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Cornell University Library 
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 Principles of accounting. 
 
Cornell University 
 Library 
 
 The original of this book is in 
 the Cornell University Library. 
 
 There are no known copyright restrictions in 
 the United States on the use of the text. 
 
 http://www.archive.org/details/cu31924013824275 
 
Principles of Accounting 
 
 BY 
 JOHN RAYMOND WILDMAN, B.Sc, M.C.S., C.P.A. 
 
 Professor of Accounting in New Yoik University School of Commerce, 
 Accounts and Finance 
 
 1920 
 THE WILLIAM G. HEWITT PRESS 
 
 61-67 NAVY STREET, BROOKLYN, NEW YORK 
 
Copyright, 1913 
 
 BY 
 
 JOHN RAYMOND WILDMAN 
 
PREFACE 
 
 In presenting this book, the author desires to have understood 
 that it is not a treatise on accountancy. It deals, as the title 
 implies, with the principles of accounting. 
 
 Accounting may be defined as that science which treats of 
 the systematic compilation and presentation in a comprehensive 
 manner, for administrative purposes, of the facts concerning the 
 financial operations of a business organization. 
 
 Accountancy is most aptly defined in the Certified Public 
 Accountant Syllabus issued by the New York Education Depart- 
 ment as, "a profession, the members of which, by virtue of their 
 general education and professional training, offer to the commu- 
 nity their services in all matters having to do with the recording, 
 verification and presentation of facts involving the acquisition, 
 production, conservation and transfer of values." 
 
 Bookkeeping has been defined as, "the art of recording pecu- 
 niary transactions in a regular and systematic manner." 
 
 From the above definitions it will be seen that there are 
 marked differences between bookkeeping and accounting, and 
 accounting and accountancy. The requirements of a knowledge 
 of bookkeeping are overshadowed by those of accounting. Ac- 
 countancy is, in turn, much broader in its scope than the latter. 
 
 With the ever-present recollection that the subject of this dis- 
 cussion is accounting as a science and not professional accounting, 
 the book should be read. 
 
 It has been prepared as a text, constituting the foundation, 
 or framework of the course in Theory of Accounting, as given 
 in New York University School of Commerce, Accounts and 
 Finance. As such it is supplemented by extensive collateral read- 
 ing, with a view of bringing to the attention of the student the 
 greater detail on many topics, which obviously is impossible in 
 a work of this character, as well as the views of other writers 
 on this and allied subjects. 
 
 The subject has herein been approached in a manner different 
 from most books on accounting. The choice of most writers 
 
Preface 
 
 seeins to be the analytical method, beginning with the financial 
 statements as a basis. The present work makes use rather of 
 the synthetical method, with the preparation of financial state* 
 ments for administrative purposes as the objective. An attempt 
 has been made to tie in the allied subjects, such as economics, 
 law, finance and organization, and to show the relation which 
 accounting bears to these subjects. 
 
 The author desires to record his appreciation of the assist- 
 ance rendered by his friends and associates, William Wallace 
 Douglas and John Thomas Madden, of the accounting faculty 
 of New York University School of Commerce, Accounts and 
 Finance. Both have been patient with his shortcomings and 
 especially helpful with suggestions and constructive criticism. 
 
 The author also desires to present the book as a modest and 
 conscientious attempt on his part to gather together for students 
 the principles of accounting rather than a masterpiece born of 
 egotism. 
 
 John Raymond Wildman. 
 
 New York, May 22, 1913. 
 
CONTENTS 
 
 CHAPTER PAGE 
 
 I The Object which Accounting Seeks to Accomplish I 
 
 II The Factors which Produce Income 6 
 
 III Profit the Object of Business Organization 8 
 
 IV Business Organization as the Chief Factor in the Pro- 
 
 duction of Income 10 
 
 V The Employer as an Economic Type of Organization 13 
 
 VT The Various Forms of Capital 18 
 
 VII Legal Types of Organization 23 
 
 VIII Books, their Classification, Form and Ruling 35 
 
 IX Methods of Bookkeeping , 43 
 
 X Accounts: Definition and Construction 46 
 
 XI Accounts : Classification SO 
 
 XII Assets and Liabilities Classified S3 
 
 XIII Nominal Accounts Classified 58 
 
 XIV Special Functions of Certain Accounts » 64 
 
 XV The Property Accounts 67 
 
 XVI Buildings 71 
 
 XVII Buildings (continued) 89 
 
 XVIII Buildings— What May Happen to Them 93 
 
 XIX Equipment 102 
 
 XX Investments 109 
 
 XXI Working and Trading Assets 118 
 
 XXII Current Assets 126 
 
 XXIII Patents, Copyrights and Trademarks 134 
 
 XXIV Franchises , 139 
 
 XXV Goodwill 142 
 
 XXVI Funds 147 
 
 XXVII Deferred Charges to Expense 153 
 
 XXVIII Consignments 159 
 
Contents 
 
 CHAPTER PAGE 
 
 XXIX Capital Liabilities 169 
 
 XXX Reserves 174 
 
 XXXI The Relation of Funds to Reserves 184 
 
 XXXII Proprietorship 193 
 
 XXXIII The Income-from-Sales Group 199 
 
 XXXIV The Cost-of-Sales Group 203 
 
 XXXV Gross Profit on Sales and Turnover 209 
 
 XXXVI The Selling-Expense Group 216 
 
 XXXVII The Administrative-Expense Group 220 
 
 XXXVIII The Secondary-Income Group 225 
 
 XXXIX Deductions from Income Group 231 
 
 XL Depreciation 236 
 
 XLI Interest 251 
 
 XLII Insurance 261 
 
 XLIII Taxes 270 
 
 XLIV Miscellaneous Profits and Losses 276 
 
 XLV Accruals and Closing Entries 280 
 
 XL VI The Preparation of Financial Statements 285 
 
 XLVII Public Service Accounting 318 
 
 XL VIII Taxation of Corporations and Reports to State Comp- 
 troller 338 
 
 XLIX Interstate Commerce Commission Accounting 345 
 
 INDEX 3S4 
 
Principles of Accounting 
 
 By John R. Wildman 
 
 CHAPTER I 
 
 THE OBJECT WHICH ACCOUNTING SEEKS TO ACCOMPLISH 
 
 The object of accounting is to ascertain, compile, and present 
 in a comprehensive manner, for administrative purposes all the 
 facts concerning financial operations and conditions. 
 
 Business men are coming to realize that proper and adequate 
 financial statements are a highly important, if not an indispen- 
 sable aid, to successful administration. 
 
 It is not so long since many concerns used merely a single 
 entry system of keeping their books and depended, so to speak, 
 upon an inventory of assets and liabilities at the end of the year 
 in order to determine their financial condition. From such an 
 inventory there was compiled a list of accounts separated as to 
 assets and liabilities which was called a balance sheet and which 
 showed the surplus or deficit. The profit or loss was determined 
 by a comparison of the surplus or deficit at the end of the period 
 with that at the beginning. All that could be established was the 
 fact that a gain had been made or a loss sustained and the extent 
 in either case. Such information was obviously very meagre. 
 
 The question, presumably, which began to arise in the minds 
 of proprietors in case of a gain was, "What was the cause or 
 causes from which the profits have resulted?" With the aid of 
 double entry bookkeeping and the accompanying nominal ac- 
 counts a profit and loss account became possible. This summary, 
 which was a transcript of the corresponding accounts in the 
 books, was crude at first, and while nothing more than a classified 
 list of debits and credits, did explain in a measure the increase or 
 decrease in the surplus or the deficit. 
 
 To the inquisitive proprietor, even of a small concern, such 
 a statement probably proved unsatisfactory. The account might 
 have been called a hodgepodge of information accounting arith- 
 metically for, and to a certain extent explaining in general terms 
 the causes of, profits and lossses, but the business man began to 
 ask for something more definite ; something more concrete ; some- 
 
 i 
 
Principles of Accounting 
 
 thing which would tell him with more precision just why a profit 
 had been made. He was also dissatisfied at having to wait until 
 the end of a year before obtaining this information. 
 
 Quite naturally he began to ask, if he happened to be engaged 
 in manufacturing, "How much do I make on my goods without 
 taking into consideration the expenses of selling them, or the 
 expense of conducting the business ?" To satisfy this want on the 
 part of the proprietor, the accountant presumably prepared a 
 more elaborate statement of the profit and loss for the period, 
 which divided the total expense of conducting the business into 
 three classes ; namely, manufacturing, selling, administrative and 
 general. He arranged to show the profit after each class of 
 expense had been deducted. His statement was in account form 
 and was known as the trading and profit and loss account, or as 
 the manufacturing, trading and profit and loss account. This 
 latter statement probably attained greater popularity than the 
 former. It was divided into three sections, entitled respectively, 
 manufacturing, trading, and profit and loss. The first section had 
 as its object the gathering together of' all the items of cost or 
 expense affecting the manufactured goods sold. These, of course, 
 comprised the stock at the beginning of the year, whether in the 
 shape of raw material, goods in process, or finished goods, to 
 which was applied the respective inventories at the end of the 
 period. It also included wages, rent and taxes of factory, depre- 
 ciation on machinery and all incidental items of expense affecting 
 the manufacturing. When this cost of manufactured goods sold 
 had been ascertained, the section was closed out by being bal- 
 anced and the balance was brought down to the second section, 
 or that called trading. This section showed on the credit side the 
 sales, and on the debit side the cost of sales plus salesmen's sal- 
 aries and expenses, together with discounts on sales. It was 
 balanced in a manner similar to the first section, and the balance 
 carried down to the profit and loss group. In this section the 
 gross profit on trading appeared on the credit side and was offset 
 by such items as the rent of warehouse, salaries of clerks, depre- 
 ciation on factory, office expenses, reserve for bad debts, interest, 
 dividends, etc. 
 
 This statement, while quite obviously an improvement over 
 the original profit and loss account, still left something to be de- 
 sired. While intended to allocate profits to a certain extent, it 
 
 2 
 
Object which Accounting Seeks to Accomplish 
 
 possessed to such a degree the features of a ledger account, that 
 it was generally condemned by the proprietor, who as a rule 
 understood little about bookkeeping, as being too intricate for 
 his interpretation. It worked its way into favor with bookkeepers 
 in this country at a time when very little attention had been given 
 by them to financial statements. It is supposed to have come from 
 England, where it originated. It has now been largely discarded 
 in favor of a statement which is known as the statement of income 
 and profit and loss. 
 
 This statement presumably came in response to the persistent 
 demands on the part of the proprietor for financial statements 
 which would be of use to him in running his business, so to speak. 
 Many such men have been heard to say, "What I want is a 
 statement which I can understand and which will help me to 
 run my business and make more money." "What I want is an 
 income statement which will tell me whether I am making money 
 through proper and consistent manufacturing cost, or whether I 
 am losing money because my selling or administrative expense 
 or my fixed charges or any one of them is too high. If I lose 
 money, I want to know whether my selling price is too low or my 
 cost and expense items too high, and above all, I want a statement 
 which I can understand. I know nothing, of bookkeeping or 
 accounting, and I do not wish to be bothered with highly technical 
 and involved statements." 
 
 The statement of income and profit and loss is the latest de- 
 vice for supplying the wants of the business man with informa- 
 tion as to his operations. While it has developed into a somewhat 
 elaborate statement, it is so arranged as to present to the business 
 man in a simple and logical manner that which he desires. It 
 does away with all bookkeeping features; there is no such thing 
 as debts and credits. It deducts one item from another in the 
 same way that the layman would do it, "if he were figuring up his 
 profits." It seems to appeal to him and be possible of interpre- 
 tation by him for this reason. It is constructed in accordance 
 with the divisions of organization. It sets out clearly the cost 
 incident to manufacturing, selling and administration. It sep- 
 arates from these departments, which comprise the operations, 
 all such items as secondary income or deductions therefrom. It 
 complies with the economic theories with regard to interest, rent, 
 taxes, etc. It allocates the profits to the respective division of 
 
 3 
 
Principles of Accounting 
 
 organization showing gross profit, selling profit and net profit. 
 It shows the income from operations and the income from sources 
 other than operations. It gives the business man a statement 
 from which to form his judgments and to administer. 
 
 The balance sheet of to-day has also undergone some remark- 
 able changes. From an intricate mixture of accounts, classified 
 only as to debit and credit, it has become a statement of great 
 refinement, showing not only the true financial condition but 
 carrying with it information which is of inestimable value to the 
 proprietor or administrative officer. It now enables him to deter- 
 mine the manner in which his capital is invested; the extent to 
 which his equity in the organization exists; to separate his fixed 
 capital from his working capital ; to determine which assets have 
 an intrinsic value and those which are carried merely as a matter 
 of courtesy for accounting purposes. 
 
 The fact that scientifically prepared financial statements are 
 desirable and, in fact, needed by the business man who hopes to 
 become successful would appear to pass unchallenged. That 
 great corporations are in effect magnified individuals, the power 
 of observation of whose officers is limited, will also probably be 
 unquestioned. That such officers must have some artificial means 
 of transcending such limits is also quite evident. Financial state- 
 ments, with their accompanying statistical data, furnish such a 
 means. 
 
 The duty which confronts the accountant is that of presenting 
 such financial statements and presenting them when needed. 
 Some concerns require statements showing daily profits, others 
 what might be termed perpetual balance sheets, while the great 
 majority probably close their books either semi-annually, quar- 
 terly or monthly. These statements will not prepare themselves. 
 They will not permit of successful preparation unless some 
 arrangement has been made to secure the facts and figures essen- 
 tial to their preparation. In order that this may be accomplished 
 it is necessary that the accountant should thoroughly understand 
 books, the object in keeping them, their classification, their form 
 and ruling; methods of bookkeeping; of accounts, their philoso- 
 phy, classification, and arrangement in books; the relation which 
 each account bears to allied subjects, such as economics, law and 
 finance ; the peculiar effect which the various economic and legal 
 
 4 
 
Object which Accounting Seeks to Accomplish 
 
 types of organization and various lines of business have upon the 
 accounts and the accounting technique. 
 
 The accountant having in mind the results which he wishes 
 to attain, plans his work accordingly. He begins with the selec- 
 tion of proper books. He proceeds by choosing such accounts 
 as will, when properly arranged, reveal, in accordance with eco- 
 nomic principles, a complete record of the financial transactions 
 of the particular type of organization involved and facilitate the 
 preparation of comprehensive financial statements. Not alone 
 arithmetical statements which are mathematically correct and 
 accurate with regard to the facts, but statements which set 
 forth such facts in a manner which can be readily understood. 
 A balance sheet may set forth all the real accounts. It may 
 show the financial condition of the organization. An income 
 statement may disclose all the nominal accounts and show the 
 results of operation during the period just past. If the arrange- 
 ment is disregarded, the statements will have little meaning. 
 Properly arranged, they may be of immense value to the pro- 
 prietor or administrative officer. They may show not only the 
 financial condition and the results of operation in the past, but 
 light the way to improvement in the future. A properly con- 
 structed balance sheet may be a most important factor in guid- 
 ing the financial policies. A statement of income and profit and 
 loss, wherein items of cost are grouped around units of pro- 
 duction and items of expense around units of service, may be 
 most helpful as an index to efficiency and honesty or as a warn- 
 ing of weakness or impending danger. To discuss the elements 
 necessary to the preparation of comprehensive financial state- 
 ments will be the purpose of the following chapters. 
 
 REFERENCE FOR COLLATERAL READING: 
 
 Business Education and Accountancy, Haskins, Chapters I, 
 II, V, VI. 
 
CHAPTER II 
 
 THE FACTORS WHICH PRODUCE INCOME 
 
 There are four distinct factors which produce income, namely, 
 land, labor, capital and business organization. The income is 
 classified as rent, wages, interest and profit. 
 
 Land as used in the economic sense is understood to mean not 
 only the surface but the trees above, the minerals beneath, to- 
 gether with the rivers and surrounding waters, with their con- 
 tents and sources of power. 
 
 The ownership of land gives to the owner the right to possess 
 and use it, or to offer its use to others. For this latter privilege 
 the owner, or landlord as he is sometimes called, derives income 
 which is called rent. 
 
 The individual's first thoughts are usually directed towards 
 supplying the wants of himself and family. Ability to supply 
 individual wants would seem to depend either upon : 
 
 a. The possession of land, or 
 
 b. The ability to work. 
 
 Possessing land, the individual may apply his labor and gain 
 his livelihood. Failing in the possession of land he may sell his 
 services and supply his wants out of the compensation which he 
 receives. Such compensation constitutes his income and is known 
 as his wages. 
 
 The result of man joining forces with nature is the production 
 of goods. Goods are of two kinds; those intended for the pro- 
 duction of other goods and those intended for consumption. The 
 former are called capital goods; the latter consumers' goods. 
 Expressed in terms of money, both constitute capital, which term 
 from the point of view of the business man is extended to include 
 
 6 
 
The Factors which Produce Income 
 
 money itself, being the equivalent of goods. The business man 
 also includes his land, with the natural resources, since he argues 
 that with these he is enabled to increase his income. 
 
 Thus it will be seen that the capital of the individual may take 
 the form of : 
 
 a. Land and natural resources, 
 
 b. Goods. 
 
 1. Capital, such as buildings, machinery and tools. 
 
 2. Consumable, such as food and clothing. 
 
 c. Money, the equivalent of land and goods. 
 
 The possessor of capital may use it himself or loan it. If he 
 uses it himself, he derives benefit therefrom. If he loans it, he 
 exacts a charge for its use, which is called interest. 
 
 Of the various individuals, some are forced to content them- 
 selves with wages ; others are content with the rent derived from 
 the land; still others are satisfied with interest on capital; while 
 the majority perhaps aspire to greater income which is to be 
 derived from business organization, as it is commonly called in 
 this country. 
 
 The income derived from investment in a business organiza- 
 tion is known as profit. 
 
 The individual who undertakes a business venture is con> 
 monly referred to in economics as an entrepreneur. 
 
 Land is excluded as a factor in organization for the reason 
 that it is included as a part of capital. Land used as land un- 
 doubtedly produces income in the form of rent. Land used or 
 included as a capital contribution to an enterprise becomes a 
 factor in the production of interest or profit. 
 
 Of the four main factors of production, land, labor, capital 
 and business organization, the latter, the prime object of which 
 is supplying the wants of the masses for profit, becomes from an 
 accounting point of view the prime topic of interest. 
 
CHAPTER III 
 
 PROFIT THE OBJECT OF BUSINESS ORGANIZATION 
 
 Profit is derived from the transfer, either temporarily or per- 
 manently, of land, goods, or services by the owner thereof or his 
 agent. 
 
 The media of organization through which such transfers are 
 effected are those involved in the industries of extraction (fishing, 
 farming, mining, etc.), transformation (manufacturing), and 
 transportation, trading, real estate, banking, insurance, ana 
 agency. 
 
 The economic function performed by the organization does 
 not affect the nature of the income produced. An organization 
 engaged in the real estate business, for example, may derive its 
 income entirely from rent, while a banking concern may derive its 
 income entirely from interest. In both instances, notwithstanding 
 the fact that for purposes of classification and identification the 
 income is given the special name of rent or of interest, it arises 
 through the use of capital invested in the organization and 
 remains unalterably the profit of same. 
 
 Capital successfully loaned returns interest. Capital success- 
 fully invested returns profit. Capital may be either loaned of 
 invested, but not both at the same time. Hence the fallacy, in 
 the opinion of the writer, of crediting to the proprietor's or in- 
 vestor's account interest on owned or invested capital. To follow 
 out such theory requires that there shall be set up in the mind a 
 business entity separate and distinct from the investors therein. 
 Interest, say at 5%, is then charged to operations and credited to 
 the individual investors. The charge to operations has the effect 
 of increasing cost and decreasing the profit so that the amount 
 ultimately received by the investor is only that profit which is in 
 excess of 5% on the investment. The advantage claimed for this 
 procedure is that it enables the proprietor or investor to compare 
 the return on his investment with that in other lines of business 
 
 8 
 
Profit the Object of Business Organization 
 
 and thus determine whether to continue with the present line or 
 transfer the investment to other fields. 
 
 That this is true must be conceded. That the same result 
 might be obtained by a simple computation quite outside the 
 books and without the annoyance of unnecessary bookkeeping 
 must, however, be maintained. Further, while the procedure 
 may seem offhand to be harmless even though unnecessary, it 
 may in reality be dangerous. Costs which have been loaded with 
 interest on owned capital will be fictitiously high and may in the 
 case of close competition operate to the detriment of an organi- 
 zation which follows this practice. 
 
 To sum up, it must be said that the procedure is unsound theo- 
 retically; it does not have advantages which cannot be obtained 
 in a simpler manner and with less work ; and the results obtained 
 thereby may be dangerous. 
 
 The same position is sometimes taken with regard to rent 
 where buildings are owned by the organization which occupies 
 them for business purposes. It is contended that if the buildings 
 were not owned rent would have to be paid. In order to put the 
 organization under discussion on the same basis with other busi- 
 ness concerns occupying rented buildings, an amount, sometimes 
 calculated scientifically and sometimes selected arbitrarily, is 
 charged to operations and credited to "rent-income." Thus there 
 is shown, it is said, "the amount of rent earned by the land on 
 which the buildings stand." 
 
 Again the statement is admittedly true, provided the amount 
 of rent is determined scientifically. The amount of profit earned 
 by the organization, however, and not the amount of rent earned 
 by the land is the matter of importance. If the amount of the rent 
 earned is needed for administrative purposes it may be readily 
 computed without making it the subject of unnecessary book- 
 keeping. Like interest, the inclusion in the costs of rent on owned 
 land or buildings produces a fictitiously high result which may 
 prove detrimental in competition. 
 
 To attempt to analyze profit and attribute certain shares to the 
 various forms of capital which assist in its production, as has 
 been suggested above, seems not only wholly uncalled for, but 
 wrong in principle. The income derived from capital invested in 
 a business organization is profit and not subject to analysis or 
 division. 
 
 9 
 
Chapter iv 
 
 BUSINESS ORGANIZATION AS THE CHIEF FACTOR IN THE PRODUC- 
 TION OF INCOME 
 
 Business organization consists in supplying the wants of the 
 masses for profit. Profit implies that the object is sales. Sales 
 denote the transfer of ownership at an increased price over cost. 
 This eliminates the sale of individual services at personal cost. 
 The professional man, or workman has a personal cost which is 
 made up of the living expenses of himself and family. This is 
 to be distinguished from business cost or expenses. Organization 
 specifically implies the engaging in business for profit. From an 
 economic view-point organization may be divided into the follow- 
 ing types : 
 
 i. The individual, 
 
 2. The associated individuals, 
 
 3. The employer. 
 
 Since all forms of organization may be looked upon as the 
 magnified individual, his functions will serve best as a basis for 
 elaboration. 
 
 The individual who organizes for business purposes has the 
 following functions to perform: 
 
 He must 
 
 a. Find a place to work, 
 
 b. See that he has proper tools, 
 
 c. Secure material, 
 
 d. Apply his labor, 
 
 e. Have a place to offer his goods for sale, 
 /. Take care of his finances, 
 
 g. Watch his relations to the government, federal, state, 
 
 county, and city. 
 h. Watch his legal relations to other individuals with 
 
 whom he does business. 
 ». Keep his accounts. 
 
 Scrutiny of the above functions as to their relation to account- 
 ing will serve to bring out the fact that all are vitally connected 
 
 10 
 
The Chief Factor in the Production of Income 
 
 therewith. All involve finance. As soon as finance enters into a 
 business, as it must without exception, then accounting becomes 
 necessary. Securing a place to work means either acquiring 
 property or renting some place. Immediately finance enters the 
 proposition and accounting necessarily follows. The acquisition 
 of property means the investment of capital of which financial 
 record must be kept. Renting a place, means keeping an account 
 with the landlord. The investment in property establishes a rela- 
 tion with some department of the government and taxes enter 
 the proposition. Entering into an agreement with the landlord 
 brings out certain legal relations which may give rise to legal 
 expenses. Thus it will be seen in running through a list of 
 functions that each is intimately connected with accounting. 
 
 Here is found the simplest type of organization. Each func- 
 tion is performed by the individual who has no help of any kind. 
 A good example is the shoemaker. Such an individual, having 
 found a place to work and equipped himself with tools, secures 
 his leather, and other miscellaneous materials and supplies, applies 
 his own labor and upon completion, offers his product. His 
 profit consists in the difference between what he sells the shoes 
 for and what they have cost him to make. 
 
 The capacity of the individual is limited. Prosperity may find 
 his progress hampered, because of the fact that when he is en- 
 gaged in buying leather and supplies, or when he is selling to 
 customers, he cannot continue to work upon his product. He may 
 be unable to keep his stock up and dissatisfaction on the part of 
 the customers and subsequent loss of trade may result. Thus the 
 thought of association may be suggested to him. A sharing of 
 functions with some associate may seem desirable. If he has some 
 one to continue at work on the shoes while he is devoting himself 
 to obtaining selected leathers for the shoes the quality will un- 
 doubtedly be improved or at least he will be able to maintain the 
 standard of quality which he has set. If he is free from annoy- 
 ance and the feeling that he is neglecting his work while waiting 
 on customers he will be in a position to give better attention to 
 them and thus gain their good-will. 
 
 While the division of labor, or division of functions, will un- 
 doubtedly produce greater results, a division of responsibility, each 
 individual being equally interested, tends to demoralize. Accord- 
 ingly, individual ambition tends towards a desire to control or 
 
 II 
 
Principles of Accounting 
 
 employ, and thus it is that the employer or entrepreneur becomes 
 the most popular form of economic organization. 
 
 As an employer the organization may take the legal form of: 
 
 1. Sole proprietor. 
 
 2. Copartnership, 
 
 General, 
 
 Limited or special. 
 
 3. Joint venture, 
 
 4. Association or society. 
 
 5. Joint stock association. 
 
 6. Corporation, 
 
 Stock, 
 Non-stock. 
 
 7. Trust or holding company. 
 
 A discussion of the legal phases of these various forms will 
 follow later. At the present a discussion of the economic phases 
 of organization in so far as they relate to the employer seems 
 advisable. 
 
 12 
 
CHAPTER V 
 
 THE EMPLOYER AS AN ECONOMIC TYPE OF ORGANIZATION 
 
 To revert to the shoemaker, it will be remembered that asso- 
 ciation with another individual was not so satisfactory. The 
 founder of the business thought to be better satisfied if he might 
 employ someone to whom he could delegate a part of his func- 
 tions without giving him a voice in the management. 
 
 If we might imagine the business as prospering, it is probable 
 that we should have to imagine an extension of the business as 
 replacing the modest shop. The bench or two with which the 
 individual began would be magnified into a manufacturing de- 
 partment with a foreman or superintendent at its head. In keep- 
 ing with the enlargement would come the retail store with a sales 
 force and a clerk in charge of the store. The organization would 
 also require an office where the accounts could be kept, the cor- 
 respondence attended to and from which the proprietor could 
 administer the business. We might say at this point that the 
 business has been organized into three departments, namely, the 
 manufacturing, selling and administrative departments. 
 
 The business as a whole, although organized into three de- 
 partments for the purpose of management, is still under the con- 
 trol of an individual, the proprietor. Without parting with any 
 voice in the business policies, he has delegated to his heads of 
 departments certain duties or functions which previously he per- 
 formed himself. 
 
