond v. Putnam, 329. Reagan v. Farmers' Loan & Trust Co., 226. Receipts, confounded with profits, 226. Redlands Water Co. v. Redlands, 125°. 366 INDEX Rehm, H., 33, 68, 154, 185, 189, 247, 250. Renewal fund, 241. Replacement, 137. Republic Iron & Steel Co., 290. Requisitions, 312. Reserve, ch. xiii, 237; of Atchison, Topeka & Santa Fd Ry., 242; for bad and doubtful debts, 100, 238; banking, 250; com- pulsory, 239; for contingen- cies, 240; disbursement of, 255; distinguished from re- serve fund, 249; for equalizing dividends, 241; for exten- sions, 238; general, 242; for increasing capital, 239; for insurance, 259; of insurance companies, 251; open, 250; for paying debts, 258; pur- poses of, 239; secret, 137, 252, 255, 257; source of, 243; spe- cial, 242; specially covered, 244; specific, 237; of United States Steel Corporation, 242. Reserve fund, 237; distinguished from reserve, 249. Rest, 237. Retired stock, 159. Revaluation, principles of, 80. Revenue account, 195. Revenue expenditure, 72. Richardson v. Buhl, 125, 213". Robinson v. Ashton, 318. Row-Fogo, J., 342. Saint Ambrose, Bank of, 240. San Diego Water Co. v. San Diego, 125°. Schaer, J. F., 22. Schulte V. Anderson, 330*. Schurtz, G. N., 41. Schuster, E., 177. Secret reserves, 137, 252, 255, 257. See V. Heppenheimer, 164, 157, 166, 172. See-Han dlungs-Gesellschaft, 228. Simon, H. V., 151, 248". Single entry,' 7, 10. Sinking fund, ch. xiv; of Chicago & Northwestern Ry., 263, 266; of Chicago, Rock Island & Pacific Ry., 262; compari- son of diSerent methods, 265; definition, 261; and deprecia- tion, 272; as a fixed charge, 266 ; formula for, 271 ; interest on, 265, 269; investment of, 263; of Louisville & Nashville Ry., 264 ; methods of booking, 261; and net income, 267; payment of bonds from, 269', of Pennsylvania R.R. Co., 267; of United States Steel Corporation, 67, 264. Sinking fund accretions, 269. Slayden v. Coal Co., 226. Slide rule, 352. Smith, A., 210. Smith, O., 304. Southern Railway, 288. Speer v. Bordeleau, 178. Sprague, C. E., 1°, 22, 45. Statement of affairs, 335. Stewart v. St. Louis, etc., R.R., 162. Stock dividends, 172. Stock watering, 79, 171. Stores record, 311. Stringer's case, 225. Subscriptions to capital stock, 147, 153. Supplementary rate, 301, 302. INDEX 367 Surplus, 155, 233, 234, 235, 237, 240. See also Reserve. Table A, Companies Act, 66, 68, 153, 248. Tabulator, mechanical, 354. Taxes, 288. Terminology, 56. Tiffany, H. L., 130, 142. Tipson, F. S., 339. Tools, valuation of, 89. Total cost, 296. Towers v. African Tug Co., 210. Trad^ discounts, 288. Trading account, 133, 274; forms of, 276, 278; selling price in, 288; trading expenses in, 287; valuation of manufactured goods in, 284. Trading expenses, 287. Trading profits, 285. Treasury stock, 150, 152. Trial balance, 35. Tutt V. Land, 125". Undervaluation, 84. Undivided profits, 237. Union Pacific B.R. Co. v. United States, 85. United Railways Investment Co., 120. United States Shipbuilding Co., 170. United States Steel Corporation, Form 29, 67, 159, 242, 249, 264. United States «. Kansas Pacific Ry. Co., 125. United Verde Copper Co., v. Rob- erts, 206°, 213". Valuation, principles of, 80. Valuation accounts, 50, 53, 57, 70, 235. Van de Linde, G., 32. Vemer v. General & Commercial Trust, 92, 207, 210, 218, 229. Wages, 309. Walton, S., 178. Warren v. King, 229. Washburn v. National Wall Paper Co., 107. Wasting assets, 203, 205, 214. Watered stock, 171. Wells-Fargo Express Co., 240. Welton, T. A., 116. Wetherbee v. Baker, 166. Whatley, G. E. S., 248. Whitcomb v. Converse, 329. Whitmore, J., 304, 307. Whittaker v. Amwell National Bank, 89, 125. Williams v. Western Union Tele- graph Co.,, 175, 230. Wilmer v. McNamara, 116, 206° 208. Woelfel V. Thompson, 329. Woodlock, T. F., 73. Working capital. 179. THE END (21)