 Imagining a still further growth of the business, it is evi- 
 dent that each department must be more highly organized. The 
 manufacturing department having begun with a few men under a 
 foreman, it was possible for the foreman to supervise the work 
 of all of the employes. To facilitate the work and provide ade- 
 quately for the output it may have been necessary to have more 
 and separate rooms, thereby making supervision more difficult. 
 Thus it may have been necessary to introduce a division of labor 
 and a division of foremanship. 
 
 Where before each man made a complete shoe from start to 
 finish, each man now performs only one function, such as cutting 
 out uppers, stitching uppers, cutting out soles, etc. This has re- 
 
 13 
 
Principles of Accounting 
 
 suited in a classification of functions and a division of the shop 
 into departments. Where the foreman previously supervised all 
 the work, each department now has its own foreman with a 
 superintendent over all. 
 
 In the latest type of economic organization, controlled by sci- 
 entific management, the functions of the superintendent and fore- 
 man have been analyzed and classified and delegated to a number 
 of individuals exercising supervision. What was previously 
 known as the military type of organization has been replaced by 
 the functional type. Great credit for this is due to Dr. F. W. 
 Taylor, of Philadelphia, who has made a study of management 
 his life work. Dr. Taylor realized that, given eight functions, 
 as the number requisite for best results, it was easier and shorter 
 work to train eight men each to learn and perform one function, 
 than to train one man to learn and perform eight functions. It 
 was also easier to find eight men of mediocre ability, each of 
 whom could learn to perform one function than to find one who 
 could learn and perform them all satisfactorily. 
 
 Under this type of management the functions of foremanship 
 are delegated to 
 
 1. Route clerks, 
 
 2. Instruction card clerks, 
 
 3. Cost and time clerks, 
 
 4. Gang bosses, 
 
 5. Speed bosses, 
 
 6. Inspectors, 
 
 7. Repair bosses, 
 
 8. Shop disciplinarian. 
 
 The fact must not be lost sight of that although such an elab- 
 orate organization of the manufacturing department might exist, 
 our individual proprietor may still be in control. He has merely 
 delegated these functions to his employes. 
 
 The selling department will probably also have been organized 
 on a more extensive scale, especially if the concern has entered 
 the wholesale field. In addition to the retail store which now 
 forms a minor part of the department, there will be a force of 
 salesmen in the field, a division for advertising, with a sales man- 
 ager presiding over the department. 
 
 14 
 
Aii Economic Type of Organisation 
 
 Here again the proprietor has merely delegated a part of the 
 work to an employe. 
 
 The administrative department will be under the immediate 
 supervision of the proprietor. As assistants he will probably 
 have men in charge of his accounting department, his financial 
 department and perhaps his legal department. 
 
 Whether the function of management is vested in a sole pro- 
 prietor, shared by partners, or in the hands of officers of a cor- 
 poration makes no difference in so far as the working divisions 
 are concerned. In the case of corporate organization the admin- 
 istrative department is somewhat more highly organized. 
 
 Corporations being artificial persons they must of necessity 
 be represented by real persons. Such persons are known as the 
 administrative officers. By administration is meant the conduct 
 of the business by these officers. Some are actively engaged in 
 its conduct while others are merely passively interested. In 
 accordance with this distinction, administration divides into di- 
 rective and executive administration. 
 
 The real owners of the corporation, namely, the stockholders, 
 are represented in interest by the directors, acting for whom, in 
 order to facilitate matters, is the executive committee. This 
 committee in turn delegates the conduct of the business to the 
 executive officers, who usually consist of 
 
 i. President, 
 
 2. Vice-president (one or more), 
 
 3. Controller, 
 
 4. Secretary, 
 
 5. Treasurer, 
 
 6. General solicitor. 
 
 The president has general charge and confers with the chair- 
 man of the executive committee. The vice-presidents, where 
 there are more than one, assist the president and may have charge 
 of certain divisions of the work such as the manufacturing or 
 selling. The controller has general charge of the accounting and 
 auditing and frequently a voice in the financial policies. He is 
 distinguished from the company's auditor usually in that the 
 auditor as a rule has no voice in financial matters, his duties being 
 confined to the control of the accounts and operating records and 
 the preparation of financial and statistical reports. 
 
 15 
 
Principles of Accounting 
 
 The secretary has the charge of the corporate records and 
 such other duties as special circumstances may indicate or the 
 president may assign to him. The treasurer, as his title indicates, 
 has the custody of the funds and frequently documents relating 
 to the finances. Where there is a solicitor, he represents the com- 
 pany legally and attends to all matters pertaining to the law. He 
 is in effect the company's lawyer. 
 
 One function which has not yet been mentioned is that of 
 purchasing materials and supplies. In many organizations, this 
 feature assumes considerable importance. The question arises 
 as to whether it is a technical or an administrative matter. 
 
 The ambition of the manufacturing department is usually to 
 establish and maintain a high quality of product. A desire to 
 improve the product frequently results, where the purchasing 
 is left to the manufacturing department, in ordering the best that 
 is in the market without regard to price. There is usually neither 
 time nor inclination to " shop " for prices. Thus it would seem 
 undesirable to place this function in the hands of the head of the 
 manufacturing department. 
 
 On the other hand, assigning this task to an administrative 
 officer is open to the objection, that perhaps not being a technical 
 man, that is not having an intimate knowledge of what is required 
 in order to turn out the best product, and having as a rule as 
 his one aim greater profits for the company which may be brought 
 about through a reduction of the cost, the tendency on his part 
 is to purchase cheaper material without " shopping for prices." 
 
 To overcome the above objection, the function of purchasing 
 is delegated to a special department of the administrative divi- 
 sion which is known as the purchasing department. It is pre- 
 sided over by the purchasing officer, who if he is to be successful 
 must be a man of special ability. He must be strictly honest and 
 upright, have a substantial knowledge of the product, materials 
 and supplies and be familiar with the markets. The work of 
 his department consists in general in obtaining prices, analyzing 
 and comparing goods and prices, and in following market fluctu- 
 ations as well as purchasing in quantities best suited to the needs 
 of the business consistent with the quality of the materials. It 
 is true also that some purchasing officers in cases where the con- 
 cerns have ample funds, purchase for speculative purposes 
 although this is an exception to the duties usually assigned to the 
 
 lb 
 
An Economic Type of Organization 
 
 purchasing officer. This instance is mentioned because of the 
 bearing which it might have on the accounting should the situa- 
 tion arise. 
 
 From the above it will be seen that in an organization engaged 
 in manufacturing there will usually be four main divisions, 
 namely, purchasing, manufacturing, selling and administrative. 
 The bearing which these have on the accounting and the rela- 
 tion which they bear to the financial statements will be discussed 
 later. For the present, the following may serve to summarize 
 roughly the general scheme of organization in a manufacturing 
 concern, together with the personnel and records with which the 
 accountant should be familiar. 
 
 DIVISION 
 
 DEPARTMENT 
 
 PERSONNEL 
 
 RECORDS 
 
 Purchasing .... 
 
 Purchasing. 
 
 Purchasing officer 
 
 Statistics as to 
 
 
 
 and clerks. 
 
 markets, prices, 
 
 
 'Factory- 
 
 
 etc. 
 
 
 Operating. 
 
 Superintende nt, 
 foremen and op- 
 eratives. 
 
 Labor records. 
 
 
 Office. 
 
 Bookkeepers and 
 
 Factory books. 
 
 Manufacturing . < 
 
 Costs. 
 
 clerks. 
 Cost clerk and as- 
 sistants. 
 
 Cost books. 
 
 
 Stores. 
 
 Store clerk and 
 
 Materials and 
 
 
 
 assistants. 
 
 supplies. 
 
 
 Shipping. 
 
 Shipping clerk and 
 
 Finished goods. 
 
 
 _ 
 
 assistant. 
 
 
 
 Advertising. 
 
 Advertising man- 
 
 Statistics as to 
 
 
 
 ager and assist- 
 
 profitable media, 
 
 Selling < 
 
 
 ant. 
 
 etc. 
 
 
 Sales. \ 
 
 Sales manager and 
 
 Statistics as to 
 
 
 V 
 
 assistant. 
 
 orders, sales, etc. 
 
 
 Directive : 
 
 
 
 
 Board of Di- 
 
 Members. 
 
 
 
 rectors. 
 
 
 
 
 Executive 
 
 Members. 
 
 
 
 Committee. 
 
 
 
 
 Executive. 
 
 President, vice- 
 president. 
 
 
 
 Accounting. 
 
 Controller. 
 
 Financial state- 
 ments. 
 
 
 
 Auditor. 
 
 General and sub- 
 
 Administrative. - 
 
 
 General book- 
 
 sidiary financial 
 
 
 
 keeper and 
 
 books. 
 
 
 
 clerks 
 
 
 
 Secretarial. 
 
 Secretary. 
 
 Minutes of stock- 
 holders, directors 
 and executivj 
 committee, etc. 
 
 
 Treasury. 
 
 Treasurer, Cashier 
 
 Cash books, secu- 
 
 
 
 and clerks. 
 
 rities, notes, etc. 
 
 
 Legal. 
 
 General solicitor. 
 
 Cases in litiga- 
 
 
 
 
 tion, etc. 
 
 17 
 
CHAPTER VI 
 
 THE VARIOUS FORMS OF CAPITAL 
 
 Proprietorship implies ownership. When used in conneo 
 tion with business organization it signifies ownership of the 
 assets. If there are liabilities the ownership is restricted to an 
 equity in the assets. Few organizations are free from liabilities 
 so that it might be said that proprietorship is that equity in the 
 financial status of a business organization which is represented 
 by the excess of assets over liabilities. This means in a sense 
 that the proprietor shares with the creditors, whose claims are 
 represented by certain accounts, the ownership of the assets. 
 
 Proprietorship is synonymous with capital. Creditors may be 
 looked upon as having loaned capital to the business. Thus it 
 would appear that in the discussion of capital, two classes of 
 persons must be considered, namely, proprietors and creditors. 
 Capital might be classified as owned and borrowed. 
 
 Owned capital appears either as capital contributed to the 
 business by the proprietor or as an accumulation of profits; bor- 
 rowed capital as having been obtained from creditors. With 
 reference to owned capital it may be interesting to inquire into 
 the different names which the accounts take under the various 
 legal types of organization and with regard to borrowed capital 
 whether same is secured or unsecured and the instruments 
 whereby the capital is obtained. 
 
 Owned Capital 
 
 The sole proprietor's capital at the start is represented by his 
 investment, or capital account. Subsequently it may be repre- 
 sented by his capital account plus his salary and drawing account 
 and accounts for reserves. The accounts for salary and draw- 
 ings while perhaps not so essential in the case of a sole proprie- 
 tor, since they will usually be closed into the capital account at 
 the end of the accounting period, are in keeping with the modern 
 practice of analysis and make statistical calculations, such as the 
 determination of return on the investment, easy. Keeping the 
 investment account separate is advisable, in order that additions 
 
 iS 
 
The Various forms of Capital 
 
 and withdrawals of invested capital may be shown without in- 
 volving the other accounts. Reserves are to be considered at all 
 times as capital, either invested or accumulated out of profits, 
 based as a rule on an estimate and set aside for certain pur- 
 poses which will be discussed later. At the present it will suffice 
 if the fact is borne in mind that reserves are always an adjunct 
 of the capital account. 
 
 In copartnership, which may be either general or limited, the 
 accounts do not differ materially, except that individual capital 
 accounts for partners, together with those for individual salary, 
 drawings and general reserve accounts are supplemented by in- 
 dividual interest accounts for partners. 
 
 Joint ventures differ from copartnerships largely in the ex- 
 tent to which the business is conducted. A copartnership trans- 
 acts any and all business incident to the line of business in which 
 it is engaged. It may continue until terminated by any one of 
 a number of causes, such as the lapse of the period specified in 
 the contract of copartnership, mutual consent, or the death of a 
 partner, etc. On the other hand, a joint venture is created for 
 the accomplishment of a specified purpose and ends usually when 
 the purpose has been accomplished. In so far as the capital 
 accounts are concerned, it will be seen that they be identical with 
 those of a copartnership. 
 
 Associations or societies (non-corporate) derive their capital 
 from contributions or dues of members. As evidence of mem- 
 bership or evidence of contribution they may issue certificates of 
 membership or indebtedness. They may also create out of cap- 
 ital, reserves for the control of certain funds. Accordingly the 
 capital accounts of associations or societies may take the names 
 of membership account, certificates of indebtedness, etc. 
 
 Joint stock associations as they are legally called, or joint 
 stock companies as they are commonly known, obtain their cap- 
 ital through the disposal of capital stock. They may also set 
 aside reserves and have undivided profits or unappropriated sur- 
 plus. Thus the capital accounts, if occasion dictates, will take 
 the names corresponding to the above. 
 
 Corporations ar,e of two kinds, stock and non-stock. Stock 
 corporations will have accounts for capital stock, reserves, un- 
 divided profits and unappropriated surplus. Capital stock may 
 be of several kinds, namely, preferred, common, voting, non- 
 19 
 
Principles of Accounting 
 
 voting, etc. The preferred stock may be preferred as to assets 
 or as to dividends, or both ; it may also be first, second or third 
 preferred, etc. The dividends may be cumulative or non-cumula- 
 tive. The capital stock accounts will take such names as are 
 appropriate under the existing facts. An account should in- 
 variably be kept for each class of stock. 
 
 Non-stock corporations obviously will require no accounts 
 for capital stock. Their capital is obtained as a rule by gift, 
 bequest (left by will), or legacy (bequests of property). It may 
 also be obtained by contribution of members. The capital ac- 
 count is usually known as surplus. There may also be reserve 
 accounts representing a part of the surplus created for the pur- 
 pose of controlling certain funds. 
 
 The capital accounts of trusts or holding companies are the 
 same as those of stock corporations. There is given below, a 
 chart summarizing the accounts as explained in the preceding 
 paragraphs. 
 
 Legal Type of Organization 
 
 Proprietary (or Capital) Accounts 
 
 Sole proprietor. 
 
 Proprietor's investment account, 
 
 
 salary, drawings, reserves. 
 
 Copartnership. 
 
 Partners' individual accounts for 
 
 General. 
 
 investment, salary, drawings, in- 
 
 Limited or special. 
 
 terest and reserves. 
 
 Joint venture. 
 
 Same as copartnership. 
 
 Associations or societies. 
 
 Membership account, certificates of 
 
 
 indebtedness, capital account, sur- 
 
 
 plus, reserves. 
 
 Joint stock associations. 
 
 Capital stock, undivided profit, un- 
 
 
 appropriated surplus, reserves. 
 
 Corporations. 
 
 Capital stock, undivided profits, un- 
 
 Stock. 
 
 appropriated surplus, reserves. 
 
 Non-stock. 
 
 Surplus, reserves. 
 
 Trusts or holding companies. 
 
 Same as stock corporations. 
 
 Borrowed Capital 
 
 Familiarity with the different forms which borrowed capital 
 may take is essential to the accountant for two reasons : first, 
 under normal conditions he should have a knowledge of the 
 accounts representing same, and more especially the instruments 
 whereby certain parts of such capital is obtained on account of 
 the legal and financial relations which arise between a business 
 
 20 
 
The Various Forms of Capital 
 
 organization and its creditors. Second, in the case of bank- 
 ruptcy or insolvency it becomes necessary to distinguish among 
 creditors as to whether their claims are secured or unsecured. 
 
 Neither the accounts nor the instruments appear to be af- 
 fected by types of organization. Borrowing on bonds is probably 
 more common with corporations than with sole proprietors or 
 copartners. This may be due to the fact that corporations, owing 
 to the peculiarities of their organization, are enabled to amass 
 enormous quantities of property and thus amply secure their 
 borrowings. However, given equal financial strength and in- 
 tegrity there would seem to be no reason why a sole proprietor 
 could not issue bonds as well as a corporation. John Wanamaker, 
 for instance, if he happened to be a sole proprietor, might bor- 
 row on an equipment trust obligation as well as the Pennsyl- 
 vania Railroad. 
 
 It is to be presumed that students are familiar with the de- 
 tails of the various forms of financial instruments so that mere 
 mention of the principal accounts and instruments involved in 
 borrowed capital with regard to whether they are usually secured 
 or unsecured, will be indulged in at this time. One thing, how- 
 ever, cannot be too firmly impressed upon the mind of the pros- 
 pective accountant; whenever it becomes necessary to make any 
 record of a financial instrument, a great deal of time and worry 
 will be avoided subsequently if the record is exact, and, above 
 all, complete. By this is meant giving the maker, description of 
 the instrument, the date, date of maturity, rate of interest and 
 how and when payable. For example, Louisville and Nashville 
 R. R. Co., ist Mortgage Sinking Fund Gold Bond; dated July i, 
 1911 ; payable July 1, 1931 ; interest 5% ; payable semi-annually, 
 January 1 and July 1. A chart, showing the accounts and in- 
 struments most commonly found, follows : 
 
 Borrowed capital. 
 
 Bonds secured by mortgage, 
 Real estate, 
 General mortgage, 
 Blanket mortgage, 
 Consolidated mortgage, 
 Divisional (railroads), 
 Collateral trust, 
 
 21 
 
Principles of Accounting 
 
 Equipment trust, 
 
 Car trust (railroads). 
 Collateral notes. 
 Collateral trust certificates. 
 Unsecured. 
 Accounts payable, 
 
 Promissory notes, drafts, foreign bills s 
 Debentures, 
 Income bonds. 
 
 22 
 
CHAPTER VII 
 
 LEGAL TYPES OF ORGANIZATION 
 
 Sole Proprietor. There are no special laws so far as is 
 known affecting the rights of an individual as a sole proprietor 
 to engage in whatsoever business he may desire so long as such 
 business is within the scope of the general law, or statutes. He 
 may conduct such business as he sees fit so long as he is mindful 
 of the legal relations to the government and the individuals or 
 companies with which he does business. The proprietor has the 
 broadest possible opportunity to do as he pleases. He may even 
 conduct business under an assumed name, either that of an in- 
 dividual, firm or company if he complies with the law. Such law 
 requires that he shall file in the office of the clerk of the county 
 court or counties, in which the business is conducted, a certifi- 
 cate, setting forth the name under which the business is con- 
 ducted and the true or real full name or names of the party or 
 parties conducting the business, with the corresponding post- 
 office address or addresses. 
 
 The law does not recognize, as in the case of a corporation, 
 a legal business entity as distinguished from an individual or 
 social being. The debts of the business are the proprietor's 
 debts, regardless of his other outside interests. When creditors 
 sue, they sue the individual. If the assets of the business are 
 not sufficient to cover a judgment which may be obtained, the 
 creditors have recourse to any assets which he may own outside 
 of the business. 
 
 Copartnership. The consolidated laws of the State of New 
 York (Vol. 3, folio 2521) define a copartnership as follows: 
 
 " A partnership as between the members thereof, is the asso- 
 ciation, not incorporated, of two or more persons who have 
 agreed to combine their labor, property and skill or some of them 
 for the purpose of engaging in any lawful trade or business, and 
 sharing the profits and losses as such between them." 
 
 Copartnerships are matters of contract, or articles of copart- 
 nership as they are sometimes called, and in addition to the 
 powers and duties usually implied in copartnership relation may 
 expressly confer upon parties to the contract certain added 
 
 23 
 
Principles of Accounting 
 
 powers and duties. In brief, the partners may agree upon any 
 arrangement no matter how unusual, so long as it violates no law, 
 and articles of copartners should always be examined by the ac- 
 countant in order to determine just what the partners have 
 agreed upon. His accounting must be governed accordingly, ir- 
 respective of whether or not it is the usual custom, whether it 
 meets his view on the subject. 
 
 There are two views as to whether or not a copartnership 
 constitutes an entity distinct from the individual members there- 
 of. One is called the mercantile idea of partnership ; the other 
 the legal idea. Concerning these views, " Parsons on Partner- 
 ship," folio 2, has this to say : " That a partnership is an entity, 
 distinct from the partners, is the view of the business world 
 everywhere. Merchants and accountants alike look upon a firm 
 as a body which has independent rights as well against its mem- 
 bers as against strangers. Accountants credit the partners with 
 advances on the books of a firm and debit them with overdrafts, 
 the accounts being kept between each partner* individually and 
 the firm not between the partners. And such is the state of 
 the law in those European countries where the civil law is in 
 force, as, for instance, Scotland and (in this country) in Louisi- 
 ana where the code is founded on the civil law. In our law, 
 however, the partnership is not clearly recognized as an entity. 
 In an action at law at least the partners alone are recognized as 
 parties in interest." 
 
 While the above quotation brings out admirably the contrast 
 in the two doctrines, it is not believed to be true that the more 
 advanced and thoughtful accountants recognize the copartner- 
 ship entity. True the partners are credited with advances, and 
 probably debited with overdrafts, if the word is to be taken 
 as meaning withdrawals, but such procedure is not because an 
 entity separate and distinct from the individual partners is rec- 
 ognized. The partners together own certain property ; or they 
 may own jointly an equity in a business. In order that their 
 individual interests may be kept separate, or in order that the 
 extent of the interests of each may be measured, a separate capital 
 account, or a series, of separate capital accounts for analytical 
 purposes is kept with each. This does not mean that a copart- 
 nership entity is indebted to each individual by any means. 
 
 The use of a partnership or a business name may be con- 
 
 24 
 
Legal Types of Organization 
 
 tinned by a new firm, provided proper certificate is filed with 
 the county clerk and duly advertised. 
 
 (a) Where the business of any firm or partnership has been 
 conducted by any partner in the new firm, for three years previ- 
 ous to the formation of the new firm. 
 
 {b) When by will of deceased person who previously to the 
 death had conducted business for five years under a right to 
 use a firm name, the right has been received by bequest. The 
 law specifies that " No person shall hereafter transact business 
 in the name of a partner not interested in the firm and that when 
 the designation ' and company,' or ' and Co.' is used it shall repre- 
 sent an actual partner." 
 
 Copartnerships may be either general or limited. The latter 
 is sometimes referred to as a special copartnership. General 
 partnerships are any partnerships formed otherwise than in the 
 manner prescribed by the law for the formation of a limited 
 partnership. 
 
 Each general partner is agent for the partnership in the 
 transaction of its business and has authority to do whatever is 
 necessary to carry on business in the ordinary manner. Each 
 general partner is liable to third parties for all the obligations of 
 the partnership, jointly and severally with his general partners. 
 Since the partnership entity is not recognized at law, partners 
 cannot sue the partnership but must in cases of dispute go into 
 equity for an accounting. 
 
 As between parties, as well as with outsiders, an account 
 stated is an agreed balance of accounts. In other words it is an 
 account which has been examined and accepted by the parties 
 concerned. It is conclusive as to the liability of the parties with 
 reference to the transactions included in the account and cannot 
 be opened except for fraud or in cases of manifest error. 
 
 Copartnerships may be terminated by the following events : 
 
 (a) The expiration of the time for which the firm was 
 
 organized. 
 
 (b) Mutual agreement. 
 
 (c) Withdrawal of a partner. 
 
 (d) Bankruptcy of a partner or the firm. 
 
 (e) Death of a partner. 
 
 (/) War between nations represented by partners. 
 (gr) Court decree in case of misconduct or insanity 
 
 25 
 
Principles of Accounting 
 
 It is not intended to convey the idea that in case the co- 
 partnership were terminated, by death, for example, that the 
 business would not be continued. An abrupt termination of the 
 business would usually be attended with unnecessary loss. To 
 avoid this, the business is usually continued by the surviving 
 partners as trustees for the deceased. What must be done, how- 
 ever, is to draw a sharp line of demarcation at the date of de- 
 cease, determine the share of the deceased partner at such time, 
 and keep separate the business which is subsequently transacted. 
 Such proceeding leads to no end of complications, unless per- 
 chance the partner happens to die on the last day of the month. 
 As there are twelve chances in the three hundred and sixty-five 
 of this occurring, the difficulty is sometimes avoided by providing 
 in the articles of copartnership, that in the event of the death 
 of any partner, his interest shall be determined by the balance 
 sheet at the end of the month, or the year, in which the death 
 occurs. 
 
 Limited Copartnerships. The consolidated laws of the 
 State of New York (Vol. 3, folio 2521), covering this topic, 
 read as follows: 
 
 " Two or more persons may form a limited partnership which 
 shall consist of one or more persons of full age, called general 
 partners, and also of one or more persons of full age who con- 
 tribute in actual cash payments, a special sum as capital, to the 
 common stock (understood to mean capital), called special part- 
 ners, for the transaction within this State of any lawful business, 
 except banking and insurance, by making, severally, signing and 
 acknowledging and causing to be filed and recorded in the clerk's 
 office in the county where the principal place of business of such 
 partnership is located, a certificate in which is stated : 
 
 " 1. The name or firm under which such partnership is to be 
 conducted and the county wherein the principal place of business 
 is to be located. 
 
 " 2. The general nature of the business intended to be trans- 
 acted. 
 
 " 3. The names, and whether of full age, of all general and 
 special partners therein, distinguishing which are general and 
 which are special partners and their places of residence. 
 
 " 4. The amount of capital which each special partner has 
 contributed to the common stock (capital). 
 
 26 
 
Legal Types of Organization 
 
 " 5. The time at which the partnership is to begin and end." 
 
 An affidavit as to the payment must be filed and notice duly 
 published. 
 
 In this form of partnership the status of the general partners 
 is the same as in a general partnership ; the special partners as 
 a rule do not have a voice in the management of the business 
 and are not general agents for the firm as are general partners. 
 They may sue the firm on a debt and are liable for the debts of 
 the firm only to the amount of the capital contributed to the 
 business. 
 
 The capital of the special partner must be maintained at least 
 in the amount contributed and while he may receive interest and 
 profits on his investment such payment must not impair his cap- 
 ital. The firm must display a sign showing the names of all 
 partners indicating which are general and which are special part- 
 ners. 
 
 A special partnership may be terminated in the same general 
 ways as a general partnership, except that a special partner may 
 not withdraw except by consent. 
 
 Joint Ventures, or joint adventures, as they are sometimes 
 called, are formed by contract or agreement in much the same 
 manner as copartnerships. They have as their object some special 
 purpose rather than to engage generally in any line of business. 
 For example, Jones may have the influence necessary to obtain 
 a contract for removing the snow from a certain section of the 
 city, either for some particular snowfall, or perhaps the entire 
 winter, but no funds with which to buy or credit with which 
 to rent, the equipment necessary or to pay the men. Smith may 
 have the funds. Jones and Smith have no idea of forming a 
 copartnership but they do join forces for the purpose of profit- 
 ing by this particular contract. Such an agreement would consti- 
 tute a joint venture. Other joint ventures are of course more 
 complicated and sometimes involve the acquisition of property. 
 Like partnerships they frequently cause disputes. Where prop- 
 erty is acquired by the parties to a joint venture, the title is usu- 
 ally vested in one member who is bound to act in accordance with 
 the contract. One member may sue the other member or mem- 
 bers at law for his share of the profits, which point it will be no- 
 ticed is different from that in partnerships. Where one mem- 
 ber has conducted the business he may sue outsiders and be sued 
 
 27 
 
Principles of Accounting 
 
 by them in his own name. The liability of parties to a joint ven- 
 ture contract is the same as partners. A joint venture may be 
 terminated by the accomplishment of the purpose for which it 
 was created, the terms of the contract, mutual agreement, and in 
 some cases bankruptcy. It is not terminated by the death of one 
 of the parties as his personal representative may take his place. 
 
 Associations or Societies are formed by mutual agreement 
 and derive their power from constitution and by-laws. They 
 usually have as their object some special purpose such as the 
 rendering of some services to their members or to charity 
 without the hope of profit. Prominent among such, frequently, 
 are friendly societies, labor unions, hospital associations and 
 clubs. However all such may quite properly exist as non-stock 
 corporations and are perhaps more frequently found as such 
 than as associations. The interest of members is represented 
 by officers and in some cases a board of trustees and no single 
 member has authority to bind the society. The liability of 
 members is the same as partners so long as the debt was in- 
 curred within the scope of the society's purpose but if without, 
 no member can be held who does not assist in incurring the 
 debt, or was present at a meeting at which the debt was au- 
 thorized, or ratifies the action of the society in creating the 
 debt. 
 
 Associations may be dissolved by mutual consent of members ; 
 such methods as may be prescribed by the constitution and by- 
 laws; by abandonment of the purpose for which the association 
 was organized; by insolvency by court decree in case of hopeless 
 dissension. 
 
 Joint Stock Associations. White on Corporations, folio 820, 
 defines a joint stock association, commonly called a joint stock 
 company, as follows : " The term joint stock association, in- 
 cludes every unincorporated joint stock association, company or 
 enterprise, having written articles of association and capital stock 
 divided into shares but does not include a corporation and the 
 term ' stockholder ' includes every member of such an associa- 
 tion." The articles of association provide: 
 
 1. That the death of a stockholder thereof or the transfer of 
 . his shares of stock therein, shall not work a dissolution of the 
 association. 
 
 28 
 
Legal Types of Organization 
 
 2. For the number of directors, not less than three, to have 
 the sole management of its affairs. 
 
 3. For the general management of its affairs not inconsistent 
 with law. 
 
 Further the law requires, that every joint stock association 
 transacting business within the state shall, within sixty days after 
 its formation, and in each January thereafter, file with the secre- 
 tary of state, and with the clerk of the county in which its prin- 
 cipal business is carried in a written certificate, signed and veri- 
 fied by its president and treasurer stating the name and date of 
 organization of such organization, the number of its stockholders, 
 the names and places of residence of its officers and the principal 
 place of business. Unlike a corporation a joint stock company 
 is not liable for any tax for the purpose of organization but is 
 of course subject to annual taxation under the state law for the 
 privilege of doing business the same as corporations. Apparently 
 it has most of the powers with which a sole proprietor or a cor- 
 poration is endowed except with regard to real estate in which 
 instance it has only the privilege of taking and conveying such 
 real property as (a) may be necessary for its immediate accom- 
 modation in the convenient transaction of its business; (b) as 
 may be mortgaged to it in good faith by way of security for loans 
 made or money due to it; (c) as it may purchase at sales under 
 judgments, decrees, or mortgages held by it. 
 
 The relation of members to the association is that of stock- 
 holders; stock may pass from hand to hand without effect 
 upon the company, however the liability of stockholders is like 
 that of partners, full liability of each member for firm debts, 
 rather than like that of stockholders in a corporation. The asso- 
 ciation may be dissolved by lapse of time specified in the articles 
 of association, consent of all stockholders or a judgment of the 
 court for fraud in the management or other good cause shown. 
 
 Corporations. A corporation is an artificial person, sep- 
 arate from its members, authorized by law, created by charter 
 and having in addition to the powers expressed in its charter, the 
 implied powers of a natural person. The word charter is fre- 
 quently referred to as the certificate of incorporation. Corpora- 
 tions are classified by the law as follows: 
 
 1. Municipal, 
 
 2. Stock Corporations. 
 
 29 
 
Principles of Accounting 
 
 (a) Moneyed corporations, 
 
 1. Banking, 
 
 2. Insurance. 
 
 (b) Railroad or other transportation corporations, 
 
 (c) Business corporations. 
 
 3. Non-stock corporations. 
 
 (a) Religious, 
 
 (b) Membership, 
 
 (c) Any corporation other than a stock corporation. 
 
 Municipal corporations include county, town, school district, 
 village and city and any other territorial division of the state with 
 the power of local government. 
 
 A stock corporation is a corporation having a capital stock 
 divided into shares and which is authorized by law to distribute 
 to the holders thereof dividends or shares of the surplus profits 
 of the corporation. 
 
 A corporation is not a stock corporation because of having 
 issued certificates of stock, but which are in fact merely certifi- 
 cates of membership and which is not authorized by law to dis- 
 tribute to its members any dividends or shares of profit arising 
 from the operation of the corporation. 
 
 Corporations may take any name desired so long as it does 
 not resemble too closely the name of some corporation already 
 existing. They may make such by-laws as are necessary and 
 proper to the conduct of their affairs. They may generally do 
 practically everything that an individual may except that the 
 powers of certain so-called public service corporations, for ex- 
 ample, street railways, gas and electric companies are restricted 
 in New York State by the public service commission. 
 
 Incorporators must be three or more natural persons of full 
 age, at least two thirds of whom i;:ust be citizens of the United 
 States, and at least one a resident of the state of New York. 
 
 Each incorporator must subscribe for at least one share of 
 stock. 
 
 An organization tax of one twentieth of one per cent, or fifty 
 cents per thousand of the authorized capital stock as stated in 
 the certificate of incorporation must be paid to the state treas- 
 urer. The secretary of state's fee for filing is $10.00 and fifteen 
 (15) cents per folio of one hundred words for recording, a 
 
 3° 
 
Legal Types' of Organization 
 
 fee of six cents for filing and ten cents per folio for recording 
 must be paid to the county clerk. 
 
 The certificate of incorporation must contain: 
 
 i. The name of the proposed corporation. 
 
 2. The purpose for which it is formed. 
 
 3. The amount and kind of capital stock. 
 
 4. The number of shares of capital stock, each of which 
 
 shall not be less than five nor more than one 
 hundred dollars and the amount of capital with 
 which the corporation will begin business which 
 shall not be less than five hundred dollars. 
 
 5. The city, village or town in which its principal busi- 
 
 ness office is to be located. 
 
 6. Its duration. 
 
 7. The number of its directors, which shall not be less 
 
 than three. 
 
 8. The names and post office addresses of the direc- 
 
 tors for the first year. 
 
 9. The names and post office addresses of the subscrib- 
 
 ers to the certificate and a statement of the 
 number of the shares of stock which each 
 agrees to take in the corporation. 
 
 The corporate existence begins at the time the certificate is 
 filed and extends over the time specified in the certificate, which 
 may be for a term of years or in perpetuity. 
 
 Each stock corporation is required to keep at its offices cor- 
 rect books of account, setting forth all its business and transac- 
 tions, and, in addition, a 
 Stock book containing 
 
 Names of stockholders, alphabetically arranged. 
 Number of shares. 
 
 The time when they became stockholders. 
 Amount paid thereon. 
 
 No transfers are valid, unless entered in this book showing 
 from whom and to whom transferred. The New Jersey laws 
 differ from New York in that there must be kept two corporate 
 books, namely, a 
 
 Stock book and a 
 Transfer book. 
 
 3i 
 
Principles of Accounting 
 
 There is no maximum limit to the capital stock; the mini- 
 mum is five hundred dollars. In New York State stock may be 
 issued for 
 
 (a) Money, 
 
 (b) Labor done, 
 
 (c) Property actually received for the use and lawful pur- 
 pose of the corporation. 
 
 Stock may be issued for property, as full paid to the extent 
 of the value of the property, and in the absence of fraud, the 
 judgment of the directors as to the value shall be conclusive. 
 
 Liability of Stockholders. A holder of stock is personally 
 liable to creditors of the corporation to an amount equal to the 
 amount unpaid on his stock, for debts of the corporation con- 
 tracted while such stock was held by him. Such liability cannot 
 be enforced until judgment for the debt has been recovered 
 against the corporation, and execution has been unsatisfied in 
 whole or in part, and the amount due on such execution is the 
 amount recoverable with costs against the stockholder. Stock- 
 holders are not personally liable for any debt of the cor- 
 poration not payable within two years from the time it is con- 
 tracted nor unless an action for its collection shall be brought 
 against the corporation within two years after the debt is due. 
 No action shall be brought against a stockholder after two years 
 from the time he ceases to be a stockholder. All stockholders 
 are personally liable for debts owing to laborers, servants or em- 
 ployes of the corporation, if properly served with notice by any 
 person seeking to enforce the liability. 
 
 A transfer of stock of a corporation made by a stockholder 
 in contemplation of its insolvency is void as to the persons in- 
 jured thereby, but in the absence of fraud it is good as between 
 the parties and as against the corporation if it assents to the 
 transfer. 
 
 No transfer of stock shall be valid as against the corporation, 
 its stockholders and creditors for any purpose, except to render 
 the transferee liable for the debts of the corporation until it shall 
 have been entered in the stock book. 
 
 The liability of stockholders to creditors is to be distinguished 
 from the liability of the stockholder to the corporation itself, its 
 receiver or assignee. Such liability rests on contract exclusively, 
 
 3 2 
 
Legal Types of Organisation 
 
 and stockholders may be liable to the creditors where they would 
 not be liable to the corporation. 
 
 If a receiver of the assets of a corporation has been appointed, 
 all unpaid subscriptions to the stock shall be paid at such time 
 in such installment as the receiver or the court may direct. 
 
 Dissolution and Surrender of Franchise. The voluntary dis- 
 solution of a corporation may be affected in two ways: (i) By 
 vote of directors declaring such dissolution to be for the best 
 interest of the corporation and calling a meeting of the stock- 
 holders, followed by the vote of the holders of two-thirds of the 
 capital stock. Statutory provisions must be strictly followed. 
 (2) By a proceeding in the supreme court which may be insti- 
 tuted by the directors. 
 
 The incorporators named in any certificate of incorporation 
 filed for the purpose of creating a domestic stock corporation, 
 other than a moneyed or transportation corporation, may, before 
 the payment of any part of the capital, and before beginning busi- 
 ness, surrender all corporate rights and franchises, by signing, 
 verifying and filing in the office of the secretary of state and the 
 clerk of the county court where the certificate of incorporation is 
 filed, a certificate setting forth that no part of the capital has 
 been paid, that there are no liabilities, that such business has not 
 been begun and surrendering all rights and franchises, and proof 
 of the facts set forth in such certificate to the satisfaction of the 
 secretary of the state and thereupon the said corporation shall 
 be dissolved and its corporate existence and powers shall cease. 
 
 Corporations are also dissolved by lapse of the time named 
 for the existence in the charter, and the court may decree disso- 
 lution for non-user, breach of law, or for fraudulent or illegal 
 acts. 
 
 Trusts or Holding Companies. Comparatively little law can 
 be found on this topic, which includes consolidations, mergers, 
 trusts and holding companies in the strict sense of the word. Ac- 
 cording to the law in the State of New York, " Any two or more 
 corporations organized for the purpose of carrying on any kind 
 of business of the same or similar nature which a corporation 
 organized under the Business Corporations Law, might carry on 
 may consolidate into a single corporation " and " any corporation 
 lawfully owning all of the stock of any other corporation or- 
 ganized for and engaged in business similar or incidental to that 
 
 33 
 
Principles of Accounting 
 
 of the possessor corporation may merge such other corporation 
 with it and be possessed of all estate, property, rights, privileges 
 and franchises of such other corporation. 
 
 Obviously if two or more companies are consolidated or 
 merged they cease from the standpoint of ownership to be sep- 
 arate companies ; however, the plants may be so separated as to 
 make their operation as separate units desirable. 
 
 It was probably the desire for ownership control of several 
 plants engaged in the same line of business while operating sep- 
 arately that prompted the development of the holding company 
 in its pure state. Such an organization contemplates the owner- 
 ship in whole or in part of "ne or more subsidiary companies 
 through the capital stock of the subsidiaries. The holding com- 
 pany, as a rule, does not operate but derives its income princi- 
 pally from the dividends of the subsidiary companies. It may 
 also hold the bonds or other securities of the subsidiaries, which 
 are a source of income, and its income may be further augmented 
 by interest or profit on transactions of a financial nature quite 
 outside of its relations with subsidiary companies. 
 
 Any group or organization, controlled by one central body, is 
 looked upon as a trust. From this it would appear that a trust 
 might take the form of a consolidation, merger, or a holding com- 
 pany. Up to the present (1911) there are few restrictions as to 
 trusts. One thing that a corporation may not do, is to create 
 another, endow it with capital and take all of its capital stock in 
 exchange. Also the right of corporations to acquire shares of 
 stock of railroad corporations and other common carriers as well 
 as gas and electrical corporations is regulated and limited by the 
 public service law, paragraphs 54 and 70. 
 
 From an accounting point of view, trusts, including consoli- 
 dations, mergers and holding companies, present some highly 
 interesting and difficult problems which will be discussed in de- 
 tail under the preparation of financial statements. 
 
 34 
 
CHAPTER VIII 
 
 BOOKS, THEIR CLASSIFICATION, FORM AND RULING 
 
 Books of account are kept for the purpose of recording finan- 
 cial transactions in the order of sequence in which they occur. 
 and classifying, summarizing and preserving such record for 
 future reference. The information thus gathered may be of 
 value in at least three different ways. It is frequently referred 
 to for detailed information in connection with the transaction of 
 current business. It is required for use in the preparation of 
 financial statements. It is often of distinct value when, in cases 
 of litigation, it serves to protect the interests of the proprietor. 
 
 While it is difficult to trace historically the evolution of books 
 it is not improbable that the first records were kept upon stone 
 or upon tablets of some composition in which stone played an 
 important part. Parchment or papyrus presumably followed the 
 stcne age, only to be supplanted by the highly refined kinds of 
 paper of which the present-day books are made. 
 
 Just what jurisdiction or control the government exercised 
 over the books of the earlier periods is not known. That certain 
 European countries have placed certain restrictions upon books 
 and methods of bookkeeping is a well known fact. In Cuba, for 
 example, unless such law has been recently repealed, it is neces- 
 sary that all books of account be submitted to government agents 
 who place on each page an official stamp and exact a tax for so 
 doing. 
 
 In this country business concerns have been left largely to 
 themselves in their choice of books and methods of bookkeeping. 
 The form, ruling, and arrangement in general, has been optional 
 with the concerns themselves. It was not until recently that the 
 slightest tendency toward government supervision was noticed. 
 The powers granted to the Interstate Commerce Commission by 
 die Federal government and those granted to the Public Service 
 Commission in the various states by the states themselves marks 
 the step perhaps in the direction of an attitude similar to that 
 assumed by certain European countries toward business con- 
 cerns in the matter of books and methods of bookkeeping. 
 
 If we could trace the evolution of books we should probably 
 
 35 
 
Principles of Accounting 
 
 find that such evolution consisted of two distinct steps. Be- 
 ginning with the simplest of records, a book providing merely 
 for receipts and disbursements, it is probable that the first step 
 consisted in supplementing the simple cash book, for example, 
 by a ledger, a journal and a day book, the purpose of which 
 was to include more generally the transactions of the business 
 as a whole rather than confining them merely to those which 
 recorded the receipts and disbursements of cash. The develop- 
 ment of business with its accompanying increase in the number 
 of transactions made analysis of the transactions necessary, if 
 anything like a comprehensive idea of results was to be obtained. 
 Obviously an analysis of transactions after having been entered 
 in a book of original entry in chronological order and without 
 regard to their nature was a loss of time. To avoid this it is 
 probable that the second step consisted in providing for the 
 classification of transactions by substituting for the original 
 journal and day book a series of special journals in which 
 columnarization was the essential feature and which served to • 
 classify the transactions as they were originally entered. In all 
 events such a provision is necessary to-day if the work which 
 bookkeeping entails is to be successfully accomplished. 
 
 Classification 
 
 A ledger may be defined as a book of account so arranged 
 as to provide for a summary of the financial transactions of a 
 business organization. 
 
 A Journal may be defined as a book of account so arranged 
 as to provide for the entry of the original records of the financial 
 transactions of a business organization. 
 
 It is to be noted that, in principle, ledgers differ from jour- 
 nals, in that they summarize the transactions, whereas journals 
 usually record the details. On this account, journals are fre- 
 quently referred to as books of original entry. It is to be noted 
 further that all bocks, in principle, are either ledgers or journals. 
 
 Ledgers 
 
 Ledgers may be divided into general and subsidiary. 
 General ledgers are those which contain the general or group 
 accounts and are sometimes separated in practice into those 
 
 36 
 
Books, their Classification, Form and Ruling 
 
 which contain the balance sheet accounts and those which con- 
 tain the operating and profit and loss accounts. The former is 
 usually referred to in practice as the private ledger, while the 
 latter is frequently referred to as the operating ledger. 
 
 Subsidiary ledgers are those which contain the details of cer- 
 tain groups or general accounts found in the general ledger. As 
 examples of these, the customers' ledger and the creditors' ledger 
 may be mentioned. 
 
 Journals 
 
 Journals naturally divide into general and special, the general 
 journal containing usually the details affecting accounts which 
 are infrequently used, while special journals are used for ac- 
 counts in which the details are voluminous. As an illustration 
 of the use of general journals, mention may be made of opening 
 and closing entries, transfers from one account in the general 
 ledger to another and corrections or adjustments of accounts 
 already posted. 
 
 Special journals divide into two classes, those which are sim- 
 ple in form, and those which are more complex. As an illus- 
 tration of the simple type, the two-column debit and credit cash 
 book may be mentioned, whereas, as illustrating the complex 
 type, there is the purchase journal, sales journal, columnar cash, 
 and petty cash books. 
 
 The classification and illustrations summarized, would appear 
 as follows : 
 
 Books of Account. 
 I. Ledgers 
 
 (a) General (containing the group accounts or 
 accounts in their most highly summa- 
 rized form) sometimes divided into 
 (i) Capital ledger (occasionally called "pri- 
 vate ledger "). 
 (2) Operating ledger (containing the operat- 
 ing and profit and loss account). 
 (&) Subsidiary (containing the details of some ac- 
 count in the general ledger), examples of 
 which are the 
 
 Customers' ledger, and 
 Creditors' ledger. 
 
 37 
 
Principles of Accounting 
 II. Journals 
 
 (a) General (for postings to accounts infrequently 
 used and for general opening and closing 
 entries and transfers). 
 
 (fc) Special (for classifying detail postings to 
 accounts where items are numerous), and 
 dividing into the 
 
 (i) Simple type (such as the journal ruled 
 cash book). 
 
 (2) Complex type (columnar in form, for the 
 purpose of classifying and summarizing 
 details, thereby reducing the posting to a 
 minimum) of which the following are 
 examples : 
 
 Purchase journal. 
 Sales journal. 
 Columnar cash book. 
 
 Form and Ruling 
 
 Ledgers and journals are now commonly seen in both bound 
 and loose leaf forms. The tendency perhaps is towards the lat- 
 ter. Like many other fads it is overdone. Some accountants will 
 use nothing else, while on the other hand, many will not use them 
 under any circumstances. Good judgment dictates the use of 
 both, as a rule. 
 
 The loose leaf ledger, when used in moderation, has distinct 
 advantages. As a general ledger, general journal, or general cash 
 book, it is not desirable. As a subsidiary ledger, or detail record 
 of any kind, it is most satisfactory. Properly controlled by an ac- 
 count in the general ledger, a loose leaf subsidiary ledger is es- 
 pecially adapted to the requirements of customers' and creditors' 
 accounts. It permits of expansion and contraction to conform to 
 conditions. Thus, it overcomes the principal objection to a bound 
 book for this purpose, namely, that space for the various accounts 
 cannot be accurately estimated and allotted when the accounts 
 are opened. 
 
 38 
 
Books, their Classification, Form and Ruling 
 
 An adaptation of the loose leaf books exists in the form of a 
 card file. As a detail record, it is well adapted to use in connec- 
 tion with materials and supplies. It has also been used to some 
 extent for customers' and creditors' accounts. 
 
 The objection to loose leaf books or cards, is that sheets or 
 cards may be removed without being easily missed. If a sheet 
 in a bound book were torn out, the ragged stub would immedi- 
 ately attract attention. If a sheet were removed from a loose 
 leaf binder or card file, it might not be missed until some one 
 had occasion to refer to it specifically, which might be consider- 
 ably, subsequent to its removal. 
 
 From the arguments for, and against it, the conclusion will 
 probably be reached, that, as a detail record, and when properly 
 controlled, the loose leaf book, especially the ledger, has certain 
 decided advantages over the bound book. 
 
 With regard to their ruling all books are either ledger or jour- 
 nal ruled, or elaborations thereof. In the case of both ledgers and 
 journals, the original, or standard, or what might be called the 
 " stock " ruling, has been changed from time to time, in order to 
 meet changed conditions. Unfortunately, in some instances, the 
 change has been brought about by the over-enterprising vendor 
 of loose leaf systems. 
 
 Originally, the ledger ruling was so arranged as to divide the 
 page in the center with a double vertical line, running downward 
 from a double horizontal line extending across the page about 
 an eighth of an inch from the top of the page. The vertical di- 
 vision was for the purpose of separating the account into debits 
 and credits, and within each side vertical rules provided columns 
 for the date, explanation, posting reference and money values. 
 
 In the majority of cases the general ledger remains the same 
 to-day. The subsidiary ledger has undergone the greatest change. 
 Such changes have been made in most cases to meet special con- 
 ditions, but the most prominent ruling among them is the three 
 column, or balance ledger. This book, instead of dividing the 
 account into two vertical parts, has the columns arranged to- 
 gether on the right hand side ; one for debits, one for credits, and 
 one for the balance, which it is contemplated will be adjusted 
 every time an entry in either of the two columns is made. 
 
 In principle, all ledgers are the same and the adaptation of 
 
 39 
 
Principles of Accounting 
 
 the principle to the requirements of special cases, through some 
 peculiar or unusual ruling, should not cause it to be overlooked. 
 
 The general journal has undergone no great change with 
 regard to its original ruling. Originally it was ruled ver- 
 tically, so as to provide in the order named, from left to 
 right, columns for the date, explanation, posting reference, 
 and money values, both debit and credit. To-day the sundry 
 journals, which have been detached from the original, in order 
 that classification of items at time of entry, leading to a quick de- 
 termination of aggregates at the end of the month, may be per- 
 mitted, have had the number of their columns so increased as to 
 practically obscure the fact that they are journals. Columnariza- 
 tion, as the above is called, and of which the columnar cash, pur- 
 chase journal, sales journal and voucher register are examples, 
 has been brought about by the extensive classification of accounts, 
 which is considered essential to the financial records of the mod- 
 ern business concern. 
 
 The simple cash book consisted in a separation of debit and 
 credit columns of the journal and the employment of a separate 
 page for each class of transactions. This was necessitated by 
 the frequency with which the cash transactions occurred. The 
 development of the more highly specialized classification of ac- 
 counts brought with it the need for a more detailed classification 
 of receipts and disbursements of cash. To fulfill this need the 
 columns providing for a classification of such receipts and dis- 
 bursements were added to the respective sides of the cash book. 
 The extent to which this columnarization may be carried is now 
 limited only by the size of the cash book which it is convenient 
 to use. In certain instances it has been found advantageous, in 
 order that sufficient columnarization may be obtained without 
 resulting in a book too cumbersome to handle, to separate the 
 cash receipts from the cash disbursements, using a separate book 
 for each purpose. In cases where the detail work is voluminous, 
 cash books have been alternated by days ; one being used by the 
 bookkeeper for posting purposes, while the other is being used 
 by the cashier in recording the receipts and disbursements. 
 
 With the passing of the merchandise account which contained 
 a mixture of financial transactions, the purchase journal came 
 into use as the result of a demand primarily for a book which 
 would permit of the classification of the purchases. The advan- 
 
 40 
 
Books, their Classification, Form and Ruling 
 
 tage thus obtained was so evident that an opportunity to classify 
 expenses as well as purchases was immediately seen. The pur- 
 chase journal has the added advantage of showing at the end 
 of the period the liability to creditors for purchases and ex- 
 penses. The book is ordinarily so arranged as to show in 
 columnar form, from left to right, the date of the invoice, number 
 of invoice, name of the creditor, and the amount of the invoice. 
 Following these there are columns permitting of classification 
 among such accounts as trading goods, materials and supplies, 
 freight and cartage, heat, light and power, factory expenses, sta- 
 ble expenses, selling expenses, office expenses, general expenses, 
 etc. It is to be borne in mind that the classification may be as 
 extensive as circumstances, require, and in many lines of business 
 this classification is very exhaustive. The return of goods pur- 
 chased and allowances, both on account of purchases and ex- 
 penses, has resulted in what is known as the return purchase 
 journal. The form and ruling of this book does not differ in any 
 way from the purchase journal. 
 
 The voucher register is an elaboration of the purchase jour- 
 nal, and, while almost identical in design, is intended to do away 
 with the ledger for creditors' accounts. In lieu of a column for 
 invoices there has been substituted one for voucher numbers. 
 Depending upon circumstances, invoices may be vouchered sep- 
 arately and given a separate voucher number, or they may be 
 assembled at the end of the month on one voucher, which is then 
 entered. Where payments are made on account, the voucher 
 register cannot be used to advantage. In such a case the some- 
 what antiquated purchase journal when used in connection with 
 the creditors' ledger serves the purpose better than the voucher 
 register. 
 
 The sales journal is similar in design to the purchase journal. 
 Its arrangement in columnar form is to show the date of the 
 invoice, number of the invoice, customer, and the amount of the 
 sale. It also provides columns for the classification of sales, 
 where a classification is desired. The matter of classifying sales 
 has become more important of late, on account of the frequency 
 with which cost systems are used, and where it is desirable to 
 cbtain information as to the gross profits on the various lines of 
 roods which are manufactured or sold. It has also its advantages 
 where consigned goods are sold frequently through the same in- 
 
 4i 
 
Principles of Accounting 
 
 voice on which manufactured or trading goods are billed. A 
 sales return journal, similar in design to the sales journal, is 
 ordinarily used for credits. 
 
 In connection with columnarization it is to be observed that 
 the use of journals so designed supplies totals at the end of the 
 accounting period, which are vital to the establishment and main- 
 tenance of controlling accounts. 
 
 REFERENCE FOR COLLATERAL READING! 
 
 Philosophy of Accounts, Sprague, Chapters XV, XVI, XVII, 
 XVIII. 
 
 ziv 
 
CHAPTER IX 
 
 METHODS OF BOOKKEEPING 
 
 It has been previously pointed out that books of account 
 were considered as media wherein the financial transactions 
 might be recorded. The methods of recording these transactions 
 are embodied in the art of bookkeeping. Bookkeeping methods 
 may be classified as single entry and double entry. Other methods 
 known as statmography and logismography have existed at one 
 time or another either in theory or practice but neither has come 
 into continued practical use. 
 
 The merchant whose object in keeping books was to find what 
 was owing to him by customers ; what he was owing to creditors ; 
 and the amount of his capital investment had little need for an 
 elaborate set of books. In theory it was probably never intended 
 that single entry should embrace anything more than accounts 
 with customers, creditors and proprietorship. That custom has 
 altered what theory planned will be pointed out later but for the 
 present may be ignored. 
 
 For the purpose of keeping his accounts he used only a ledger 
 and a journal. In the journal he recorded the capital which he 
 had invested at the time of beginning business, any amount 
 which he had withdrawn therefrom, and amounts that he had 
 added thereto. His journal consisted of a blotter or memoran- 
 dum book, in which he made a single entry as to each of these 
 transactions. As he purchased goods he recorded the fact, to- 
 gether with the amount, as constituting a. credit to the individual 
 from whom he had purchased the goods. As sales were made 
 he recorded the appropriate facts and amounts, showing the 
 names of the individuals to whom he had sold the goods, stating 
 that such individuals were to be debited with the values involved. 
 As cash was received he credited the customers. As cash was 
 paid he charged the creditors receiving the cash. 
 
 In his ledger he maintained an account with the individual 
 customers and creditors, charging and crediting them from his 
 journal as the transaction indicated. He also maintained in the 
 ledger an account with himself as proprietor, debiting and cred- 
 iting such account whenever he added to or withdrew from his 
 
 43 
 
Principles of Accounting 
 
 capital investment. At stated intervals he balanced and ruled 
 off his accounts with customers and creditors and carried the 
 excess in amount of customers' accounts over creditors' accounts 
 to his account as proprietor. 
 
 At the end of a given period, all items having been posted, 
 the most which the ledger would show, was what it was planned 
 to show, namely, the balances of individual accounts with cus- 
 tomers, creditors and the proprietor. 
 
 Such a showing was far from representative of the financial 
 condition of the proprietor. Many important factors in the 
 financial condition were entirely ignored. In order to ascertain 
 the worth of the business it was necessary to search, outside of 
 the books, for values affecting it. An inventory of assets and 
 liabilities was necessary. The books were there, but they did 
 not contain the accounts necessary to reveal the situation with 
 regard to financial condition. Further than that, such accounts 
 told the proprietor nothing of the profits of his business. For 
 such information, he was obliged, first, to prepare a statement of 
 assets and liabilities, taken in part from the books and in part 
 from outside sources, determine his capital, and, second, compare 
 such capital with that at the end of some preceding period. If 
 the capital at the end of the current period was greater than at 
 the end of the prior period, there had been a prcfit. If the 
 reverse was true there had been a loss. The conclusion in either 
 case, however, is based on the assumption that no capital had 
 been added or withdrawn during the period. Additions of cap- 
 ital decreased the profit, because clearly in such cases the in- 
 crease in capital was due to a contribution and not an earning. 
 Withdrawals increased the profits, because of the fact, quite 
 obviously, that if they had been allowed to remain, the increase 
 would have been so much larger. 
 
 Single entry has been succeeded in part by a system which is 
 neither single nor double entry. With the demand on the part 
 of business conditions, and presumably through ignorance on tne 
 part of bookkeepers, as to what single entry originally provided 
 • for, there have been introduced into the ledger from time to 
 time, accounts other than those of customers, creditors and the 
 proprietor. Among these are, cash, notes receivable, notes pay- 
 able, land and buildings, furniture and fixtures, etc. Such pro- 
 cedure has no particular bearing on single entry further than 
 
Methods of Bookkeeping 
 
 to make it somewhat easier to prepare a statement of assets and 
 liabilities. Finding such accounts on the ledger obviates a search 
 through miscellaneous records for the information. 
 
 Double entry is said to have been originated and made public 
 in 1494 by an Italian named Luca Paciolo. He began his rea- 
 soning on the assumption, expressed in modern terminology : 
 
 Goods=: Proprietorship . 
 
 The system is based on equilibrium. Every change in the value 
 of goods brings about a change in the proprietorship. Every 
 change in goods must be referred to a cause. Every cause is 
 expressed in a complimentary account called a nominal account. 
 The purpose of the nominal accounts is to show the progress 
 of the business or the manner in which the proprietor's capital 
 has increased or decreased. Their purpose is analysis, and their 
 life limited to the period of operations. When the period comes 
 to an end the nominal accounts are closed out to profit and loss, 
 and the balance resulting through opposing debits against credits, 
 is carried to the proprietor's account. When customers are 
 charged merchandise is credited. When goods are purchased, 
 merchandise is charged, and the individuals from whom they are 
 purchased are credited. As a result of opposing against the 
 sales, the cost thereof, the proprietor is enabled to determine 
 what his profit has been. Through the use of the double entry 
 system, he is afforded an opportunity of seeing not only how 
 much money he has made or lost, but the manner in which such 
 gain or loss occurred. When the books are closed there remains 
 thereon only such values as are owed him or due him; such 
 values as he is liable for, and the capital which he possesses, 
 which is represented by his equity in the assets shown by his 
 books. 
 
 REFERENCES FOR COLLATERAL READING I 
 
 Accounting Practice and Procedure, Dickinson, Chapter I. 
 Philosophy of Accounts, Sprague, Chapters XIX, XX. 
 Modern Accounting, Hatfield, Chapters I, II. 
 Business Education and Accountancy, Haskins, Chapters VII, 
 VIII. 
 
 Journal of Accountancy, Vol II, page 202. 
 
 *X 
 
CHAPTER X 
 
 accounts: definition and construction 
 
 An account is one or more items representing money values, 
 preceded by an explanatory or descriptive title, the items of 
 which reflect the transactions relating to the subject of the ac- 
 count and which items are classified as to debit and credit and 
 arranged respectively in chronological order. 
 
 Books are kept for the purpose of recording financial trans- 
 actions. Accounts are kept in order that transactions may be 
 classified. 
 
 In their construction, or the manner in which the transactions 
 are arranged within them, accounts are of three distinct kinds, 
 embraced in two classes : 
 
 (i) Those which contain transactions of the same nature, 
 reflecting one kind of information, concerning some simple sub- 
 ject, which subject is indicated by the title of the account. 
 
 (2) Those which contain transactions of opposite natures, 
 reflecting two kinds of information concerning the simple sub- 
 ject of the account. 
 
 (3) Those which contain transactions of opposing natures, 
 reflecting two kinds of information, concerning various topics of 
 the complex subject indicated by the title of the account. 
 
 From the foregoing it will be observed that, with regard to 
 their construction, all accounts are either simple or mixed, 
 whether or not the title of the account so indicates. The ac- 
 counts in the second and third groups differ from those in the 
 first, in that they are mixed instead of simple, while as between 
 themselves they differ only as to the degree of mixture. 
 
 Financial transactions consist in the doing or performing of 
 financial acts. It is, of course, intended that the record thereof 
 shall be complete and accurate. This, however, frequently does 
 not take place for various reasons. The transaction may involve 
 the purchase of goods where a certain number of units are 
 purchased at a certain price. The computation of units at the 
 specified price establishes the money value representing the 
 transaction. A clerical error in not stating correctly the number 
 of units or the price will be followed by an erroneous result. A 
 
 46 
 
Accounts: Definition and Construction 
 
 transaction of this kind is usually recorded first, upon an in- 
 voice, and if there be a number of similar transactions they may 
 all be recorded on the same invoice. An error in footing the 
 items on the invoice will result in a total which is incorrect. 
 Thus it will be seen that there are many ways in which errors 
 in recording transactions may occur and that a corresponding 
 number of correcting entries may be necessary. 
 
 The recording of the financial transactions should be distin- 
 guished from a subsequent entry which may be made for the 
 purpose of adjusting or correcting the amount involved in the 
 transaction; the latter operation being regarded as in the light 
 of doing something right ultimately which should have been done 
 right originally. 
 
 An exhaustive analysis of the different financial transactions 
 would result in an ideal classification of accounts. Such a classi- 
 fication would not permit in any one account, of items other 
 than those of precisely the same nature. The nature of the item 
 should not be confused with the bookkeeping tendency of the 
 transactions. By bookkeeping tendency is meant, that tendency 
 which is expressed by the words debit and credit to denote items 
 which are positive or negative in their character. In any one 
 account items representing transactions of the same nature might 
 be either all of the same or opposing tendencies. In such a case 
 the items of a positive tendency might represent adjustments 
 or corrections of errors in recording the transactions. As an 
 illustration of this, may be cited the account for " purchases." 
 In its simplest form the purchase account would consist of a 
 series of items on the debit side where the items are all of the 
 same nature and same tendency. An error in any of the amounts 
 might require an off-setting credit for the purpose of correction. 
 In such a case, the nature of the transaction would be the same, 
 but the respective entries of opposite tendencies. However, 
 such entries would not in any way conflict with the principle of 
 simplicity upon which the account is founded. 
 
 If there were to be introduced into the purchase account on 
 the credit side an entry representing the return of certain goods 
 purchased, it is apparent that the account would then contain 
 transactions different in their nature as well as transactions of 
 opposing tendencies. Professor Sprague in his treatise on the 
 philosophy of accounts closes his definition of an account with 
 
 47 
 
Principles of Accounting 
 
 the statement that it " leads to a conclusion." The conclusion to 
 be drawn from the hypothetical purchase account is that the 
 balance shows the purchase for the period covered by the account. 
 Such an account appears offhand to have fulfilled the purpose 
 for which it was constructed, namely, to lead to a conclusion. 
 That the conclusion is a correct one should be disputed, for the 
 reason that the account contains entries representing transac- 
 tions which differ in their nature. Such transactions consist 
 of two kinds ; one representing purchases, the other representing 
 returns. For this reason the account loses its simplicity and 
 becomes a mixed account. There is a conclusion but the con- 
 clusion is a false one. In order to reflect the true condition, the 
 balance must be analyzed and the different elements set forth. 
 
 The simple account should contain nothing except elements 
 intimately characteristic of the account, and attention should 
 again be directed to distinguishing between entries representing 
 transactions which are characteristic of the account, and those 
 which merely adjust or correct such entries as have been im- 
 properly or incorrectly made. 
 
 Mixed accounts are those which contain either entries which 
 are contrary in their character to those strictly indicated by the 
 title of the account, or a series of transactions of opposing na- 
 tures, intentionally so arranged for the purpose of producing a 
 certain result. 
 
 The most striking example of a mixed account is the mer- 
 chandise account. While it is to be observed that the use of the 
 merchandise account is no longer permitted by good practice, 
 for very good reasons, the principle involved is frequently met 
 with in other accounts where the transactions are not so numer- 
 ous and the account not so involved. The use of the merchan- 
 dise account might be excused if it existed in an ideal state. 
 By an ideal state is meant, one item representing each of the 
 elements found in the merchandise account. In such an event 
 the work of analysis would be a matter of a few moments. 
 When increased by the great number of items not only of op- 
 posing tendencies, but opposing natures which occur even in the 
 short period of a month, the work of analysis becomes extremely 
 laborious and a loss of time results. In the merchandise account, 
 as it exists in practice, there are found either on the one side 
 or the other, sales, sales returns, purchases, purchase returns, 
 
 48 
 
Accounts: Definition and Construction 
 
 trade discount allowed on sales, trade discount received on pur- 
 chases, cash discount on both sales and purchases, freight and 
 cartage inward, and freight and cartage outward, to say nothing 
 of off-setting items to the above arising in connection with the 
 corrections of errors and adjustments. In addition it is to be 
 noted that the account contains an element of profit as well as 
 the items of, income from sales, and cost of sales, and is closed 
 by the introduction into the account, on the credit side, of the 
 inventory at the end of the period. The effect of the inventory 
 is two-fold. One effect is, that of off-setting the cost of the 
 goods purchased, while the amount of the inventory brought 
 down, serves to provide an asset which remains on the books 
 after they are closed. 
 
 There is a decided movement to-day in the direction of sim- 
 ple accounts. Accounts which will represent transactions of a 
 similar nature and nothing else; accounts which will give com- 
 prehensive and unqualified information on the subject indicated 
 by their titles without being confused in any way through the 
 introduction of elements differing in their nature. 
 
 Mixed accounts before they are closed merely show balances. 
 Without analysis of the opposing items from which the balance 
 results, the conclusion has little meaning. After being closed, 
 the account will usually show a profit or a loss, as the case may 
 be, but without analysis it gives no hint as to the economic 
 transactions from which the profit or loss resulted. It serves in 
 no way to provide information as to how the profit or loss came 
 about. It helps no one to take advantage of such information 
 in providing against a loss or increasing the profits in the future. 
 It has no value as an index to operations or to efficiency. It 
 gives no hint to the proprietor as to possible defects in his 
 organization or the work of his employees. Its uses while per- 
 missible in certain cases where the items are few is to be avoided 
 wherever possible, especially in cases similar in character to 
 those in which the merchandise account is used, for the reason 
 that the elements comprising a mixed account may as well be 
 classified first as last and the information so greatly to be de- 
 sired by the proprietor secured without unnecessary effort. 
 
 REFERENCE FOR COLLATERAL READING: 
 
 Philosophy of Accounts, Sprague, Chapters I, III, Mono- 
 graphs A and B. 
 
 49 
 
CHAPTER XI 
 
 ACCOUNTS : CLASSIFICATION 
 
 The kinds of accounts to be kept depend upon the informa- 
 tion desired. The primary demand is for information concern- 
 ing the financial condition. The secondary demand is for in- 
 formation as to how the financial condition was brought about. 
 
 Financial condition is shown by gathering together all values 
 of a positive character and opposing against them all values of 
 a negative character. The difference resulting is expressed in 
 an account called " capital " or " proprietorship." 
 
 Financial condition is constantly changing. Scarcely a sale 
 of goods takes place which does not effect such a change. It 
 usually consists in substituting in place of goods on hand for 
 sale, carried at cost, an account due from a customer, the amount 
 of which includes in addition to the cost of the goods sold, an 
 item of profit. Any change in the values reflecting financial 
 condition changes the capital. A comparison of capital at two 
 dates determines the extent of its growth or shrinkage during the 
 period intervening. It shows the effect of having engaged in a 
 financial undertaking. It does not show the cause of the change 
 in capital. Whether the effect be pleasing or otherwise, curiosity 
 might be assigned as a reason for demanding information con- 
 cerning the cause of the change. As a matter of fact the reason 
 is a far more logical one. Men have found that by getting 
 information as to what has happened in the past they are in a 
 better position to direct the affairs of the future. 
 
 In order to be able to express the financial condition at the 
 proper time, it is only necessary to have accounts, the titles of 
 which will describe individually the various values which reflect 
 financial condition. 
 
 To trace the steps in the ever-changing financial condition is 
 a more difficult matter. Every change alters the proprietor's or 
 capital account. Such changes may be due to one or more of 
 several causes ; the result of operating, or the active employment 
 of the capital; fluctuations in values due to economic conditions; 
 a decrease in certain material values owing to lapse of time. To 
 record every change in the proprietor's account would be an 
 arduous task. In order that this may be avoided it has been 
 
 So 
 
Accounts: Classification 
 
 found desirable, to substitute and use in place of the capital 
 account, during the time which the account period covers, a 
 series of accounts which will record, in a classified manner, the 
 changes taking place in the capital account. When they have 
 done this, they have served their purpose and they are closed, 
 at the end of the accounting period, into a summary, the net 
 result shown therein being subsequently closed into the proprie- 
 tor's account. 
 
 Having in mind the above remarks it may be said that ac- 
 counts divide into two great kinds, or classes, namely, 
 
 real, and 
 nominal 
 definitions for which may now be constructed without any par- 
 ticular difficulty. 
 
 Real accounts are those which reflect financial condition. 
 
 Nominal accounts are those which reflect changes in financial 
 condition. 
 
 It is not to be thought strange if the mind of the attentive 
 student seeks information as to the reason for selecting the 
 words real and nominal to describe two classes of accounts of 
 such importance. Authority for the use of the words is difficult 
 to find but it is probable that they were selected because of the 
 fact that accounts showing the financial condition represent 
 values which really and definitely exist, whereas those accounts 
 which record the changes merely mark the course of the changes. 
 The latter are accounts which exist in name only so far as rep- 
 resenting anything concrete is concerned. 
 
 Whether real accounts show the financial relations of the pro- 
 prietor with persons as distinguished from things would seem 
 to be of little importance ; however, in passing it is to be noted 
 that some authors do take considerable cognizance of a classifi- 
 cation which divides accounts into personal and impersonal. If 
 definitions of these terms were required it might be said, al- 
 though with some absurdity, that a personal account is a real 
 account purporting to reflect the financial relation existing be- 
 tween the proprietor and some person, whereas an impersonal ac- 
 count purports to reflect the financial relation existing between 
 the proprietor and some thing. 
 
 Attention should be directed to the fact that nominal accounts 
 are frequently known by other names. They are sometimes re- 
 
 5i 
 
Principles of Accounting 
 
 ferred to as, economic accounts, income and expense accounts, 
 revenue and expense accounts, profit and loss accounts, income 
 and outgo, etc. 
 
 Real accounts divide into two classes : those which represent 
 positive values and those which represent negative values. The 
 accounts in the former class are called assets; in the latter, lia- 
 bilities. An asset is a possession of positive value. An asset 
 account may be defined as one which represents an asset. An 
 asset may be tangible or intangible. Some assets are in the form 
 of property or funds. They are said to be tangible assets. Other 
 assets exist in the form of rights against persons, which persons 
 may be either real or artificial. Such assets are said to be in- 
 tangible. Assets may also take the form of deferred charges to 
 income. They are, in truth, expenses, but in view of the fact 
 that the accounting period to which they are applicable has not 
 yet arrived, they are considered as in the light of having value, 
 which value is positive in its nature and they are consequently 
 entitled to inclusion among the assets. 
 
 A liability denotes negative value. It is an offset to values 
 possessed. It is something which must ordinarily be made good 
 out of the assets. Further than that, it is something which the 
 proprietor of a business, if the assets of the business are in- 
 sufficient, must settle out of private funds. It is something 
 which gives a right of action at law in favor of the creditor as 
 against the proprietor. A liability may be defined as an indebted- 
 ness giving to the creditor a right of action at law against the 
 debtor. A liability account may be defined as one which sets 
 forth a liability. 
 
 A liability should be distinguished from an accountability in 
 that an account must be stated and the amount definitely ascer- 
 tained before a liability arises. Accountability is perhaps best 
 illustrated by showing its application in agency. An agent is the 
 representative of his principal. He may have received from the 
 principal certain values for which he must account. He may be- 
 come liable to his principal, ultimately, but technically he is not 
 liable until such time as he has accounted to his principal for the 
 values received and the disposition made of same. An account- 
 ability may be defined as that condition existing, where in the 
 relation between two parties, or entities, one must account to the 
 other for values received. 
 
 REFERENCE FOR COLLATERAL READING: 
 
 Philosophy of Accounts, Sprague, Chapters IV, VII. 
 
 5? 
 
CHAPTER XII 
 
 ASSETS AND LIABILITIES CLASSIFIED 
 
 Assets may be divided into five general groups, namely, fixed 
 or capital assets, working and trading assets, current assets, 
 miscellaneous or special assets and deferred charges to expense. 
 
 Fixed or capital assets are those which represent that portion 
 of the capital of the organization invested in assets which are 
 more stable in their nature ; those which tend toward permanency 
 in their character. Among this group will be found, property 
 and plant, composed of real estate (technically representing land 
 but more commonly found to include both land and buildings), 
 and equipment (including machinery, tools, power plant and 
 other operating or auxiliary equipment). Other items in the 
 group are furniture and fixtures, outside investments, comprised 
 of stocks and bonds of other companies, and bonds and mort- 
 gages of other companies or individuals. 
 
 Working and trading assets are those which represent that 
 portion of the capital which is invested in assets, (a) available 
 for use in creating' the product, or service, which the organiza- 
 tion offers for sale, (b) involved in the process of creating the 
 product, or (c) in product completed and ready for sale. 
 This group is usually represented by inventories, and includes 
 materials and supplies, goods in process of manufacture and 
 finished goods ; also items incidental to the operation or conduct 
 of the business, such as the inventories of coal, oil, and waste,' 
 stationery, postage, etc. 
 
 Current assets are those which represent that portion of the 
 capital which is invested in assets maturing within a short time; 
 those which may be realized upon readily or converted into cash ; 
 those which are available for the liquidation of current liabilities. 
 They include, cash in hand, deposits, working funds, accounts 
 receivable, notes "receivable, and interest which has accrued. 
 They are sometimes called " liquid " assets. 
 
 Special or miscellaneous assets, as a group, are difficult to 
 define on account of their varied natures. Certain of them may 
 represent investment of capital. Some of them may represent 
 
 53 
 
Principles of Accounting 
 
 reserves or surplus. In some instances the accounts may be 
 balanced by offsetting accounts reflecting direct liabilities or con- 
 tingent liabilities ; in others, the account may be maintained as a 
 memorandum, in order that certain things may not be lost sight 
 of, and be balanced by an offsetting account for the purpose of 
 maintaining equilibrium. This group comprises, patents, copy- 
 rights, trademarks, good-will, sinking funds, leaseholds, contract 
 rights, franchises, treasury stock, notes, receivable discounted, 
 and consignments received. Such items as patents, copyrights, 
 trademarks, good-will, leaseholds and franchises might represent 
 investments of capital. On the other hand some of them might 
 be acquired by gift or by accumulation, in which cases they 
 would probably be offset by reserves or surplus. Sinking funds 
 are usually set aside to provide for the liquidation of some lia- 
 bility and would constitute a setting aside of capital unless the 
 funds were offset by a reserve accumulated out of profits. Notes 
 receivable discounted would be offset by an account merely for 
 the purpose of maintaining an equilibrium. 
 
 Deferred charges to expense, constituting the last group, may 
 be defined as investments of capital in items of expense not 
 applicable to the accounting, or fiscal, period in which they 
 originate, the charge to expense for which is deferred to a sub- 
 sequent period. They are sometimes called " assets by courtesy." 
 They embrace all prepaid expenses, prominent among which are, 
 insurance, taxes, rent, advertising, organization expense, moving 
 expense, etc. 
 
 Liabilities may be divided into four general groups : capital 
 liabilities, current liabilities, special liabilities, and deferred credits 
 to income. Reserves are sometimes classified as liabilities, but it 
 would appear to be more nearly correct to consider them as a 
 portion of the capital or proprietorship, which has been set aside 
 for specific purposes, and they will be so considered and treated 
 in this discussion. 
 
 Capital liabilities are those which arise in connection with 
 capital obtained for investment in the business. If specific at all 
 with regard to their maturity, they are usually obligations, the 
 term of which extends over a period of years. They are usually 
 of such a nature, that they do not become due until the date 
 specified for their maturity, except by special provision in the 
 instrument whereby they are represented. When such provision 
 
 54 
 
Assets and Liabilities Classified 
 
 exists, it is usually in the form of a right accruing to the holder 
 of the obligation, by virtue of which he may enforce collection 
 if interest on the obligation is not paid when due. Among cap- 
 ital liabilities are found, bonds, debentures, long-term notes, etc. 
 
 Current liabilities are those which mature within a short time. 
 They are those for which funds must be obtained to provide for 
 their liquidation. They are the obligations incurred in connec- 
 tion with operating expenses, the securing of materials and sup- 
 plies, the purchase of trading goods, or obtaining of current 
 funds. They are the constantly maturing obligations which must 
 be met out of the realization of current assets. They include 
 such items as taxes accrued, wages accrued, accounts payable, 
 notes payable, interest accrued, dividends payable. 
 
 Special liabilities are perhaps not liabilities in a strict sense 
 of the word. Accounts for them are, however, frequently found 
 in the books and they should not be passed over without ex- 
 planation. They frequently represent a condition of account- 
 ability, rather than liability, and in some cases where a liability 
 might be expected to exist it is contingent upon the realization 
 of some existing asset. Prominent in this group are consigned 
 sales and notes receivable discounted. In some instances it is 
 also made to include an account with consignors for goods re- 
 ceived on consignment. 
 
 Deferred credits to income, represent income which has been 
 received in a period prior to that to which it is applicable. In 
 cases of this kind payment has usually been received in advance 
 on account of right, services, or goods which will not be deliv- 
 ered until some subsequent period. They are sometimes re- 
 ferred to as deferred liabilities and include such items as rents 
 and royalties, etc., received in advance. 
 
 Reserves are to be considered as capital, set aside for specific 
 purposes, rather than direct liabilities. If it is true, that capital 
 or proprietorship is an accountability, rather than a liability, it 
 is probably also true that reserves are accountabilities, rather 
 than liabilities. 
 
 Proprietorship is that financial investment which is repre- 
 sented by the excess of assets over liabilities. It may be ex- 
 pressed in several ways, depending upon the type of organization. 
 It may be restricted or unrestricted. It may be restricted, in that 
 it is set aside as a reserve for the purpose of providing for the 
 
 55 
 
Principles of Accounting 
 
 depreciation of some of the physical assets, or a possible loss 
 through failure to collect outstanding accounts. As unrestricted, 
 it may appear as capital of the proprietor, or in the case of a 
 corporation, as capital stock, undistributed profits, or surplus. 
 As capital stock it may be either common or preferred. It may 
 also be represented by temporary evidence of its existence in the 
 form of scrip. 
 
 It would appear to be appropriate at this time to discuss a 
 question with regard to proprietorship upon which there is some 
 difference of opinion among accountants. The subject for dis- 
 cussion may be presented in the form of the question " Is pro- 
 prietorship a liability?" The arguments for and against, con- 
 sidering proprietorship as a liability, will also bring out the 
 reason why English accountants place liabilities on the left hand 
 side of the balance sheet, rather than upon the right hand side, 
 as is the custom in this country. Whether or not, proprietor- 
 ship is a liability depends entirely upon the viewpoint of the 
 accountant. It depends upon whether or not there is a dis- 
 tinction made between the financial status of an individual, as an 
 individual and a business entity. In other words, when John 
 Jones engages in business, the question to be decided is, shall 
 he be regarded as an individual who has invested money in a 
 business organization and which organization is indebted to him 
 for the funds so invested, or as the organization itself? In order 
 to make the situation conform to the first suggestion it is neces- 
 sary to raise a theoretical entity in the form of John Jones, 
 Proprietor, which is indebted to John Jones, Individual, for 
 funds invested. Under such circumstances and with the crea- 
 tion of such theoretical entity, it would be quite proper to con- 
 sider the account of John Jones, Proprietor, as a liability, were 
 it not for the fact that the law does not recognize such a dis- 
 tinction. If perchance the assets of John Jones, Proprietor, are 
 insufficient to liquidate the liabilities of John Jones, Proprietor, 
 the law permits any assets of John Jones, Individual, to be ap- 
 propriated by due process of law and applied to the liquidation of 
 outstanding liabilities of the business. 
 
 Looking at it from the other point of view, there is no dis- 
 tinction made between John Jones, Individual, and John Jones, 
 Proprietor. John Jones is the business ; whatever assets the busi- 
 ness may have are his. Whatever liabilities exist he must liq- 
 
 ^6 
 
Assets and Liabilities Classified 
 
 uidate. The excess of assets over liabilities constitutes his equity 
 in the organization, or the extent of his proprietary interest ; it 
 is his capital. What he possesses he cannot very well be liable 
 to himself for. He cannot sue himself for the capital which he 
 has invested in the business. Upon such grounds it would ap- 
 pear to be more reasonable and logical to consider proprietorship 
 as an accountability rather than a liability. The positive and 
 negative forces of his business organization account for his 
 financial condition. While he ;s able to determine his financial 
 condition through having his account stated, there is no liability. 
 He cannot enforce collection. If he desires to obtain the funds, 
 or the capital, invested in the business he is forced to wind up 
 his affairs as a proprietor either through realization and liquida- 
 tion of the concern, or a sale to other interests. 
 
 It was probably from the first interpretation of organization 
 above stated that the English placed liabilities on the left hand 
 side and assets on the right hand side of the balance sheet. It 
 has been said that while this is required by law that it was due 
 to ignorance of accounting on the part of the framers of the law 
 that such provision was made. This may, or may not have been 
 the case, but at all events such has become an established prac- 
 tice with the English accountants. The business is considered 
 as a distinct entity, liable to the proprietor, for the excess of 
 assets over liabilities in favor of other creditors. 
 
 REFERENCES FOR COLLATERAL READING: 
 
 Accounting Practice and Procedure, Dickinson, Chapter II. 
 Philosophy of Accounts, Spraeue, Chapter XI. 
 Modern Accounting-, Hatfield, Chapter III. 
 
CHAPTER XIII 
 
 NOMINAL ACCOUNTS CLASSIFIED 
 
 In connection with nominal accounts it will be remembered 
 that they were defined as those accounts which reflect changes 
 in financial condition. The elements of financial condition are 
 assets and liabilities. Nominal accounts reflect changes in either 
 assets or liabilities. Assets like liabilities may either increase or 
 decrease. 
 
 An increase in an asset, without a corresponding increase in 
 a liability, or a decrease in a liability, without a corresponding 
 decrease in an asset, increases capital. 
 
 A decrease in an asset, without a corresponding decrease in 
 a liability, or an increase in a liability without a corresponding 
 increase in an asset, decreases capital. 
 
 The increase of capital is called profit. The decrease of 
 capital is called loss. Profit may be the result of actively em- 
 ploying the assets in the business enterprise, or it may result 
 from an increase in value, due to economic conditions and sub- 
 sequent sale of the asset. That class of profit which results from 
 the employment, with the object of direct or specific return, of the 
 assets in the business enterprise is distinguished from the rest by 
 being called income. 
 
 Income may be defined as the increase in capital resulting 
 from its employment in a business enterprise or other invest- 
 ment. It is sometimes called revenue and earnings. The capital 
 may be either actively or passively employed. Capital invested 
 in goods, sold at a price which is an increase over what the 
 goods cost, for the purpose of profit, is an example of the active 
 employment of capital. Capital invested in securities for pur- 
 poses of income is a passive employment of capital. 
 
 A business organization usually engages in some particular 
 line of business. The efforts of the organization are devoted to 
 the securing of income in that particular line ; from the sale of 
 goods ; the sale of services ; the use of property ; or combinations 
 in part or whole of these. It is for the income from these that 
 operations are conducted. This income is the principal or pri- 
 mary income of the organization. It is called the income from 
 
 58 
 
Nominal Accounts Classified 
 
 operations. It is the income which arises from the assets ac- 
 tively employed in the business. A concern employing its cap- 
 ital in buying and selling goods, derives its principal income from 
 trading. Incidentally some capital in the form of cash may not 
 be constantly required for use and is allowed to remain on de- 
 posit with some bank. The interest which the bank pays for 
 use of such money does not result from operations. It is in- 
 come but it does not come from trading. No more does interest 
 on funds, which have been invested in securities because the 
 return therefrom might be greater than if such funds were 
 invested in goods, come from trading. The hypothetical organ- 
 ization under discussion is not in the business of loaning money. 
 It has earned certain income from the employment of surplus 
 funds in a manner other than that embraced in the operations 
 of the principal business in which it is engaged. Such income 
 is distinguished from the principal income by being called sec- 
 ondary income, or income from sources other than operation. 
 The two combined constitute the income of the organization, or 
 the net income from all sources. 
 
 The decrease in capital is called loss. Loss may be of a 
 permanent or a temporary nature. The decline in the value of 
 an asset due to economic conditions, from which it does not 
 recover ; its becoming unsuited to the requirements of the busi- 
 ness, or its deterioration owing to lapse of time, may all cause a 
 permanent loss. The decrease of certain assets, or the incurring 
 of a liability, both of which have the same effect upon capital, 
 may result in a temporary loss which presumably will be re- 
 stored by the income from operations for which the loss was 
 sustained. Temporary losses are distinguished from permanent 
 ones by being called expense. 
 
 Expense may be defined as that temporary decrease in capital 
 which has as its object the increase of capital through income. 
 Expense is sometimes called outgo. 
 
 Expense may be divided into that which pertains specifically 
 to operations and that which is of the organization as a whole. 
 That in the first group, is called operating expense or expense 
 of operation ; that in the second, on account of being an expense 
 applicable to the business as a whole is called an income charge, 
 or a deduction from income. The operating expense may be 
 further divided. It falls naturally into three classes; the direct 
 
 59 
 
Principles of Accountiny 
 
 expense of securing the goods, services, or maintaining the prop- 
 erty which produces the income; the expense of obtaining the 
 business or selling the product; and the expense of administra- 
 tion. The so-called deductions from income embrace expenses 
 as a rule in connection with capital, either the expense of secur- 
 ing it, or protecting it, such as interest, rent, taxes, insurance, etc. 
 From the foregoing, we may classify nominal accounts as fol- 
 lows: 
 
 (a) Profits (Increases of Capital). 
 
 (i) Income. 
 
 (a) Primary (from operations). 
 
 (b) Secondary (from sources other than opera- 
 
 tion). 
 (2) Miscellaneous. 
 
 (b) Losses (Decreases of Capital). 
 
 (1) Expense. 
 
 (a) Operation. 
 
 (1) Prime. 
 
 (2) Selling. 
 
 (3) Administration. 
 
 (b) Capital (other than expense of operation). 
 
 (2) Miscellaneous. 
 
 It is of course impossible to attempt a detailed classification 
 of nominal accounts which will be completely exhaustive. What 
 may be done is to give a classification as adapted to a typical 
 manufacturing and selling organization, including all the accounts 
 which might ordinarily appear therein. Such an organization 
 may well be selected, since the accounts involved include a wide 
 range. Where accounts are met with which differ in name from 
 those appearing in the classification presented, it would seem 
 only to be necessary to determine the real meaning of the ac- 
 count in question and classify it by means of comparison with 
 other accounts, similar in their purpose and about the names of 
 which there is no question. 
 
 The following presents a detailed analysis of the nominal 
 accounts as used in an extensive manufacturing and selling con- 
 cern, and is offered principally for the purpose of bringing out 
 clearly the main divisions, or sources of profits and losses : 
 
 60 
 
Nominal Accounts Classified 
 
 
 Debits 
 
 Credits 
 
 Income from Sales 
 (Primary Income) 
 
 Sales returns 
 
 Trade discounts 
 
 Allowances : 
 
 Defective goods 
 Breakage 
 Damage 
 Loss 
 
 Rebates 
 
 Outward freight 
 
 Outward cartage (propor- 
 tion of stable expense) 
 
 Miscellaneous items 
 
 Gross sales 
 
 Income from Other 
 
 Sources 
 (Secondary Income) 
 
 
 Interest on bonds 
 owned 
 
 Dividends on stocks 
 owned 
 
 Interest on bond and 
 mortgage receiv- 
 able 
 
 Cash discount on 
 purchases 
 
 Interest on bank 
 balances 
 
 Interest on accounts 
 receivable 
 
 Interest on notes re- 
 ceivable 
 
 Rent (receivable) 
 
 Royalties (receiv- 
 able) 
 
 Commission (receiv- 
 able) 
 
 Consideration for en- 
 dorsing notes 
 
 Accumulation of dis- 
 count on bonds 
 
 Miscellaneous Profits 
 
 
 Sales of 
 
 Land or buildings 
 Machinery or tools 
 Horses, wagons or 
 
 harness 
 Furniture or fix- 
 tures 
 Securities 
 Materials and sup- 
 plies 
 Amounts previously 
 written off — now 
 collected 
 Appreciation of land 
 Appreciation of se- 
 curities 
 
 61 
 
Principles of Accounting 
 
 Expense of Operation 
 (Prime) 
 (Cost of Sales) 
 
 Debits 
 
 Expense of Operation 
 (Selling) 
 
 Materials and supplies 
 
 Gross purchases 
 Inward freight 
 Inward cartage (proportion 
 
 of stable expense) 
 Salaries and expenses — 
 
 Purchasing department 
 Laboi- — Direct 
 Labor — Indirect 
 Foremen 
 
 Laborers and helpers 
 Factory expense 
 Superintendence 
 Clerks (keeping factory 
 
 records) 
 Factory office expense 
 Heat, light and power 
 Factory supplies 
 Repairs and renewals of 
 shop tools and minor 
 equipment 
 Depreciation of machinery 
 and other major equip- 
 ment 
 
 Credits 
 
 Purchase returns 
 Trade discounts 
 Allowances 
 Rebates 
 
 Sales department expenses 
 Salary sales manager 
 Salaries of clerks 
 Office expenses 
 Salesmen 
 Salaries 
 Traveling 
 Commissions 
 Advertising 
 Entertaining customers 
 
 Expense of Operation 
 (Administration) 
 
 Salaries of officers 
 
 Salaries of clerks (keeping 
 
 general records) 
 Directors' fees 
 Printing and stationery 
 Postage 
 
 Telephone and telegraph 
 Traveling — officers and clerks 
 Legal expenses 
 Miscellaneous office expenses 
 
 Expenses Other than 
 those of Operation 
 (Capital Expenses) 
 
 Interest on bond and mort- 
 gage payable 
 
 Interest on debentures or in- 
 come bonds 
 
 Interest on accounts payable 
 
 Interest on notes payable 
 
 Interest on loans payable 
 
 Cash discount on sales 
 
 Rent (payable) 
 
 Insurance expense 
 
 Taxes 
 
 Interest on capital 
 
 Royalties (payable) 
 
 62 
 
Nominal Accounts Classified 
 
 Miscellaneous Losses 
 
 Debits 
 
 Sales of 
 
 Land or buildings 
 
 Machinery or tools 
 
 Horses, wagons or harness 
 
 Furniture or fixtures 
 
 Securities 
 
 Materials and supplies 
 
 Provision for doubtful ac- 
 counts 
 
 Depreciation of buildings 
 
 Amortization of patents, 
 trademarks or goodwill 
 
 Organization Expense — 
 written off 
 
 Credits 
 
 Dividends have not been included in the above for specific 
 reason. They are analogous to the distribution of profits in a 
 sole-proprietorship or copartnership. 
 
 If a proprietor withdraws $10,000 from his business, it is 
 true the amount has been lost so far as the business is concerned. 
 The capital has been accordingly reduced. We should not, how- 
 ever, consider it as a loss to the business, if at the same time of 
 the withdrawal, it had been determined that the profits for the 
 year were $12,000. We should look upon the withdrawal as the 
 distribution of profit rather than a loss. So should dividends be 
 regarded as a distribution of profit, rather than a loss; since they 
 will not be distributed as such unless a profit has resulted from 
 the business operations. 
 
 REFERENCES FOR COLLATERAL READING: 
 
 Philosophy of Accounts, Sprague, Chapters XII-XIV. 
 Accounting Practice and Procedure, Dickinson, Chapter III. 
 Modern Accounting, Hatfield, Chapter XV. 
 
 63 
 
Principles of Accounting 
 CHAPTER XIV 
 
 SPECIAL FUNCTIONS OF CERTAIN ACCOUNTS 
 
 While most accounts are kept for the purpose of classifying 
 the records of financial transactions, there are certain classes of 
 accounts which are sort of supplementary or secondary in their 
 purpose and certain classes of accounts which have functions 
 added to those which they originally had. 
 
 In the first class are included group accounts, summary ac- 
 counts, statistical or administrative accounts, and general ac- 
 counts. In the second class the most striking example is the 
 controlling account. 
 
 A group account is one into which a number of detail ac- 
 counts are closed for the purpose of determining the status of 
 a general factor in the economic result. For example : profit and 
 loss shows the economic result. The general factors bearing 
 upon the result are, income from sales, cost of sales, selling ex 
 pense, administrative expense, etc. The account — income from 
 sales — is made up of various detail accounts of which there are 
 gross sales on the credit side, and the returns together with the 
 deductions from sales on the debit side. 
 
 A summary account, as its name implies, summarizes a series 
 of accounts of a general nature and shows the net result in totals 
 of the field of accounts which it covers. The profit and loss 
 account, as above mentioned, illustrates a summary account, 
 showing after it has been closed, on the credit side, income from 
 sales, income from sources other than sales, and miscellaneous 
 profits, and on the debit side cost of sales, selling expense, adminis- 
 trative expense, deductions from income, miscellaneous losses 
 and withdrawals or Jividends. 
 
 A statistical, or administrative account, is a group account 
 which gathers together the information necessary to exhibit a 
 specific result following certain transactions. Examples of this 
 are a manufacturing account, a trading account, a contract 
 account, showing the gain or loss on a certain contract, etc. 
 
 64 
 
Special Functions of Certain Accounts 
 
 A general account is a bookkeeping device for balancing a 
 number of detail accounts. It is always of an opposing ten- 
 
 Dr. 
 
 Controlling 
 Account 
 
 Cr. 
 
 General 
 Account 
 
 dency to the detail accounts. The keeper of a customers' ledger, 
 in which case the aggregate of the detail accounts would be of a 
 debit nature, might keep his ledger in balance by running in the 
 back of the book a general account, wherein he would post as a 
 credit, the total of a number of debits which he had posted in 
 detail to the individual customers' accounts and vice versa. In 
 so far as the items which have been furnished him are concerned, 
 he would have no occasion to consult the controlling in the gen- 
 eral ledger, in order to determine whether or not his ledger was in 
 balance. 
 
 The accounts receivable account is a real account, which is 
 an asset. It shows the amount due from customers presumably. 
 It is quite customary for this account to have an added function, 
 namely, that of a controlling account. 
 
 A controlling account is an account appearing in the general 
 ledger, which reflects, in total, the condition of two or more 
 detail accounts, of the same tendency as the controlling account. 
 It is to be distinguished from a general account in that while it 
 shows the same mathematical result the result is of an opposite 
 tendency. 
 
 The prime object of a controlling account is conciseness. 
 It is not always convenient to wait for a large number of indi- 
 vidual accounts to be balanced in order that the result with 
 regard to these accounts as a whole may be known. It is fre- 
 quently necessary to close the general books and prepare the 
 
 65 
 
Principles of Accounting 
 
 financial statements before the detail work of posting the under- 
 lying ledgers is completed. 
 
 In addition to conciseness, the controlling account offers an 
 opportunity for a division of the bookkeeping work and gives 
 the general bookkeeper at the same time an opportunity to con- 
 trol the detail work which he assigns to his assistants. What 
 he does in total they are obliged to do in detail. When he 
 makes a charge to the controlling account for sales to customers 
 they are required to make the charges to the individual cus- 
 tomers' accounts. When, at the end of the month, he makes a 
 total credit from the cash book of remittances from customers, 
 and the other necessary entries for returns, allowances, etc., he 
 is enabled, as soon as trial balances of the customers' ledgers 
 are submitted to him, to tell whether or not the assistant is doing 
 his work faithfully and from the standpoint of mathematical 
 results correctly. A controlling account will not prevent a book- 
 keeper from posting an item to a wrong account any more than 
 systems of bookkeeping will prevent dishonesty. Neither will 
 the controlling account discover such mistakes. It does assist in 
 the discovery of mathematical errors, however, by offering an 
 opportunity for the localization of the error. 
 
 As to the order in which accounts should be arranged in the 
 general ledger, apparently, just a word is necessary. If it is 
 definitely known that the information as to financial transactions 
 is to be set forth in certain financial statements and that in order 
 to convey the information intelligently and in the manner which 
 will be most useful to the person to whom it is furnished, then 
 it would seem that some provision should be made for getting 
 at this information with the least possible effort. Planning is 
 one of the essential elements of scientific management. Planning 
 should be one of the most essential elements of scientific account- 
 ing. Columnar books were the improved machinery which made 
 the classification of transactions possible and prevented tiresome 
 and time-consuming analysis necessary. The proper arrangement 
 of the accounts in the general ledger will do wonders toward 
 facilitating the preparation of financial statements. In a word 
 or two the rule may be thus stated : as far as possible, observe 
 the same order of arrangement in the general ledger as that in 
 which the results shown by the accounts will appear in the 
 financial statements. 
 
 66 
 
CHAPTER XV 
 
 THE PROPERTY ACCOUNTS 
 
 Among the accounts prominent in all lines of business are the 
 so-called " property accounts." This has become a common 
 term, although it is probably to be criticized in that it is not 
 sufficiently specific. It includes, as a rule, land, buildings and 
 equipment. It is too frequently confused by being called real 
 estate, real property, property and plant, etc. These terms while 
 not so bad perhaps when used as general descriptive titles in 
 financial statements have no place in the books as account titles. 
 An abundance of accounts is preferable to a scarcity. Not much 
 time is gained by economizing in the number of accounts and 
 much time and useful information is many times subsequently 
 lost by this procedure. It is easier to combine than to separate. 
 Combination is the rule in financial statements because of their 
 general nature. Division should be the rule as to the means of 
 securing the information. 
 
 Thus it is proposed in the discussion of property accounts 
 to look at the items which may unquestionably come under prop- 
 erty and take up one by one the accounts representing these 
 items. 
 
 An analysis of the possibilities which the word embraces 
 would include in general terms land, buildings, machinery, tools, 
 equipment, horses, wagons, harness and automobiles, and furni- 
 ture and fixtures. 
 
 Land is sometimes referred to as real property. Real prop- 
 erty is a technical legal word. " Property is the right to possess 
 and use." " Real property is the right to possess and use land " 
 for an indefinite period of time. Land is also sometimes referred 
 to as real estate, but this term like so many others applied to 
 land and buildings is confusing, for the reason, that the term 
 real estate is also used to designate a business, the object of 
 which is to deal in real property and those chattel interests which 
 attach to real property such as leases and leasing, mortgages and 
 liens. All confusion may be avoided by not using any of these 
 terms and merely referring to land as such. 
 
 Since accounting follows bookkeeping and bookkeeping fo)- 
 
 67 
 
Principles of Accounting 
 
 lows the business transactions, it will no doubt be of interest 
 in discussing the account for land and the manner in which the 
 account is manipulated, to examine the subject of the account with 
 regard to — how it may be acquired, either permanently and tem- 
 porarily, what may happen to it, and how it may be disposed of. 
 
 Land may be acquired by inheritance, purchase or gift. In 
 some cases it may be improved by reclaiming or draining, and 
 in others by filling in or making new land. It will probably be 
 seen immediately that all of these possibilities might exist and 
 that all have a distinct bearing upon the accounting. In any 
 case the permanent acquisition of land is accompanied by a deed 
 which vests title in the holder thereof. Land acquired by gift or 
 inheritance has a very different effect upon the accounts from 
 that which is purchased, made or reclaimed. Land which is 
 purchased will be acquired either for cash or through credit. 
 The credit may take the form of an open account or may be 
 represented by a mortgage. The purchaser may take the land 
 subject to the mortgage or he may assume the mortgage. Where 
 land is made or reclaimed there are certain expenses incident to 
 its improvement which may add to the first cost or perhaps the 
 entire cost. In just these few simple statements the acquisition 
 of land has brought sharply to the attention the fact that it is 
 closely related to bookkeeping, accounting, law and finance. 
 
 The holder of land is brought into direct contact with the 
 government through its ownership. The government affords 
 police protection to its citizens and in return exacts a tax for 
 such service and the general maintenance of the government. 
 Taxes will be treated at length in another chapter. In addition 
 to the right to taxation which the state claims, there is what is 
 known as the right of eminent domain. This is the right to 
 confiscate any property which may be needed for the common 
 good. Included under such necessities, are thoroughfares, pro- 
 jected railroad lines, and street car systems. While such pro- 
 ceedings are possible under the right granted him by the con- 
 stitution of the United States, the holder must be given an op- 
 portunity to be heard and he must be paid a fair compensation 
 for his land. 
 
 In the absence of ownership, land may be hired or it may be 
 leased. The distinction between hiring and leasing seems to be, 
 that hiring implies as a rule a verbal contract from month to 
 
 68 
 
The Property Accounts 
 
 month, or from one short period of time to another; whereas 
 leasing carries with it a written contract with certain express and 
 implied conditions and usually covers a longer period of time; 
 for example, a year, five years or ten years. 
 
 At first thought, it would not seem that much of consequence 
 could happen to land. Upon further investigation it will be 
 quite plain that economic conditions may have a very great effect 
 upon land. A given locality, perfectly adapted to certain lines 
 of business to-day, may within ten years be entirely unsuited to 
 the needs of the same line of business. Land which is of no 
 particular value to-day may within the same period of time be- 
 come exceedingly high in price owing to the demand. Thus, 
 land may either appreciate or depreciate in value. If the owner 
 of the land does not pay his taxes or his other obligations, the 
 state may impose a lien, or the courts may take similar action 
 in favor of some judgment creditor. The holder of a mortgage 
 may foreclose and take title. 
 
 Land may be a direct factor in the production of income or 
 it may be an indirect factor. As the part of the property of a 
 business organization it is an indirect factor in the production 
 of income in the form of profits. Remembering that land in- 
 cludes not only the surface, but the natural resources above and 
 below the surface, it may be a direct factor in the production 
 of income in the case of mining, hunting, fishing, forestry, and 
 water power. The income may be obtained through any one of 
 these extractive industries or by temporarily assigning these 
 rights to others in consideration of rent. 
 
 Land may be disposed of by sale, for cash or on credit; on 
 account, through an unsecured claim or through a mortgage; 
 by sale through foreclosure either in the case of a mortgage, tax, 
 or other lien. 
 
 The application of the above principles may be seen in the 
 following test : 
 
 Applied Theory Test Number One 
 
 James Morrison, being in business for himself, inherits from 
 his father certain land (Parcel A) which can be used to ad- 
 vantage in the business. It was valued in the inventory of the 
 estate at $10,000. He purchases one additional parcel of land 
 
 69 
 
Principles of Accounting 
 
 (Parcel B) for $15,000 paying $8,000 in cash, giving a purchase 
 money mortgage for the balance and taking it subject to a 
 mortgage of $4,000. On another parcel (Parcel C) he purchases 
 the land for $20,000 paying $1,000 in cash, giving a purchase 
 money mortgage for the balance and assuming a mortgage of 
 $5,000. He receives gratis from a neighboring town a parcel 
 (Parcel D) for a manufacturing plant. This plot is low and 
 swampy and requires draining and filling in which cost $2,500 
 but was held by a former owner at $4,000. It subsequently ap- 
 preciated in value $7,500, while Parcel B depreciated $2,000. 
 One-half of Parcel A was taken by the state under the right 
 of eminent domain, at an appraised value equal to cost. Parcel 
 D was sold by the state under a tax lien realizing for Morrison 
 $11,000 and the mortgagee foreclosed on Parcel C selling it for 
 $13,000. 
 
 Frame the journal entries necessary to express the preceding 
 transactions. 
 
 REFERENCES FOR COLLATERAL READING : 
 
 Modern Accounting, Hatfield, pages 86-87. 
 Accounting Practice and Procedure, Dickinson, pages 76-77. 
 Science of Accounts, Bentley, pages 139-142. 
 Auditing Theory and Practice, Montgomery, pages 119, 331, 
 494- 
 
 Journal of Accountancy, Vol VIII, page 237. 
 
 70 
 
CHAPTER XVI 
 
 BUILDINGS 
 
 Buildings present a somewhat different subject for discussion 
 than land. They are subject to a greater variety of possibilities 
 than land, since it may almost be said of land that it cannot be 
 carried away or destroyed, which is not true of buildings. 
 
 A new concern about to engage in business and seeking build- 
 ings for such purposes has a choice of two means of securing 
 them. They may be constructed anew or they may be pur- 
 chased. If not adapted to the needs of the business they may 
 be altered to meet the demands. 
 
 Construction, presumably, is the method to be preferred. 
 Having acquired the land upon which to place the building, the 
 concern may proceed in one of three ways. The first is to pur- 
 chase the material, engage the necessary workmen and supervise 
 the construction. This statement while generally true should be 
 qualified in one or two particulars. In New York City, and 
 probably in all the other large cities of the United States, the 
 building department of the city requires that the plans shall be 
 drawn by, or under the direction of, an architect. In some 
 cases where engineering construction is involved the plans must 
 be made by an engineer. 
 
 As an alternative a contract may be made with some builder 
 to erect the building. By this is meant an individual or concern 
 which will take over the entire work of construction and be 
 responsible for its completion. The plans may be obtained from 
 an architect and furnished to the builder to follow. 
 
 As a second alternative the work may be turned over to an 
 architect who will attend to the drawing of the plans, the letting 
 of the contracts and sub-contracts, and the supervision of the 
 work as it progresses. In this latter case it is customary for the 
 concern, for which this work is being done and which is called 
 the client of the architect, to make payments to the construction 
 company or the contractors upon certificates of the architect as 
 portions of the work are from time to time completed. 
 
 The architect receives for his services a fee which is based 
 on a percentage of the cost of the work done. The rate for 
 
 71 
 
Principles of Accounting 
 
 general work as established by the American Institute of Archi- 
 tects is six (6) per cent. The service which this rate covers 
 includes the necessary conferences, preparation of preliminary 
 studies, working drawings, specifications, large and full size de- 
 tail drawings and the general direction and supervision of the 
 work. The rate varies according to the class of work, ranging 
 from six per cent as above to fifteen (15) per cent in the case 
 of designs for fabrics or special decorative work and is higher 
 for work outside, than inside, the city. 
 
 The architect is becoming an important factor in the new 
 construction work of to-day, especially in the larger cities. 
 Where formerly perhaps the scope of his work was limited to 
 the drawing of the plans, to-day, as a rule, he is the building 
 specialist, who combines his technical skill with artistic taste for 
 the best interests of his client and superintends the work from 
 beginning to end. Among his duties in addition to preparing the 
 plans are those of determining the location of the building; the 
 quality of the soil on which the foundations are to rest; filing 
 the plans with the building departments and securing their ap- 
 proval; getting the necessary permits to begin operations, ob- 
 struct the streets, open the streets for gas, sewer, and electric 
 connection, etc. As to the installation of electricity he must 
 secure permission from the Department of Water, Gas and 
 Electricity and the Board of Fire Underwriters. Further, he 
 must see that there are no violations of the rules and regulations 
 affecting the public health. 
 
 One point in connection with building operations and one 
 which should have a decided effect upon the accounting is that 
 of the acceptance of the work. The risk for employer's lia- 
 bility and for fire is with the contractor until the work has been 
 accepted by the client. Two things would appear to be certain. 
 First, payment on account of the contract price is a matter of 
 convenience and does not imply acceptance of the work. Sec- 
 ond, the liability of the client to the contractor does not rise, 
 even after the signing of the contract until the contractor has 
 complied with the terms of the contract and performed the work 
 required of him. Hence it would seem to represent something 
 not true as to facts if at the time of signing the contract, the 
 contract price were to be recorded on the books as showing the 
 cost of the construction and the corresponding liability to the 
 
 72 
 
Buildings 
 
 contractor. What would appear if such a thing were to be 
 done would be a so-called contingent asset on one side, offset 
 by a contingent liability. It would probably be expressing it 
 more correctly to say that two statistical accounts, having as their 
 basis the contract price, have been raised, not to record facts 
 but to provide for the recording of possibilities. The method 
 which would seem to be more correct would be to charge — cost of 
 contract and credit — the contractor when estimates certified by 
 the architect are received, closing out the liability in favor of 
 the contractor when the payment to him is made. One of these 
 steps might be eliminated also by charging the contract account 
 direct and crediting cash at the time the payment of the estimate 
 is made. A summary of the two ways of handling the matter 
 would show as follows : 
 
 First Method: 
 
 First Step. Charge a contract account with the con- 
 tract price. 
 
 Second Step. Credit the contractor in a similar 
 amount. 
 
 Third Step. As estimates are paid charge the con- 
 tractor and credit cash. 
 
 Result. The account with the contractor will be 
 closed and the contract account remaining 
 open will show the cost of the construction. 
 
 Second Method: 
 
 First Step. As estimates are certified by the archi- 
 tect, charge the contract account and credit 
 the contractor. 
 
 Second Step. As estimates are paid, charge con- 
 tractor and credit cash. 
 
 Result. Same as first method. 
 
 One point in connection with the final payment on contracts 
 arises regardless of which method is employed. That is the 
 amount which is reserved by the client to protect himself against 
 defective work. Such a reserve is customary in contract work 
 and is sometimes withheld for a year or more. The effect which 
 such procedure would have on the second method is apparent. 
 Pending final payment the contract account will not show the 
 total cost of the work which information might be needed for 
 
 73 
 
Principles of Accounting 
 
 various purposes prior to final settlement. On the other hand it 
 is not desirable to charge the contract and credit the contractor 
 with the amount retained since it may not be a liability in his 
 favor if defective or unsatisfactory work is discovered subse- 
 quent to the completion of the work. Both ends may be served 
 by charging the contract and crediting a reserve for defective 
 work, or an account with some other appropriate title. 
 
 To leave the matter of contracts, while having discussed them 
 from the side of the client only, would seem to leave the sub- 
 ject only half completed. Apparently, to find a more appro- 
 priate time to consider this phase of contracts would be difficult. 
 
 Approaching the subject from the point of view of the con- 
 tractor, he appears to be in this position : he holds a contract 
 under which he is to do certain work and from which presumably 
 he will derive some profit. With him it is largely a question of 
 whether he shall consider a profit as earned until the contract 
 is completed and the actual cost determined and if so how the 
 earnings shall be taken up with regard to periods. 
 
 The price at which a contractor agrees to do a certain piece 
 of work is presumably made up of two parts, namely, cost and 
 profit. Taking for example a contract in which the price is 
 $10,000, made up of an estimated cost of $8,000 and an esti- 
 mated profit of $2,000, it would appear that when the contract 
 is one-half completed, if the actual cost has not exceeded $4,000, 
 the contractor is entitled to take up a profit of $1,000. In other 
 words, he appears to be entitled to take into his earnings, one- 
 half of the contract price, or $5,000. In an ideal case such as 
 this is, it is not probable that any objection could be raised to 
 this procedure. Two things in practice, however, complicate 
 matters. 
 
 Many contractors, while making estimates on individual jobs, 
 do not keep accurate records, and in some cases do not keep 
 records at all, showing the actual cost of the individual jobs. 
 Thus it is impossible in such cases to determine from the cost 
 records the stage of completion which has been reached when 
 the general books are closed. By this is meant whether the con- 
 tract is one-half or two-thirds completed, or whatever the stage 
 may be. 
 
 In a large concern having several contracts there will be a 
 variation in the length of time required to do the different jobs, 
 
 74 
 
Buildings 
 
 so that no exact data as to the stage of completion can, in the 
 absence of a cost system, be obtained. If the contractor decides 
 to take up a part of the earnings before completion, the per- 
 centage to be taken up will necessarily be based on an estimate 
 which should be an average of the various stages of completion 
 of all contracts. 
 
 In addition to the above two complications it may be men- 
 tioned that the second half of a contract may be the part which 
 will prove destructive to the profits. At a stage of half com- 
 pletion the actual cost may have been kept within the estimated 
 cost and one-half of the earning and accompanying profit quite 
 properly taken up. In completing the contract the balance of the 
 estimated cost may be so greatly exceeded as to wipe out not 
 only the profit corresponding to the latter one-half but also that 
 pertaining to the former part. 
 
 As contrasted with the practice of taking a percentage of the 
 contract price into earnings before completion, there exists the 
 practice of deferring such an operation until the contract is com- 
 pleted. This practice meets with the objection that the cost is 
 not consistently applied against the income. Under such methods 
 it would be possible to have a case wherein all the cost with 
 no income, would appear in one accounting period, whereas in 
 the succeeding period all the income, with no cost, might be 
 shown. 
 
 While such an occurrence is possible it is rather improbable 
 and many accountants are inclined to the opinion, that as be- 
 tween periods the two factors will be " averaged up." 
 
 One more point should, it seems, be discussed before leaving 
 this topic. The two previous cases were based on the assump- 
 tion that, upon the signing of the contract, or as estimates had 
 been rendered charges had been made to the customer's account 
 in the amount of the contract price and some account, the name 
 of which at this time is unimportant, had been credited. In this 
 case it may be assumed that such a step is deferred until the 
 contract is practically completed. As estimates are rendered no 
 record is made in the financial books. When the estimates are 
 paid, cash is charged and the customer's account credited. When 
 the contract is completed, the customer is charged with the full 
 contract price and the earning account is credited. 
 
 All of the above cases have been founded on building and 
 
 75 
 
Principles of Accounting 
 
 similar contracts where payments on account, or estimates, as 
 they are called, affect the bookkeeping. The above remarks are 
 equally applicable to other kinds of contracts, such, for instance, 
 as an accountant would make with a client. The variation is 
 slight in such cases and consists principally in substituting tem- 
 porarily for the client's account, one termed, unfinished con- 
 tracts or unfinished engagements. This offers an opportunity 
 for building up or adjusting the charges to the customer's ac- 
 count until the contract or engagement is completed. 
 
 No matter which method is adopted the contractor must make 
 provision for an appropriate reserve if the customer retains a 
 certain percentage for defective work after completion. The 
 manner in which this is accomplished depends upon whether the 
 contracts are entered in total or by estimates and whether the 
 estimates are entered gross or net. 
 
 An entry to cover this reserve would be necessary upon com- 
 pletion of the contract were the estimates to be entered net. 
 Were they to be entered broad, or gross, the reserve would be 
 automatically built up from time to time. To explain this, let 
 it be assumed that the first estimate on a $40,000 contract is as 
 follows : 
 
 To material and labor supplied in the con- 
 struction of factory building at Flushing, 
 Long Island ' $6,550 
 
 Less 10% 655 
 
 Amount due $5,895 
 
 The estimate after being approved or certified by the architect, 
 or his inspector, goes to the customer. If the contract price is 
 $40,000 then it will be plain that upon completion the various de- 
 ductions will have accumulated so that $36,000 will have been 
 paid and $4,000 withheld. 
 
 If the estimates are entered net, the account with the customer 
 will have been charged with $36,000 and the earnings account 
 credited with a corresponding amount. It will then be necessary 
 to make a final entry charging the customer's account and credit- 
 ing the reserve in the amount of $4,000. 
 
 76 
 
Buildings 
 
 If the estimates had been entered broad, the entry in the in- 
 stance of the above estimate would have charged the customer 
 with $6,550 and credited earnings with $5,895 while the reserve 
 account was credited with $655. Subsequently as estimates were 
 made, ten per cent would have been credited to the reserve so 
 that at the end of the contract, the customer's account would 
 have been charged with $40,000, an amount of $36,000 credited 
 to earnings and $4,000 to the reserve. No further entry would 
 then be necessary for this purpose. 
 
 The question may now arise as to the amount of $4,000 
 standing in the customer's account, and offset by a reserve of 
 $4,000, as to its status from an accounting point of view. May 
 it be looked upon as a positive or as a contingent asset? 
 
 The reserve has been created because of an uncertainty in 
 collecting the amount from the customer. Failure to collect it 
 may be due to defective work. If defects arise, the customer 
 will usually notify the contractor who will proceed to make the 
 work satisfactory, after which time the contractor may collect 
 the balance due him. 
 
 If the contractor refuses to make good the defect, or correct 
 something which has proven unsatisfactory, the contract usually 
 provides that the customer may cause the necessary work to be 
 done and pay for same out of the funds of the contractor which 
 he has retained. Any balance remaining will then be paid over 
 to the contractor. If the funds prove insufficient a demand for 
 additional funds will usually lead to legal complications which 
 need not be followed out here. 
 
 What is of interest, is the effect which the procedure just 
 mentioned has upon the item of $4,000 in the customer's ac- 
 count. At first glance, and from the side of the contractor, it 
 has the appearance of a contingent asset. From the side of the 
 customer, it appears to be a contingent liability. The contingency 
 in both cases is that the work may prove defective or unsatis- 
 factory. If such a thing happens the contractor, it would appear, 
 will have no claim upon the customer and the customer will not 
 be obliged to pay the contractor. 
 
 It is just here that the fallacy of such reasoning becomes 
 apparent. In the first place it may be considered that the con- 
 tractor did have a good claim upon the customer. He has not 
 been able to realize upon it on account of being obliged to make 
 
 77 
 
Principles of Accounting 
 
 the customer an allowance for defective work. Need a mer- 
 chant who sells goods look upon his accounts receivable as being 
 in part contingent assets because of the fact that he may be 
 obliged to make allowances to customers for damaged or defec- 
 tive goods? It is not probable that many accountants would 
 reason thus. Consequently the contractor will probably be seen 
 in the same light as the merchant. The contractor seems to have 
 agreed for a certain price, to deliver certain " goods " in the 
 form of a building. If the building is not satisfactory he allows 
 the customer to make it so at his (the contractor's) expense. 
 
 The customer, on the other hand, is relieved from making the 
 final payment to the contractor and thus would appear to escape 
 the liability. He is obliged, however, if the defect is to be cor- 
 rected, to pay some one other than the contractor. This has no 
 effect on the liability. A liability, it must be remembered, is not 
 determined by determining who the creditor is. The fact that 
 the customer has to pay some one to do the work would seem 
 to remove any trace of a contingency and stamp the amount in 
 question as a definite liability. 
 
 The various methods of handling contracts on the books of 
 the contractor may be generally represented by eight typical 
 cases. To show the accounts affected and the manner in which 
 they are affected, in the different cases, is the object of the fol- 
 lowing journal entries and ledger accounts. The figures used in 
 each case are : 
 
 Contract price $40,000 
 
 Amount retained 4,000 (or 10 per cent) 
 
 Cost 30,000 
 
 Estimates 
 
 (1) $12,000 
 
 (2) 8,000 
 
 (3) 14,000 
 
 (4) 6,000 
 
 First Case, based on the assumption that 
 
 (a) Contract price is entered in books when contract is 
 
 signed, 
 (fe) Income (or earning) from contract is not taken up 
 
 until contract is completed. 
 
 78 
 
Buildings 
 
 Upon signing the contract 
 Customer 
 To Income from Contracts 
 Upon payment of estimates 
 Cash 
 
 To Customer 
 For cost of contract 
 Cost of Contract 
 
 To Accounts Payable (or cash) 
 Upon completion of contract 
 Income from Contracts 
 To Reserve for Defective Work 
 
 The ledger accounts will appear as follows : 
 
 Customer 
 
 Income from Contracts 
 
 $40,000 
 36,000 
 30,000 
 
 4,000 
 
 Cost of Contract 
 
 0,000 $36,000 
 
 Cash 
 
 000 $40,000 
 
 Accounts Payable 
 
 Reserve for Defective 
 Work 
 
 $36,000 
 
 $4,000 
 
 Second Case, based on the assumption that 
 
 (a) Contract price is entered in books when contract is 
 
 signed. 
 (&) Income from contracts is applied to period in which 
 
 earned, 
 (c) Books close when contract is half completed. 
 Upon signing the contract 
 Customer 
 
 To Income from Contracts $40,000 
 
 Upon payment of two estimates 
 Cash 
 
 To Customer 18,000 
 
 For Cost of Contract 
 Cost of Contract 
 To Accounts Payable (or cash) 15,000 
 
 79 
 
Principles of Accounting 
 
 Upon closing the books 
 
 Income from Contracts $22,000 
 
 To Reserve for Uncompleted Contracts $20,000 
 Reserve for Defective Work 2,000 
 
 The ledger accounts will appear as follows : 
 
 Customer Income from Contracts Cash Cost of Contracts 
 
 $40,000 
 
 $18,000 $22,000 
 
 $40,000 $18,000 
 
 $15,000 
 
 Accounts Payable 
 
 Reserve for Uncompleted 
 Contracts 
 
 Reserve for Defective 
 Work 
 
 $15,000 
 
 $20,000 
 
 $2,000 
 
 Third Case, based on the assumption that 
 
 (a) Contract price is not entered in books when contract 
 
 is signed. 
 
 (b) Estimates are entered broad as rendered. 
 
 (c) Income from contracts is not taken up until contract 
 
 is completed. 
 Upon signing the contract 
 
 No entry in general books 
 Upon rendering estimates 1 to 4 
 
 Customer (1) $12,000 
 
 To Income from Contracts $10,800 
 
 Reserve for Defective Work 1,200 
 
 Customer (2) (3) (4) 28,000 
 
 To Income from Contracts 25,200 
 
 Reserve for Defective Work 2,800 
 
 Upon payment of estimates 
 Cash 
 
 To Customer 36,000 
 
 For Cost of Contract 
 Cost of Contract 
 To Accounts Payable (or cash) 30,000 
 
 Upon closing the books — no entry necessary 
 
 80 
 
Buildings 
 The ledger accounts: 
 
 Customer Income from Contracts 
 
 §12,000 
 28,000 
 
 $36,000 
 
 $10,800 
 25,200 
 
 Reserve for Defec- 
 tive Work 
 
 $1,200 
 2,800 
 
 Cash 
 
 $36,000 
 
 Cost of Contract 
 
 $30,000 
 
 Accounts Payable 
 
 $30,000 
 
 Fourth Case, based on the assumption that 
 
 (a) Contract price is not entered in books when contract 
 
 is signed. 
 (&) Estimates are entered broad as rendered. 
 
 (c) Income from contracts is applied to period in which 
 
 earned. 
 
 (d) Books close when contract is half completed. 
 Upon signing the contract — no entry 
 
 Upon rendering estimates 1 and 2 
 
 (1) Customer $12,000 
 
 To Income from Contracts $10,800 
 
 Reserve for Defective Work 1,200 
 
 (2) Customer 8,000 
 
 To Income from Contracts 
 
 Reserve for Defective Work 
 Upon payment of estimates 
 Cash 
 
 To Customer 
 For Cost of Contract 
 Cost of Contract 
 
 To Accounts Payable (or cash) 
 
 Upon closing the books — no entry 
 81 
 
 7,200 
 800 
 
 18,000 
 
 15,000 
 
Principles of Accounting 
 The ledger accounts : 
 
 Customer 
 
 Income from Contracts 
 
 Reserve for Defective 
 Work 
 
 |5 1 2,000 
 8,000 
 
 $1 8,000 
 
 Cash 
 
 $10,800 
 7,200 
 
 Cost of Contract 
 
 $1,200 
 800 
 
 Accounts Payable 
 
 $18,000 
 
 $ 1 5. 000 
 
 $15,000 
 
 Fifth Case, based on the assumption that 
 
 (a) Contract price is not entered in books when contract 
 
 is signed. 
 
 (b) Estimates are entered net as rendered. 
 
 (c) Income from contracts is not taken up until contract 
 
 is completed. 
 Upon signing the contract — no entry 
 Upon rendering estimates 1 to 4 
 Customer 
 
 To Income from Contracts $36,000 
 
 (1) $10,800 
 
 (2) 7,200 
 
 (3) 12,600 
 
 (4) 3.400 
 Upon payment of estimates 
 
 Cash 
 
 To Customer 36,000 
 
 For Cost of Contract 
 Cost of Contract 
 
 To Accounts Payable (or cash) 30,000 
 
 Upon closing the books 
 Customer 
 
 To Reserve for Defective Work 4,000 
 
 The ledger accounts : 
 
 Reserve for Defective 
 Work 
 
 Customer 
 
 Income from Contracts 
 
 $36,000 
 4,000 
 
 $36,000 
 
 $36,000 
 
 $4,000 
 
 82 
 
Cash 
 
 Buildings 
 
 Cost of Contracts 
 
 Accounts Payable 
 
 $36,000 
 
 $30,000 
 
 $30,000 
 
 Sixth Case, based on the assumption that 
 
 (a) Contract price is not entered in books when contract 
 
 is signed. 
 (&) Estimates are entered net as rendered, 
 (c) Income from contract is applied to period in which 
 
 earned, 
 (rf) Books close when contract is half completed. 
 Upon signing the contract — no entry 
 Upon rendering estimates I and 2 
 
 (1) Customer 
 
 To Income from Contracts $10,800 
 
 (2) Customer 
 
 To Income from Contracts 
 Upon payment of estimates 
 Cash 
 
 To Customer 
 For Cost of Contract 
 Cost of Contract 
 
 To Accounts Payable (or cash) 
 Upon closing the books 
 Customer 
 
 To Reserve for Defective Work 
 
 7,200 
 
 r 8,000 
 
 15,000 
 
 2,000 
 
 The ledger accounts : 
 
 Customer 
 
 Income from Contracts 
 
 Reserve for Defective 
 Work 
 
 $10,800 
 7,200 
 2,000 
 
 $18,000 
 ish 
 
 Cost of Cc 
 
 $10,800 
 7,200 
 
 ntract 
 
 Accounts 
 
 $2,000 
 Payable 
 
 $18,000 
 
 
 $15,000 
 
 
 
 $15,000 
 
 83 
 
Principles of Accounting 
 
 Seventh Case, based on the assumption that 
 
 (a) Contract price is not entered in books when contract 
 
 is signed. 
 
 (b) Estimates are not entered as rendered. 
 
 (c) First entry is made when cash is received. 
 
 (d) Income from contracts is not taken up until con- 
 
 tract is completed. 
 Upon signing the contract — no entry 
 Upon rendering estimates — no entry 
 Upon payment of estimates 
 Cash 
 
 To Customer $36,000 
 
 For Cost of Contract 
 Cost of Contract 
 
 To Accounts Payable (or cash) 30,000 
 
 Upon closing the books 
 
 Customer $40,000 
 
 To Income from Contracts 36,000 
 
 Reserve for Defective Work 4,000 
 
 The ledger accounts: 
 
 Customer Income from Contracts 
 
 Reserve for Defective 
 Work 
 
 000 $36,000 
 
 $36,000 
 
 Cash 
 
 Cost of Contract 
 
 $30,000 
 
 Accounts Payable 
 
 $30,000 
 
 Eighth Case, based on the assumption that 
 
 (a) Contract price is not entered in books when contract 
 
 is signed. 
 
 (b) Estimates are not entered as rendered. 
 
 (c) First entry is made when cash is received. 
 
 (rf) Income from contracts is applied in the period in 
 which earned. 
 
 84 
 
Buildings 
 
 (e) Books close when contract is half completed. 
 Upon signing the contract — no entry 
 Upon rendering estimates — no entry 
 Upon payment of estimates i and 2 
 
 (1) Cash 
 
 To Customer $10,800 
 
 (2) Cash 
 
 To Customer 7,200 
 
 For Cost of Contract 
 Cost of Contract 
 
 To Accounts Payable (or cash) 15,000 
 
 Upon closing the books 
 
 Customer $20,000 
 
 To Income from Contracts 18,000 
 
 Reserve for Defective Work 2,000 
 
 The ledger accounts: 
 
 Customer Income from Contracts 
 
 Reserve for Defective 
 Work 
 
 $20,000 
 
 $10,800 
 7,200 
 
 Cash 
 
 $18,000 
 
 Cost of Contract 
 
 $2,000 
 
 Accounts Payable 
 
 $10,800 
 7,200 
 
 $15,000 
 
 $15,000 
 
 Before leaving the subject, a word or two should be offered 
 in explanation of the foregoing cases. 
 
 When the statement has been made that no entry has been 
 made in the books it is understood to mean the general books. 
 Few cases could probably be found in which a memorandum of 
 contracts in some subsidiary book of account or record are not 
 made. Statistics are not available to show the preference with 
 regard to the various methods shown. 
 
 It will be noted that the ledger accounts have been allowed 
 to remain unclosed to profit and loss. It should be understood 
 that no closing entries have been made except such as are neces- 
 sary to make the accounts affected by the contracts show the true 
 facts in the different cases. If the closing entries were con- 
 
 r>i» 
 
Principles of Accounting 
 
 tinued, such accounts as cost of contracts and income from con- 
 tracts would be closed out to profit and loss to show either of 
 these two results, as the case might be. An intermediate account, 
 called a contract account, is sometimes used for this purpose. 
 Into it are closed the cost of contracts and income from con- 
 tracts, and after the profit or loss on contracts is thus deter- 
 mined it is closed out to profit and loss. It may also be men- 
 tioned that this contract account is frequently used in practice, 
 not as an intermediary in closing, but to take the place of the 
 detail accounts just mentioned, namely, cost of contracts and 
 income from contracts. It is true that such an account will show 
 the profit or loss on contracts, but it has too great a resemblance 
 to the merchandise and other mixed accounts to meet with 
 favor in the best modern practice. 
 
 In the eight typical cases previously illustrated by journal 
 entries and ledger accounts the reserve for defective work was 
 left open. The question which might naturally arise is, what 
 is to become of the reserve? The disposition of it will depend 
 upon whether the work withstands the test of a reasonable length 
 of time. If it does, the reserve will have served its purpose. 
 The amount reserved by the customer will be due. The reserve 
 may be closed into the income from contracts account or to 
 profit and loss, depending upon the circumstances. 
 
 If the work becomes defective, one of two things may occur; 
 either the customer will cause the contractor to cure the defect 
 or if the contractor refuses he will proceed to do it himself. If 
 the contractor is obliged to do further work, while he will still 
 be able to collect the amount withheld, from the customer, the 
 additional work will have the effect of increasing the cost and 
 consequently reducing the profit. Reducing the profit means 
 reducing the reserve if the cost of the contract happens to have 
 been closed out to profit and loss, so that if such is the case it 
 would appear proper to charge the additional work against the 
 reserve. 
 
 Should the contractor refuse to make good the defects and 
 the customer proceeds with such work, then at time of settlement, 
 the customer would be credited with the amount expended and 
 would pay over the balance. Assuming that of $4,000 retained 
 by the customer, $2,500 has been so expended, the situation 
 would be described by the following journal entries: 
 
 86 
 
Buildings 
 
 Reserve for Defective Work $4,000 
 
 To Customer $2,500 
 
 Income from Contracts 1,500 
 
 (or profit and loss) 
 Cash 
 
 To Customer 1,500 
 
 Applied Theory Test Number Two 
 part 1 
 
 A employs B to draw plans for a building, paying him there- 
 for four per cent of the cost of the building. B furnishes no 
 supervision. A buys from C all material, amounting to $40,000 on 
 which he has paid $35,000. The labor cost $55,000. Incidentals, 
 permits, etc., $1,153.85 (paid). Determine the cost of the build- 
 ing and express the factors entering into the cost in the form 
 of a journal entry followed by full description. 
 
 PART 11 
 
 The Spencer Manufacturing Company engaged Mr. Archi- 
 bald Russian as the architect to draw plans and supervise the 
 construction of an addition to its plant. The customary rate was 
 to be charged for this work, but it was agreed that he should 
 design certain decorative work in the private office which was a 
 part of the new construction. For this work he was to receive 
 fifteen per cent. The contract was let to James Downs for 
 $60,000, who rendered three estimates from time to time in the 
 amounts of $15,000, $25,000, and $20,000. Extra work amounted 
 to $2,500. Ten per cent was retained on the regular work, but 
 not on the extra work. The decorative work in the private office 
 cost $2,250. The work was begun in May and was two thirds 
 completed at June 30, 1908, when both firms closed their books. 
 The extra work and decorative work was completed at such 
 time. The extra work had been invoiced, as had the first two esti- 
 mates. The decorative work was included in the contract. 
 Downs had received pay for the first estimate. Both firms fol- 
 lowed the practice of entering estimates broad, as rendered. 
 Downs had expended $37,500 and charged it to an account — ■ 
 Spencer Contract — and had figured $51,000 as the cost to him 
 
 87 
 
Principles of Accounting 
 
 when he made the contract. The cost of the extra work was 
 $1,800. Frame the entries necessary to show the facts at June 
 30th, (a) as to the books of the Spencer Manufacturing Co., (b) 
 as to the books of James Downs. 
 
 PART III 
 
 After the work was completed, some parts of it proved de- 
 fective. Downs refused to make the necessary corrections and 
 the company was obliged to spend $2,500 in making it right. 
 The balance of Downs's funds were paid over to him. Assuming 
 all bills of every description to have been paid by both parties, 
 frame the journal entries and set up skeleton ledger accounts to 
 show how the work would finally stand on the books of the three 
 different parties interested in the construction. 
 
 REFERENCES FOR COLLATERAL READING: 
 
 Accounts, Their Construction and Interpretation, Cole, Chap- 
 ters VII, XIII. 
 
 Modern Accounting, Hatfield, Chapter IV. 
 
 Auditing Theory and Practice, Montgomery, page 304. 
 
CHAPTER XVII 
 buildings — (continued) 
 
 Land in the last chapter was seen to have an important 
 bearing upon the business situation with respect to its location. 
 Buildings play an equally important part with regard to their 
 physical arrangement. Considerable attention has undoubtedly 
 been given always to the matter of convenience in constructing 
 or arranging a new building or system of buildings. More than 
 the usual attention is now being paid to what might be termed 
 the scientific arrangement of buildings in a manufacturing plant, 
 which is in effect a system of buildings. Great attention is given 
 to the planning in order that there may be no lost motion in the 
 case of production. The receiving department should be easily 
 accessible for wagon and team deliveries as well as on the rail- 
 road siding if one exists. The stores department should be ad- 
 jacent to both the receiving department and the manufacturing 
 department in which the material is first used. The idea thus 
 conveyed should be carried out in the succeeding stages of manu- 
 facture, in such manner that the finished goods will, with the 
 least possible amount of lost motion, end in the shipping room. 
 
 New construction, and especially that of new plants, which 
 rather than old plants are usually best adapted to maximum pro- 
 duction with a minimum of cost and expense, frequently involve 
 such large sums of money that concerns are obliged to borrow 
 for construction purposes. Such funds are frequently obtained 
 through the medium of bonds, the security for which is vested 
 in the newly constructed buildings. It is usually provided in 
 such bonds that the proceeds resulting from their sale are to be 
 used only in the construction for which the funds are obtained. 
 
 In addition to the above ways in which buildings may be ob- 
 tained for business purposes, it should of course be mentioned 
 that they may be purchased. If adapted to the purposes of the 
 business they may be occupied without alteration or improvement. 
 They may be purchased for cash or on credit. In either case 
 they may be free or they may carry a mortgage. In the pur- 
 chase of buildings on which there is a mortgage such mortgage 
 may be assumed or the buildings bought subject to the mort- 
 
 89 
 
Principles of Accounting 
 
 gage, and regardless of this the building may be partially paid 
 for by a purchase money mortgage. After a building or build- 
 ings have been acquired free from mortgage it may be necessary 
 to borrow money, giving the buildings as security. 
 
 Thus in the purchase of land or buildings, or both, or in the 
 borrowing of money as security for which the building is offered 
 the accountant may come in contact with two classes of items 
 which may affect the accounts. 
 
 One may be that of commission paid to the real estate broker 
 who brings about the transaction. The transaction itself may 
 consist in a sale or a loan. In either case, in New York City at 
 least, the broker as a rule receives a commission of one per cent. 
 In the case of a sale the commission is usually paid by the client 
 who retains the broker. In the case of a loan the commission is 
 usually paid by the borrower. 
 
 Another interesting and somewhat involved situation occurs 
 in the " closing of a title," as it is called. This is the technical 
 expression used by real estate men to describe the consummation 
 of the transaction involving the purchase of a piece of property. 
 It is the time when the title of the property is actually transferred 
 by the vendor to the vendee. 
 
 There are usually many details which arise at the time of clos- 
 ing title which may not be overlooked, such as insurance, taxes, 
 interest, rents, assessments, water rates, and the expense of draw- 
 ing and recording the mortgage, as well as the mortgage tax if a 
 mortgage is involved. 
 
 The insurance premium is usually pro-rated and an amount 
 equal to the unexpired proportion paid to the seller by the pur- 
 chaser. 
 
 The expenses in connection with the mortgage, such as the 
 drawing and recording and the mortgage tax, are borne by the 
 purchaser. 
 
 Rents, and interest on the mortgage, will depend upon 
 whether they have been collected or paid, in either case, by the 
 seller or whether they are to be collected or paid by him. 
 
 Taxes and assessments are usually paid by seller if at date of 
 closing they have become a lien upon the property. The same 
 is true of water rates when based upon the frontage, but where 
 measured by meter the item is subject to adjustment. 
 
 The matter of rents, for example, would depend upon 
 
 90 
 
B uildings — Con tinned 
 
 whether they were payable in advance or at the end of a period 
 and whether or not they have been collected by the owner, or 
 seller, at the time of closing title. If they have been collected, 
 it is clear that the purchaser will not receive them. If the rent 
 of a certain store is $100 per month payable in advance, and the 
 property changes hands on the fifteenth of a given month, then 
 at time of closing title the seller will have received $50 which 
 belongs to the purchaser. This amount the seller must give the 
 purchaser credit for in closing. 
 
 To bring out the various points which arise in the purchase 
 of property, and to confront the accountant with a situation such 
 as he is liable to meet, is the purpose of the following tests : 
 
 Applied Theory Test Number Three 
 
 The Mellenette Realty Company after negotiations with 
 James Stafford has entered into a contract to purchase from 
 him a four-story building occupied as a factory. The contract 
 price is $80,000. The title is to close December 15th. There was 
 paid, by the Company, as earnest money, $10,000. The prop- 
 erty is to be taken subject to a mortgage of $15,000 which bears 
 interest at six per cent and which was last paid to include June 
 30th. The building is insured. The last premium paid was 
 $360, which covered the property for the year beginning January 
 1st. There are two firms occupying the building. Ore pays 
 $600 per month in advance. The other $100 per month, at the 
 end of the month. The liens against the property are: taxes, 
 $1,320; paving, $400; water rents, $250. 
 
 Assuming that at the time of closing, there was to be a pur- 
 chase money mortgage of $3,000 given, the rents had been paid 
 according to agreement and that the expense of drawing the 
 mortgage was $10, recording $3, and the mortgage tax $15, pre- 
 pare the closing statement. 
 
 In connection with the closing of title mention may be made of 
 the title insurance policy which the purchaser usually provides 
 himself with before closing. 
 
 The purchaser is presumed to know that the title is free and 
 clear of encumbrances. To be sure of this fact it is necessary 
 that the public record be searched. Few laymen are qualified 
 for this work. A lawyer may furnish a report on a title and 
 
 91 
 
Principles of Accounting 
 
 still the purchaser has nothing more than the lawyer's opinion 
 that the title is clear. 
 
 Title insurance companies engage in such business and not 
 only render opinions in the shape of reports, but back up reports 
 with a guarantee against defect in the title. For this service 
 a premium, payable but once, is charged. That such companies 
 fill a long-felt demand is evidenced by their number and prosper- 
 ous condition. 
 
 REFERENCES FOR COLLATERAL READING: 
 
 Accounts, Their Construction and Interpretation, Cole Chap- 
 ters VII, XIII. 
 
 Modern Accounting, Hatfield, Chapter IV. 
 Auditing Theory and Practice, Montgomery, page 304. 
 
CHAPTER XVIII 
 
 BUILDINGS WHAT MAY HAPPEN TO THEM 
 
 In discussing buildings with regard to what may happen to 
 them, two phases of the situation should be covered, namely, 
 what may occur physically, and, as to the title. 
 
 Physically they are subject to improvement, betterment, re- 
 pair, renewal, replacement, alteration, depreciation, assessment, 
 and destruction. Of these, the questions of assessment for taxes 
 and of depreciation are of such importance that they will be dis- 
 cussed in detail later on. 
 
 As to the title, buildings may be affected by encroachment, 
 encumbrance, restriction, non-payment of taxes, and through 
 liens obtained by builders or other judgment creditors. The 
 courts will usually grant what is known as a builder's lien in cases 
 where a builder remains unpaid for material furnished in the 
 construction of the building. Equal protection is afforded to the 
 laborer through what is known as the mechanic's lien. 
 
 The terms, improvement, addition, alteration, repair, renewal, 
 and replacement are used somewhat promiscuously in bookkeep- 
 ing and accounting. They should be used with a great deal of 
 care. Such care can only be exercised by giving thought to the 
 meaning of the various terms. The basis for decision in each 
 case should be one of value rather than cost. 
 
 An improvement signifies an increase in value. Nothing 
 should be recognized as an improvement which does not add 
 value to the property. Adding value usually carries with it the 
 thought that the earning power of the property is increased, al- 
 though not necessarily. It distinctly implies value added to that 
 which previously existed. 
 
 In connection with improvements, two questions arise. 
 First, is the improvement permanent in its nature? Second, 
 is the improvement temporary in its nature ? Both questions are 
 practically answered by determining whether the property in- 
 volved is owned or rented. 
 
 If the property is owned, the improvement usually becomes 
 a permanent addition, subject, like that to which it was added, 
 
 93 
 
Principles of Accounting 
 
 to destruction by time and use. If the improvement is made rb 
 rented property, then the question of permanency, or of the life 
 of the added value, is fixed by the terms of the lease. 
 
 Fire escapes, for example, might constitute the improvement 
 in a given case. If the building were owned, there would prob- 
 ably be no doubt about the practice of capitalizing the improve- 
 ment and subsequently writing the cost down along with the 
 remainder of the building. If such an improvement were made 
 to rented property, the treatment of such an addition would de- 
 pend upon the terms of the lease. One of two things would 
 probably be true; either the owner would allow the tenant a cer- 
 tain amount for the improvement at the expiration of the lease, 
 or it would pass at such time to the owner of the building. If 
 the former were the case, and the amount, as usually happens, 
 could be determined sufficiently in advance, then there should be 
 written off over the period covered by the lease, or the balance 
 of the period of its life, an amount equal to the difference be- 
 tween the original cost of the improvement and the amount to be 
 allowed by the owner of the building. 
 
 The accounting procedure would be similar in case, if no 
 allowance were to be made by the owner at the expiration of the 
 lease, except that the amount to be written off over the number of 
 years covered by the lease would be the entire cost of the im- 
 provement, rather than the net amount, as in the preceding case. 
 
 Additions are practically synonymous with improvements. 
 They are subject to the same qualifications concerning owned and 
 rented property and to similar treatment after determining 
 whether they are permanent or temporary in their nature. 
 
 Repairs should convey to the mind, restoration to the original 
 condition after deterioration or impairment. They seem to differ 
 from renewals and from replacements principally in extent. 
 They may be termed minor renewals. They involve such work 
 as is necessary to maintain the subject to which they are applied 
 in its original state of efficiency, or of appearance. 
 
 The relation of repairs to renewals and replacements may 
 perhaps be seen more clearly by taking a shingle roof, for exam- 
 ple. The roof loses its efficiency when it begins to leak. It is 
 failing to perform the function for which it was partially in- 
 tended, namely, to keep out the water. The efficiency of the 
 
 94 
 
Buildings — What May Happen to Them 
 
 roof may be restored by patching the holes. This is repairing 
 the roof and answers the purpose until the holes become so 
 numerous that a renewal of the entire roof becomes advisable. 
 It might be said with equal truth that the old roof had been re- 
 placed. 
 
 Thus, while the roof might have been repaired, or renewed 
 or replaced, no value has been added to the building for the rea- 
 son that in either case, the cost of the repair or renewal has 
 merely been in connection with the restoration of the roof to a 
 condition represented by the original cost. The cost of the re- 
 pair or renewal becomes an expense and is chargeable to the up- 
 keep or maintenance of the building. 
 
 The general rule above mentioned is subject to qualification 
 in certain instances and under certain conditions. In the case of 
 renewals or replacements, if the material replaced has a salvage 
 or scrap value, it is usually considered proper to reduce the ex- 
 pense of the renewal by such value and charge to up-keep or 
 maintenance the net amount. 
 
 On the other hand where the material used to replace the 
 old is different in its character, or of better quality, there would 
 seem to be no objection to charging a part of the expense to 
 maintenance and capitalizing the remainder. The division is 
 arrived at by a comparison of values of the two kinds of ma- 
 terial and capitalizing the amount by which the value of the new 
 material exceeds the old. 
 
 This point is well illustrated by a railroad, which replaces 
 sixty pound rail with eighty pound rail. Using one rail, as an 
 example, the cost of the new eighty pound rail would be divided 
 into two parts ; one part, corresponding to three- fourths of the 
 cost of the eighty pound rail, which would be chargeable to 
 maintenance and the other part, corresponding to the remaining 
 one-fourth of the eighty pound rail which would be chargeable 
 to cost of road. 
 
 Alterations may partake either of improvements or repairs. 
 An alteration constitutes a change. Changing the doors of a 
 room does not seem to add any material value to the room. It 
 may render the room better adapted to the needs of the occu- 
 pants. Putting a partition in a room seems slightly different in 
 that it makes one room do the work of two. In the first in- 
 
 9S 
 
Principles of Accounting 
 
 stance the alteration would seem to constitute a repair, while in 
 the second instance it appears to partake rather of an improve- 
 ment. The accounting procedure would in such cases be gov- 
 erned by the interpretation which was placed upon the work. 
 
 The possibility of their being destroyed adds an interesting 
 phase to the discussion of buildings. Earthquakes, floods, cy- 
 clones and fires are among the dangers at times besetting build- 
 ings. Their destruction may be partial or complete. It is 
 brought about more frequently by fire than any other cause. 
 Thus the discussion may profitably center around destruction by 
 fire but the effect upon the accounting will be the same in any 
 case, except as to the insurance. 
 
 Ordinarily the loss or destruction of an asset means a credit 
 to the asset account and a charge to profit and loss. If build- 
 ings are not insured such will be the procedure in case they are 
 destroyed. As a rule buildings are probably not insured as to 
 earthquakes, floods and cyclones. They are usually insured 
 against fire. Their partial or entire loss through any of the first 
 three named causes would result in a charge to profit and loss 
 in the amount of the loss. When insured, as in the case of fire, 
 the accounting depends upon the circumstances. If the building 
 is restored to its original condition by the insurance company, no 
 entry is necessary. If a cash settlement is made by the insurance 
 company the situation is altered. The owner of the building may 
 decide to restore the old building in the case of an entire loss or 
 he may decide not to rebuild. 
 
 Where an insured building is entirely destroyed, the situation, 
 so far as the owner is concerned, is that he has converted his 
 building into cash in an amount equal to the loss fixed by the 
 insurance company. He has at his disposal a cash fund out of 
 which he may rebuild. If the amount is equal to the book value 
 of the building the procedure is simple; cash would be debited 
 and the building account would be credited. Following the 
 transactions historically in such a case, it might be advisable to 
 interpose another entry. If the payment of the cash by the com- 
 pany was not concurrent with the notification of the amount of 
 loss allowed, then it would be proper to charge the company 
 with the amount allowed and adjust the building account, clos- 
 ing out the account with the company subsequently when the cash 
 was received. 
 
 96 
 
Buildings — What May Happen to Them 
 
 The same thing might happen in the case of a partial loss. 
 In such an event the adjustment of the building account presents 
 greater difficulties. Suppose that on a building costing $25,000 
 the company on a partial loss allowed and paid in cash $5,000. 
 The general cash account or a special insurance fund account 
 would be debited and the building account credited in the 
 amount of $5,000. While this is the amount of the loss as fixed, 
 by the company, it does not necessarily follow that $5,000 will 
 repair the damage. If it would, the proposition would be sim- 
 ple. As the cash was expended and the cash account credited 
 the building account would be charged and thus the value re- 
 stored to the account. But supposing the cost of restoration 
 was $6,000 instead of $5,000, would the entire $6,000 be charged 
 to the cost of the building? It would not. What really hap- 
 pened was, that the loss was underestimated by the insurance 
 company and that while it allowed only $5,000 the loss in reality 
 was $6,000. The credit to the building account should have been 
 $6,000, of which $5,000 should have been charged to cash while 
 the $1,000 was charged to profit and loss. Obviously it is im- 
 possible to foresee such results so that the proper end is finally 
 attained in partial loss by charging disbursements from the cash 
 or insurance fund to the building until they have reached the 
 amount allowed by the company, after which any further pay- 
 ments are charged to profit and loss. 
 
 As to the disposition of buildings it may be said that they 
 may be disposed of by sale, or transfer, or demolished. If sold, 
 such sale may be for cash or on credit. When on credit it may 
 stand in an open account or be represented by a mortgage. 
 
 Where buildings are erected on leased ground, the question 
 of their value at the termination of the lease becomes a problem. 
 While it may be the intention, especially where the buildings are 
 of an expensive and permanent character, that the lease will be 
 renewed from time to time for long terms of years, eventually 
 some one will have to face the problem. 
 
 The disposition of such property is usually covered by the 
 lease, and while perhaps no general rule of practice can be stated, 
 in many cases the lease provides that the buildings shall be ap- 
 praised and that the owner of the land shall have the option of 
 purchase at the appraised value. Where such is the provision 
 and the owner of the land fails to exercise his option, the owner 
 
 97 
 
Principles of Accounting 
 
 of the building may be under the painful necessity of moving the 
 buildings, or having them demolished. 
 
 Where it is stipulated that the owner of the land shall pur- 
 chase the buildings at an agreed price, it is customary, if such 
 price be lower than the cost, to write down the excess over the 
 period covered by the lease. 
 
Buildings — What May Happen to Them 
 
 Applied Theory Test Number Four 
 part I 
 
 The New York Foundry Company, located at Mt. Vernon, 
 N. Y., on the main line of the N. Y., N. H. & H. Railroad, leased 
 on January i, 1909, for a term of five years a plant well adapted 
 to its needs, except that there was no railroad siding. 
 
 The Company expended $2,000 in constructing such siding 
 with the understanding that at the termination of occupancy the 
 siding should pass to the owners of the property. 
 
 Frame the entries covering such a case. 
 
 Assume that, having proceeded with the accounting under 
 the theory that the lease was to terminate at the end of five years, 
 you were informed near the end of .the period that the lease had 
 been renewed for five years, how would the situation be affected ? 
 
 Assume that the lease provided that the improvement was to 
 be taken over by the landlord at the expiration of the original 
 lease at a valuation of $1,200, payment therefor to be spread 
 over the terms of the lease by deduction from the rent. The rent 
 was $6,000 a year. Frame an entry covering the transactions for 
 any given year. 
 
 99 
 
Principles of Accounting 
 
 Applied Theory Test Number Four 
 part II 
 
 Jennings & Company leased a four-story building on Univer- 
 sity Place for a term of twenty years, paying therefor an annual 
 rental of $12,000. The firm occupied the first, second and fourth 
 floors, sub-letting to another tenant the third floor at an annual 
 rental of $2,400. During the first year of occupancy Jennings & 
 Company expended $20,000 in alterations and fixtures with the 
 understanding that certain partitions and other fixtures might be 
 removed upon the expiration of the lease. 
 
 At the beginning of the eleventh year Jennings & Company 
 moved to a building on Murray Street, taking with them fixtures 
 valued at $4,000 and renting the space which they had occupied 
 in the University Place building to various tenants at annual 
 rentals aggregating $6,000. In order to secure desirable tenants 
 it was necessary to expend $2,000 for alterations which it was 
 understood would revert to the landlord upon expiration of the 
 lease. 
 
 One sub-tenant at University Place whose occupancy began 
 January 1, 1910, and whose annual rental was $960 paid his 
 monthly rent for December, 1910, in advance. The remaining 
 tenants did not pay for December until January, 191 1. One of 
 these latter, on a ten-year lease at $600 per annum, for whom 
 alterations amounting to $600 were made in January, 1910, 
 agreed to pay for the alterations in equal monthly installments 
 extending over the period covered by the lease. 
 
 Frame the entries covering the alterations to the University 
 Place building for the year 1910 and show the net income on the 
 building for the year. 
 
 IOO 
 
Buildings — What 'May Happen to Them 
 
 Applied Theory Test Number Four 
 part III 
 
 The Bundy Manufacturing Company carried its buildings at 
 $75,000. The buildings were designated by the letters A-B-C and 
 D. The values were respectively $30,000, $15,000, $20,000 and 
 $10,000. The equipment in building A cost $3,000; building B, 
 $7,000; building C, $8,000; building D, $500. The plant was 
 insured for $100,000. 
 
 On December 31, 1910, a fire occurred involving buildings 
 A, B and C. The insurance adjusters visited the scene of the 
 fire on January 2, 191 1, and the insurance company subsequently 
 offered the following settlement: 
 
 Building A, including equipment $13,000 
 
 Building B, including equipment 18,000 
 
 Building C, including equipment 22,000 
 
 $53,000 
 
 The insurance company offered to make a cash settlement on 
 building A. On building C it undertook to restore the building 
 itself. On building B it agreed to approve bills for restoration 
 up to the amount offered in settlement. The offers were all 
 accepted on February 5, 1911, and the cash on building A was 
 received February 6, 191 1. 
 
 The restoration of building A, including equipment, cost 
 $12,500. The restoration of building B, including equipment, 
 cost $22,500, but included certain improvements valued at $2,500. 
 
 Frame the entries necessary to record the transactions his- 
 torically. 
 
 REFERENCES FOR COLLATERAL READING: 
 
 Accounts, Their Construction and Interpretation, Cole, Chap- 
 ters VII, XIII. 
 
 Modern Accounting, Hatfield, Chapter IV. 
 
 Auditing Theory and Practice, Montgomery, page 304. 
 
 101 
 
CHAPTER XIX 
 
 EQUIPMENT 
 
 The term equipment has been given many different meanings. 
 Used in one sense it seems to be merely an adjunct of machinery 
 and tools as indicated by the balance sheet caption frequently seen 
 —"machinery, tools, and other equipment." In other instances it 
 is apparently considered as quite distinct from machinery and 
 tools as evidenced by the separate balance sheet caption — "equip- 
 ment." 
 
 The term when used in its broadest sense would seem to in- 
 clude everything except buildings proper. By buildings proper 
 is meant the bare structures. Thus, equipment would seem to 
 include everything within the plant walls or attached to them. 
 To enumerate the items comprised in such a broad general class 
 would be to embrace the equipment attached to the building walls, 
 machinery and tools, equipment used in connection with machin- 
 ery, any other equipment used in connection with the manufac- 
 turing processes, office furniture and fixtures, horses, wagons, 
 harness, automobiles, etc. 
 
 To properly classify equipment is no easy task. The task may 
 be somewhat simplified, however, if the term is first understood 
 as covering everything in and about a plant with the exception of 
 land and buildings. The ideal plant would seem to consist of a 
 manufacturing department, a department for the generation of 
 heat, light and power, a stores department, a stable and an office. 
 All of these departments are housed in buildings. All of these 
 buildings will undoubtedly be equipped with apparatus essential 
 to the occupancy of the building regardless of the purpose for 
 which each is used. They will doubtless all be equipped with 
 what may be termed technical appurtenances which are necessary 
 adjuncts to the purpose for which each is used. Thus it would 
 seem for the moment that two broad general classes might be 
 established, namely, building equipment and technical equipment. 
 Building equipment might properly, it would seem, be allowed to 
 stand without further division. Technical equipment would seem 
 to require further classification in accordance with the use to 
 which it is put. 
 
 102 
 
Equipment 
 
 In attempting to go into the refinements of the classification 
 in the case of technical equipment certain conflicts which will 
 become apparent from time to time as this discussion proceeds, 
 are bound to arise between building equipment and technical 
 equipment. 
 
 Building equipment is usually understood to mean the heating 
 system (steam pipes, radiators, etc.), the lighting system (includ- 
 ing fixtures), elevators, the plumbing system, the water system, 
 with its pipes, hydrants and faucets, the sprinkler system, ven- 
 tilating system, fire hose and extinguishers, etc. 
 
 Since the principal activities center around the manufacturing 
 department, such department must needs occupy an important 
 place in this discussion. In analyzing the technical equipment of 
 the manufacturing department our attention is directed primarily 
 to the machinery and tools used in the process of manufacturing. 
 We find shafting and belting, cranes and overhead trolleys, inter- 
 shop tracks and cars, racks and other receptacles for holding 
 tools, facilities for moving the product about, such as wheelbar- 
 rows, boxes, cases, bins, etc. ; we find vats, shovels, picks, tongs, 
 stools and benches and chairs for operatives. We find certain 
 auxiliaries, such as machine shops, carpenter shops, paint shops, 
 repair departments ; we frequently find welfare accessories in the 
 form of kitchens, dining rooms, and hospitals. In the manufac- 
 turing department we also find desks and other furniture, and 
 mechanical devices in connection with the recording of the 
 work, etc. 
 
 The power plant consists of the engines, boilers, generators, 
 transformers, and is usually understood as including the transmis- 
 sion ramifications. There will also be found in this part of the 
 plant, shovels, wheelbarrows and miscellaneous tools. 
 
 The stores department will contain little technical equipment 
 except facilities for handling materials and supplies and some 
 office furniture and equipment. 
 
 The stable equipment will depend of course upon its size 
 and the character of the conveyances which this department 
 comprises. They will undoubtedly be equipped with an assort- 
 ment of tools and where automobiles are used with sundry spare 
 parts. The office will consist principally of furniture supple- 
 mented by sundry mechanical appliances and devices employed 
 in the office work. 
 
 103 
 
Principles of Accounting 
 
 Froro the above it will be seen that various classifications may 
 be evolved. The equipment seems largely to be connected with 
 the manufacturing department. This might also be called the 
 operating department. It will be further evident that much of 
 the equipment is in departments or divisions which are auxiliaries 
 to the operating department; also that throughout the various 
 departments furniture and appliances devoted to the recording of 
 the work are found. In all of the above, some equipment is 
 noticeably large and important, while in ether cases it is small 
 and unimportant. For the purpose of classification of technical 
 equipment it would seem that there were three main divisions, 
 namely, manufacturing equipment, stable equipment, and furni- 
 ture and office equipment. In the first instance it might be divided 
 into operating and auxiliary equipment. Miscellaneous operating 
 equipment might be further divided into major and minor. 
 Auxiliary equipment might be also further classified as major 
 and minor. 
 
 In the matter of conflicts the principal difficulty is found in 
 the cases of the water system and the lighting system. The water 
 system with its pipes, hydrants and faucets is undoubtedly a part 
 of the building equipment, yet in many cases its principal service 
 will be to supply water to the operating department for use in 
 the process of manufacture, so that it will illustrate one of the 
 many difficulties which the classification of equipment presents. 
 It may be true that light is served principally to the employees 
 engaged in work upon the product so that this point frequently 
 furnishes opportunity for a discussion. Conflict will frequently 
 arise in connection with the power plant. Its ramifications may 
 transmit heat, light, or power and the question arises as to 
 whether the steam pipes, light wires, and tubing, and the shafting 
 and belting, shall be considered a part of the major operating 
 equipment. There will be found below a chart in which classifica- 
 tion of the above mentioned items of equipment as well as some 
 others not previously mentioned is attempted. In presenting it 
 the author calls attention to the fact that he is not an engineer 
 and makes no pretensions at submitting a classification which 
 is proof against criticism. The whole subject is so confused in 
 the mind of the average student that this chart is intended 
 merely to give him a broad general idea of the contents of a 
 plant and enable him to reason more clearly with regard to the 
 
 104 
 
Equipment 
 
 •Z, 
 W 
 
 a 
 
 t— I 
 
 p 
 a 
 w 
 
 ►J 
 
 «! 
 o 
 
 § 
 k 
 o 
 w 
 
 
 o 
 
 o 
 
 
 Desks 
 
 Chairs 
 
 Typewriters 
 
 Safes 
 
 Rugs 
 
 Partitions and fix- 
 tures 
 
 Computing ma- 
 chine 
 
 Filing cases 
 
 Book cases 
 
 Tables 
 
 M 
 
 •So 
 
 a 
 
 Horses 
 
 Wagons 
 
 Harness 
 
 Autos 
 
 Auto-trucks 
 
 Repair tools 
 
 Spare parts 
 
 
 
 g 
 
 H 
 U 
 < 
 to 
 
 a 
 z 
 < 
 
 S 
 
 c 
 
 V 
 
 E 
 
 U 
 
 a 
 ft 
 
 P 
 
 .5 
 "k 
 
 < 
 
 U 
 
 o 
 a 
 
 § 
 
 Tools 
 
 ii 
 
 Patterns, plans 
 and designs 
 
 Utensils 
 
 Dishes, chairs and 
 tables 
 
 Instruments 
 
 Tools, wheelbar- 
 rows, shovels, 
 etc. 
 
 Shelves, tools, etc. 
 
 
 Machine shop 
 Carpenter shop 
 Paint shop 
 Repair shop 
 Exhaust system 
 Draughting room 
 
 Welfare: 
 Kitchen 
 Dining-room 
 Hospital 
 
 Power plant, in- 
 cluding main 
 shaft 
 
 Stores 
 
 Railroad siding 
 
 E 
 
 1 
 
 a, 
 
 Q 
 
 bo 
 _B 
 
 a 
 
 & 
 O 
 
 in 
 o 
 c 
 
 s 
 
 Hand tools 
 
 Facilities for mov- 
 ing product 
 about, such as 
 wheelbarrows, 
 boxes, ca ses, 
 racks, bins, etc. 
 
 Vats 
 
 Shovels 
 
 Picks 
 
 Tongs 
 
 Stools, benches 
 and chairs for 
 operatives 
 
 t-l 
 
 Machinery and 
 machine tools 
 
 Shafting and belt- 
 ing 
 
 Cranes and over- 
 head trolleys 
 
 Inter-shop tracks 
 and cars 
 
 1 
 
 c 
 c 
 
 t- 
 
 ) 
 
 i 
 
 1 
 
 ) 
 1 
 
 
 Heating system (steam 
 pipes, radiators, etc.) 
 
 Lighting system (tubing, 
 wires and fixtures) 
 
 Water system (pipes, 
 hydrants and faucets) 
 
 Sprinkler system 
 
 Plumbing system 
 
 Ventilating system 
 
 Elevators 
 
 Fire hose and extin- 
 guishers 
 
 i°5 
 
Principles of Accounting 
 
 various phases of accounting work which are related to plant 
 equipment. 
 
 Equipment like buildings is subject to various possibilities. 
 In studying the subject, thought should be given to it with regard 
 to how it may be acquired, what may happen to it and how it 
 may be disposed of. Briefly stated, it may be acquired by pur- 
 chase or construction. It is subject to destruction either partially 
 or wholly by fire and the other elements. It is usually affected 
 more than buildings by depreciation. It requires repair and 
 replacement frequently. It may be sold, demolished or discarded. 
 
 There are several phases of interest which arise in connection 
 with equipment. Among these is the cost. In this connection 
 it must first be determined whether the equipment is purchased 
 from outsiders or constructed by the proprietor. Equipment 
 may be purchased on a contract which provides for its installa- 
 tion, or the purchase price may cover merely the bare cost when 
 an extra charge is made for its installation. If constructed by 
 the proprietor it will contain all the elements of cost, namely, 
 material, labor and overhead. Taking as an example a new 
 machine purchased from an outsider to be installed free of 
 charge, the cost will be merely that stated in the contract. 
 If the contract price covers only the machine itself then there is 
 a possibility that there will be charges covering the inward 
 freight and cartage, foundations for the machine, and the further 
 expense of installation. The cost in this case would include all 
 these charges. If the machine were to be constructed by the 
 proprietor, the cost would include the material of which it was 
 composed, the labor incident to its construction, the preparation 
 of the foundation including the material, the labor involved in the 
 installation and a percentage of the overhead of the proprietary 
 concern while the machine was in course of construction. 
 
 The division of equipment known as machinery and tools is 
 frequently subdivided and sometimes classified as machines, 
 machine tools, fixed machinery, movable machinery, hand tools, 
 etc., and is so classified presumably for purposes of identification 
 in individual cases where the circumstances indicate. In any 
 event, machinery should be understood to include machine foun- 
 dations and fixed appurtenances of any importance. The ques- 
 tion of tools brings to mind certain instances wherein equipment 
 may be considered by some concerns as supplies rather than 
 
 ,to6 
 
Equipment 
 
 equipment. These are cases of concerns which use large numbers 
 of small tools which are so quickly worn out that it is not con- 
 sidered advisable to capitalize them. They are looked upon as 
 supplies and are charged to expense immediately upon being 
 purchased or as soon as issued for use. It is rather difficult to 
 lay down any hard and fast rule in cases of this kind and the 
 treatment will depend largely upon the circumstances in each 
 individual case, such as the policy of the company, or the wishes 
 of the proprietor. There are two or three checks which are 
 sometimes placed upon the tendency of employees to treat care- 
 lessly such articles of equipment. In the case of small tools which 
 wear out quickly the life of the tool is determined and the issue 
 placed upon a standard basis. They are sometimes charged to 
 the individuals who are obliged to present the worn out tools 
 before receiving new ones. They are sometimes accounted for 
 by inventories. In this case instead of being charged immediately 
 to expense at time of purchase they are charged to a purchase 
 account and the amount to be charged to expense for the period 
 is determined by taking an inventory at the end of the period, 
 placing upon it a value and deducting it from the cost of the 
 tools purchased. In one concern where scientific management is 
 in operation each employee is furnished with a supply of small 
 metal checks bearing his number. The supply of tools in the 
 tool room being systematically arranged, the man in charge of 
 the tool room upon receipt from any given operative of a certain 
 number of checks, issues the tools required and substitutes in 
 place of the tools the various checks which he has received. Thus 
 he is enabled to tell at a glance the employee to whom each tool 
 is issued. The writer was interested to know how the bonus 
 system which was in use in the plant affected the man who had 
 charge of the tools and upon inquiry learned that it was his duty 
 to be in his place during certain designated hours, to see that 
 all the tools were clean, sharp and in their proper places. This 
 was the task imposed upon this particular individual. His work 
 was inspected periodically and if he had complied with all the 
 requirements of his task he received an efficiency bonus. 
 
 The accounts for equipment will depend largely upon the 
 peculiar circumstances existing in each case. The classification 
 in the general ledger will depend upon the captions which are 
 required for balance sheet purposes. One concern may be satis- 
 
 107 
 
Principles of Accounting 
 
 fied with an account called equipment to which will be charged 
 machinery of every description such as building equipment, 
 machinery and tools, other operating and auxiliary manufacturing 
 equipment, power plant, horses, wagons, harness, automobiles, 
 office furniture, etc. In other concerns separate accounts may 
 be kept for these different classes of equipment, consolidating 
 them in various combinations in the balance sheet. The accounts 
 may also be kept separate at times for the purpose of determining 
 the separate cost of some particular class of equipment or for 
 controlling underlying records containing the details. It should 
 be also borne in mind that in some instances the accounts on the 
 general ledger will be kept with the various buildings in order 
 to show in connection therewith the cost of the respective build- 
 ings, including their equipment. Detailed records of equipment 
 are sometimes kept for the purpose of classifying it for depre- 
 ciation purposes. In such cases the equipment is classified in ac- 
 cordance with its life. The matter of depreciation of equipment 
 will be discussed under that general topic later on. 
 
 REFERENCES FOR COLLATERAL READING: 
 
 Science of Accounts, Bentley, pages 151-156, 191-194, 196 
 197. 
 
CHAPTER XX 
 
 INVESTMENTS 
 
 Every business organization must be assumed to have some 
 specific object in engaging in business. It is true of course that 
 the object of all business organizations is profit. This, how- 
 ever, is not sufficiently specific. Each organization is engaged 
 in some particular line of business for profit. For such an under- 
 taking, capital is made available and the assumption is that any 
 given concern will upon organizing supply itself with such an 
 amount of capital as is adequate to carry on the business in 
 question. Such capital will be in the form of assets which are 
 required for the purposes of the business. For example a con- 
 cern may invest in land upon which to construct a building; it 
 may subsequently construct the building and equip it with the 
 necessary facilities for transacting the business. A part of the 
 capital may be in the form of cash and after a period of opera- 
 tions some of the capital will usually be in the form of accounts 
 and notes receivable. Whether engaged merely in trading or in 
 manufacturing and selling, some capital will be in the form of 
 materials and supplies or merchandise either partially or wholly 
 completed and ready for sale. 
 
 In the ideal case the proportion of capital invested in these 
 various assets would be distributed proportionately to the need 
 of the business. Money will not be tied up in land or buildings 
 to such an extent that there is no cash available for liquidating 
 current liabilities. A concern will not overstock itself in the 
 matter of merchandise to such an extent that it is embarrassed for 
 cash with which to meet its pay rolls. If profits result from the 
 transaction of business they will presumably be converted into 
 cash and paid out in the form of dividends, thereby reducing the 
 surplus. 
 
 It sometimes happens that a concern accumulates or acquires 
 profits which are greater than the dividends necessary to allow a 
 fair return on the invested capital. Such undivided profits con- 
 stitute a surplus. The cash may increase to such an extent that 
 there is more on hand than that required for current purposes 
 
 ioq 
 
Principles of Accounting 
 
 and dividends. It may then be converted into various forms of 
 assets known as investments. Such a class comprises stocks and 
 bonds, bonds and mortgages and land or buildings not required 
 in the conduct of the business. They may be income producing, 
 but such income is not the result of operations incident to the 
 principal business of the organization. It is to be considered as 
 secondary income or income from sources other than operations. 
 The income may take the form of interest, dividends, or rent. 
 
 Such items may be represented on the general ledger by one 
 account for investments. However, the accounts will usually be 
 such as to show the classification of investments if they are nu- 
 merous. By this is meant that ordinarily if there were securities, 
 bonds and mortgages and real estate, there would be separate 
 accounts for each of the above mentioned class on the general 
 ledger. Frequently, especially in large concerns such investments 
 become sufficiently numerous to warrant subsidiary records, sup- 
 porting the controlling account, in which the details of the invest- 
 ments are recorded. It is especially desirable that such books 
 should provide for all the information pertaining to the assets. 
 
 Bonds call for the payment of a fixed amount of money at a 
 given time. They may be purchased at par, above par when they 
 are said to be bought at a premium, or below par, when they are 
 said to be bought at a discount. The face of the bond is payable 
 with interest at a certain rate per cent. The interest although 
 calculated annually may be payable semi-annually or quarterly on 
 specified dates. Thus there arises the question of the accrual of 
 the interest. There is also the no less important question of what 
 is to be done with the premium, in case the bonds were purchased 
 or acquired at a figure above par, or what to do with the discount 
 if they were purchased or acquired below par. 
 
 A bond for $1,000, payable 20 years hence, if purchased at 
 120 will only produce at maturity $1,000. The premium of $200 
 will be lost. On the other hand the same bond purchased at 80 
 will produce at maturity $1,000 and there will be a gain of $200. 
 In the case of the bond purchased at a premium, if no steps are 
 taken to prevent, upon maturity $200 will be charged to profit 
 and loss. In the opposite case $200 will be credited to profit and 
 loss. The best practice in both these instances dictates spreading 
 either the premium or discount over the remaining life of the 
 
 no 
 
Investments 
 
 bond. These processes are known as amortization in the case ot 
 premium and accumulation in the case of discount. 
 
 The principles involved in amortization and accumulation are 
 well illustrated as applied in estate accounting to a life-tenant 
 and a remainder-man. The life-tenant is the party who enjoys 
 the benefit of the income of the estate during life, after which 
 time the principal passes to the so-called remainder-man. The 
 illustration which follows is purposely freed from any element of 
 compound interest, such as attends the scientific evaluation of 
 bonds and division of interest, in order that the principles may be 
 the more easily understood. 
 
 A bond the par value of which is $1,000 is appraised on Janu- 
 ary i, 1910, at $1,200. The bond bears interest at 4% per annum 
 and matures January 1, 1930. Under the terms of the will the 
 bond is bequeathed to A, but the income is to be enjoyed by B 
 during his life. B is the life-tenant and A is the remainder-man. 
 A has received a bequest of $1,200. 
 
 If B receives the annual interest of $40 he will during the 
 period of twenty years have collected $800. Upon the maturity 
 of the bond at the expiration of twenty years there will be no 
 further income and the proceeds of the bond ($1,000) would 
 presumably be re-invested if B were still alive. It will be noted 
 that there has been a loss of $200, all of which under the circum- 
 stances A would have to bear. In other words, the' principal of 
 the estate has been decreased $200. This occurs because no pro- 
 vision has been made to amortize the premium, which was 
 included in the appraisal. B has apparently been receiving more 
 interest than he should have received. 
 
 The facts are that B has received annually more than he 
 should have received. Provision should have been made for the 
 loss of premium at maturity. The premium of $200 should have 
 been provided for by annual amortization extending over the 
 period of ten years. Ten dollars ($10.00) should have been, de- 
 ducted from the interest paid to B every year, and instead of 
 receiving $40.00 each time he should have received only $30.00. 
 Thus during the twenty years $200 would have accumulated to 
 make good the loss of premium upon maturity of the bond. 
 
 To make the accounting procedure clear the following entries 
 and skeleton ledger accounts may serve: 
 
 in 
 
Principles of Accounting 
 
 1910 
 
 January 1. Bonds $1,200 
 
 To Principal $1,200 
 
 Cash $800 
 
 To Reserve for Amortization $2 go 
 
 Income 600 
 
 (covering the period of 20 years) 
 
 Income $600 
 
 To Cash $600 
 
 (for income paid to B) 
 
 1930 
 
 January 1. Cash $1,000 
 
 Reserve for Amortization 200 
 
 To Bonds 
 
 (upon maturity of bonds) 
 
 Pi, 200 
 
 Bonds 
 
 fl,2QO 
 
 Cash 
 
 $ 800 
 
 1,000 
 
 $600 
 
 $1,800 
 
 $600 
 
 $1,200 
 
 
 Principal 
 
 £1,200 
 
 Reserve for Amortization 
 
 200 $200 
 
 Income 
 
 These accounts, it will be seen, show that the principal of the 
 estate has been maintained at $1,200, notwithstanding the fact 
 that the assets have been converted from bonds into cash. 
 
 Accumulation is the opposite of amortization and describes the 
 process where discount obtains. Thus it may be reasoned out 
 that the bond inventoried in an estate at a discount increases 
 gradually in value as maturity approaches. The accumulation in 
 this case accrues to the remainder-man and has the effect of 
 decreasing the effective rate of income. The interest will corre- 
 spondingly be credited part to income and part to principal, 
 thereby increasing the principal of the estate. 
 
 The application of the principles to mercantile or other or- 
 ganizations has the effect of measuring through amortization and 
 
 112 
 
Investments 
 
 accumulation the exact amount on interest bearing securities like 
 bonds which can be taken into income. The scientific method of 
 calculation takes into consideration the compound interest but as 
 this is a matter of mathematics which tends to cloud the elucida- 
 tion of principles and tables are available for the purpose of deter- 
 mining the yield of bonds it will not be discussed here. 
 
 In considering the matter of accrued interest it might be 
 assumed that the interest on a bond of $1,000 amounted to $60.00 
 and was payable semi-annually on July 1st and January 1st. 
 Under these circumstances in closing the books for the quarter 
 ended March 31st it would be necessary to take into consideration 
 the accrued interest of three months, or $15. To carry the 
 illustration a step further in connection with the purchase of a 
 bond and assuming it to have been purchased on February 28th at 
 par, the purchaser would pay to the seller $1,010, representing the 
 face value of the bond and the accrued interest. The seller has 
 transferred to the buyer, having been paid therefor, the right to 
 collect the interest on the bond from the beginning of the year 
 and when the buyer receives the interest for the first six months 
 he will receive $60.00 and not $50.00. 
 
 Taking into consideration all of the above facts, it appears 
 then that the records for bonds should be rather elaborate and 
 provide for many possibilities. Thus such a record should show 
 the date of the bond, the par, the purchase price, the accrued 
 interest, the rate of interest, the dates of payment of interest, the 
 date of maturity of the bond, the accumulations of discount, the 
 amortization of premium, the sale of bonds with the amount of 
 par sold, the sale price and the accrued interest at time of sale. 
 Such possibilities are provided for usually by columnar ledgers, 
 having appropriate headings for the columns. 
 
 Stocks differ from bonds in that instead of being promises to 
 pay a certain sum of money at a certain stated time, they are 
 evidences of share ownership in the net assets of some corpora- 
 tion. The income differs from bonds in that it cannot be accrued 
 like interest. The income on stocks is in the shape of dividends 
 whereby profits are distributed, and become available only by an 
 act of the directors of the corporation declaring such a distribu- 
 tion of profits and such a dividend payable. Dividends may be 
 taken up as income only after having been declared. A concern 
 owning certain shares of stock in the Pennsylvania Railroad 
 
 ".I 
 
Principles of Accounting 
 
 Company where dividends continued uninterrupted at a fixed 
 rate over a period of years would not be justified if upon closing 
 the books at March 31st the quarterly dividend on Pennsylvania 
 stock had not been declared. If, however, such a dividend were 
 declared on March 27th, payable on April 15th to stockholders of 
 record on March 31st, then a concern owning stock in the Penn- 
 sylvania Railroad might properly take such a dividend into income 
 even though it had not yet been actually received. The books 
 in such case should provide adequately for all details concerning 
 stock showing the date of purchase, the par purchased, the market 
 price whether with or without dividends, the date of sale, the 
 sales price, the par sold and whether with or without dividends. 
 Columnar ledgers are generally used for this purpose. 
 
 Bonds and mortgages as investments constitute two instru- 
 ments. A bond is the instrument which promises to pay a certain 
 sum of money at a specified date at a certain rate of interest. The 
 mortgage is the instrument which secures the bond. For account- 
 ing purposes the mortgage may be ignored and the attention 
 directed to the bond. The interest on this class of securities 
 may be accrued like that on any other bond, and in closing the 
 books cognizance should be taken of the amount accrued whether 
 or not at such time it has been actually received. If for exam- 
 ple, a bond and mortgage of $10,000 bears interest at the rate of 
 5% per annum, upon closing the books at March 31st, provided 
 the bond has been held for the three months preceding such date, 
 the interest should be accrued and the corresponding amount taken 
 into income. The entry in such case would consist in charging 
 accrued interest on mortgage and crediting interest earned on 
 bond* and mortgage. The accrued interest constitutes an asset. 
 The careful use of words in describing such an entry is desirable. 
 By common consent among many accountants it has become cus- 
 tomary in describing this asset as well as various other assets 
 involving accruals, to make the word accrued the first word of 
 the title. For example : "Accrued interest on bond and mort- 
 gage," rather than "Interest accrued on bond and mortgage " 
 The former expression is accepted as indicating an asset whereas 
 the latter is usually understood to denote a liability. This rule 
 applies as well to other forms of bonds, and the income from 
 land or buildings. Thus in practice the expressions are used to 
 denote the accrual of income represented by assets as "accrued 
 
 114 
 
Investments 
 
 interest on securities," or "accrued rent," etc. The books pro- 
 viding for the record of the details in the case of bonds and mort- 
 gages should as in the other instances provide for all the possi- 
 bilities. There is, however, in this case no question of par, pre- 
 mium or discount involved, as in the case of corporation bonds 
 bought and sold in the market. The records should show the date 
 of the bond, and date of maturity, the face of the bond, the rate 
 of interest and the dates on which such interest is payable. Atten- 
 tion should in this case be given to any interest accrued on the 
 instrument at time of acquisition in order that upon actual receipt 
 of the interest in cash the proper account may be credited. 
 
 Little need be said with regard to the detail records for rent 
 except in such cases as where tenants are numerous. Instances of 
 this kind require that the detail records shall show the name of 
 the tenant, the period covered by the lease, the annual rental and 
 the manner in which it is payable, whether in advance or at the 
 expiration of the month. 
 
 Two questions arise frequently concerning the above men- 
 tioned investments. One is the value at which they shall be car- 
 ried in the balance sheet, and the second whether they are capital 
 assets or current assets. In attempting to answer these questions 
 it would seem that land and buildings might be eliminated, for 
 the reason that they could scarcely be considered as current assets 
 under any circumstances and for the further reason that the 
 subject has been discussed rather thoroughly in the chapters 
 dealing with land and buildings. With bonds and mortgages it 
 is somewhat different. As to their value probably no one will 
 dispute that they should be carried at cost. The fact of their 
 being capital assets is open to discussion. It is not believed that 
 they should be considered current assets, for the reason that they 
 represent an excess of capital over and above that required by the 
 business, and that while they may be in the majority of cases 
 easily convertible into cash it is only in the event of some extraor- 
 dinary circumstances or unusual demand that such proceeding 
 takes place. They seem to be looked upon more in the nature of 
 fixed capital and not as something which is fluctuating constantly 
 in conformity with the volume of business. 
 
 What has been said concerning bonds and mortgages in 
 respect to their being current assets is believed to be also true of 
 other bonds and stocks. Such a conclusion eliminates from the 
 
 "5 
 
frinciples of Accounting 
 
 discussion everything then except as to the value at which they 
 shall be carried as assets. Some organizations adjust them to 
 market prices at closing dates. In some of these cases such a 
 procedure is merely a part of the policy of the company, in other 
 cases where the government exercises supervision and control 
 over them, it is because of the requirements of the government 
 regulations. To carry them on the books at cost seems proper. 
 In showing them on a balance sheet it is desirable to show, either 
 as a footnote or in parentheses opposite or immediately under the 
 caption, the market value. Where they are carried at cost and 
 the market has declined at closing dates the effect of the market 
 fluctuation is sometimes indicated on the balance sheet by a 
 reserve without making any change in the figures shown on the 
 asset side. 
 
 Treasury stock is sometimes included under investments. 
 While this is quite proper, precaution should be taken where it 
 is so included to make sure that the item so represented is in 
 reality treasury stock and not capital stock unissued. Unfortu- 
 nately the term treasury stock is at times given two different 
 meanings. It is sometimes used to denote capital stock which is 
 unissued. 
 
 Capital stock may be considered as issued when it is signed, 
 sealed and delivered for value. Until the last named of these 
 steps has taken place it must be considered as unissued. It is 
 hard to see how unissued stock can ever be considered as an 
 asset. Up to the time of issue it is not in reality capital stock in 
 any sense of the word. The certificate of stock is evidence of the 
 fact that capital has been received and must be accounted for to 
 the party from whom it was received to the extent indicated by 
 the certificate. The difference between the capital received and 
 the amount of capital which the corporation is authorized to 
 secure is represented by nothing except figures expressing this 
 amount. The words treasury stock carry with them a significance 
 of value. For this reason it appears rather incompatible to con- 
 sider this amount, descriptive of nothing but a measure of pos- 
 sibilities, as treasury stock. 
 
 If the evidence of receipt of capital, namely a certificate of 
 stock has once been issued for money or property, then something 
 of value attaches to it and it becomes representative of an asset. 
 Stock issued in this manner and subsequently acquired has a 
 
 116 
 
Investments 
 
 value, instead of being a worthless piece of paper, it represents 
 something for which value has been received. Upon having been 
 acquired subsequent to its original issue for value, it may be 
 properly considered as treasury stock. To acquire it presumably 
 means that the accountability for capital for which it was orig- 
 inally issued has been reduced. Why not then ask the question, 
 "Why is it carried in the treasury?" "Why not cancel the ac- 
 countability represented on the books by the capital stock out- 
 standing accounts ?" The answer to these questions is that there 
 is a possibility that it may again be issued or in reality sold, and 
 it seems useless to go to the trouble of cancelling the outstanding 
 accountability and subsequently restoring it in accordance with 
 the fluctuations of treasury stock. Then there is the added reason 
 that the original issue of capital stock cannot be disposed of at 
 less than par without a corresponding liability for the difference 
 between what it was issued for and par attaching to it. Treasury 
 stock is presumed to have been issued once for its par value and 
 therefore may subsequently be sold at any price or given away if 
 desired. Attention is again called to the fact that if treasury 
 stock is shown on the books or balance sheet as an investment or 
 in fact in any other group of assets, the above mentioned distinc- 
 tions must be observed. 
 
 REFERENCES FOR COLLATERAL READING: 
 
 Accounting Practice and Procedure, Dickinson, pages 38, 
 82-87, 116-118. 
 
 Modern Accounting, Hatfield, pages 90-97. 
 
 Accountancy of Investment, Sprague and Perrine. 
 
 Auditing Theory and Practice, Montgomery, pages 113, 362- 
 365- 
 
 117 
 
CHAPTER XXI 
 
 WORKING AND TRADING ASSETS 
 
 This group comprises materials and supplies, goods in process, 
 finished goods, finished parts purchased to complete manufactured 
 goods, packing material, coal, oil and waste, stationery, adver- 
 tising matter, postage and any inventories similar in their nature 
 to the foregoing. They are physical assets which are consumed 
 either in the manufacture of the goods or the conduct of the 
 business. They are called working and trading assets because 
 they are the assets which the organization is working into goods 
 for sale or into expenses attending such operation or because they 
 are assets which are on hand for sale or trading purposes. 
 
 The accounts for items in this group are used in practice in 
 three distinct ways. The first is to combine the old inventory 
 and the purchases in one account and determine the consump- 
 tion by the inventory method of crediting the new inventory and 
 closing out the balance to a consumption account. The second is 
 to combine the old inventory and the purchases in one account 
 and determine the consumption by the direct method, so that 
 crediting the amount consumed to the asset account will show the 
 inventory. The third way is to run separate accounts for inven- 
 tories and purchases. The inventory is entered in the asset ac- 
 count both at the beginning and at the end of the period and the 
 difference only, whether it be debit or credit carried to the con- 
 sumption account. The consumption account as used herein is 
 used in a broad sense. The term is intended to mean any nom- 
 inal account into which working or trading assets may be closed. 
 It would embrace manufacturing cost, cost of goods sold and 
 expense accounts such as stationery and printing expense, postage 
 expense, etc. 
 
 In the illustrations of the varieties of practice which follow 
 let these facts with regard to materials and supplies remain con- 
 stant: inventory December 31, 1910, $20,000; purchases, $15,000; 
 inventory December 31, 191 1, $28,000; consumption, $7,000. 
 
 In the first case, the account becomes a mixed one. It par- 
 takes of the nature of both a real and a nominal account. At 
 the beginning it is a real account. During the period it is a mixed 
 
 118 
 
Working and Trading Assets 
 
 account. In construction it is precisely like the old-fashioned 
 merchandise account. In operation it is also identical. It is 
 opened on the debit side with the inventory at the beginning of 
 the period. It is charged with the purchases. It is credited with 
 the inventory at the end of the period. It is closed by the balance 
 in the account which is carried to the consumption or manufactur- 
 ing account. Thus, if to the inventory at the beginning of the 
 period of $20,000 we add the purchases of $15,000 there is 
 $35,000 to be accounted for. If at the end of the period $28,000 
 remains on hand, $7,000 must have been consumed or have dis- 
 appeared. It will be seen that the amount of material has been 
 determined by the inventory method. The accounts would appear 
 as follows : 
 
 Materials and Supplies 
 
 Inventory, beginning . 
 Purchases 
 
 $20,000 
 15,000 
 
 Inventory, end , , 
 Consumption. . . 
 
 $28,000 
 7,000 
 
 Inventory, new 
 
 $35,000 
 $28,000 
 
 $35,000 
 
 Consumption Account 
 
 Materials and supplies $7,000 
 
 In the second case, the account can scarcely be called a mixed 
 one. It might appear without thought to partake of the nature 
 of both a real and a nominal account. It does not, however, since 
 the consumption is determined by the direct method. When the 
 account is used in this way the materials and supplies are usually 
 issued on requisition. The requisition when honored and priced 
 becomes the basis of a charge to the consumption account and a 
 corresponding credit to materials and supplies account. It is true 
 of course that for convenience the requisition will be summarized 
 and the aggregate amount credited to the materials and supplies 
 account only at the end of the month, or end of the accounting 
 period. Theoretically, however, the materials and supplies ac- 
 count is reduced every time a requisition is filled. 
 
 In many instances the consumption is determined by keeping 
 
 119 
 
Principles of Accountmy 
 
 a running stock account with each class of material or stock. The 
 determining of consumption does not necessarily depend upon 
 the use of requisitions. The stock account may be kept in a book, 
 either bound, or composed of loose leaves, or upon cards. For 
 convenience cards are sometimes located adjacent to the stock 
 itself. The location of the record has little bearing upon the 
 method so long as there is an account for each class of stock. 
 Given such accounts, they are debited with the opening inventory. 
 They are subsequently charged with any receipts, whether by pur- 
 chase or otherwise. They are credited with all issues" at the time 
 the issues are made. The balance in the account should show the 
 stock on hand. 
 
 In connection with stock records, the question frequently 
 arises, "what shall be done when the balance in the stock accounts 
 does not agree with the physical inventory?" The disposition of 
 such discrepancies must necessarily depend upon the cause. There 
 are various things which cause the difference which may arise. 
 One is failure to enter all receipts on the debit side of the ac- 
 count. Another is an error in footing the debit side. Still another 
 may be failure to record an issue on the credit side. It is also 
 possible that the actual stock issued did not agree with the record 
 which was made of the issue or that the credit side of the account 
 has been incorrectly footed. An attempt should first be made to 
 correct any of the above mentioned causes of the discrepancy. 
 If such measures prove ineffectual the account should be adjusted 
 to agree with the physical inventory. 
 
 The question which now presents itself is "which complimen- 
 tary account shall be affected by the difference ?" If the physical 
 inventory is greater than the book inventory the stock account 
 must be charged. Which account is to be credited, consumption 
 or profit and loss? If the physical inventory is less than the 
 book inventory the stock account must be credited. Which 
 account is to be charged, consumption or profit and loss? If the 
 consumption account is charged or credited the cost of the goods 
 manufactured or sold will be affected accordingly. Supposing, 
 for example, that profit and loss has been charged for a shortage 
 which although not clearly shown by the accounts was actually 
 consumed in the manufacture of goods. The cost of manufacture 
 will be incorrect to the extent of the shortage thus charged. On 
 the other hand suppose that the difference was due to theft and 
 
 1 20 
 
Working and Trading Assets 
 
 instead of being charged to profit and loss the amount was 
 charged to consumption or cost of manufacture. Again the con- 
 sumption account would be incorrect to the extent of the shortage. 
 To frame a hard and fast rule in this case is a difficult one. The 
 best apparently that can be done is to say that the consumption 
 account should be adjusted in accordance with any necessary 
 adjustments to the stock account, except where it is known defin- 
 itely that the consumption account has not been affected, when the 
 adjustment should be carried to profit and loss. 
 
 The general ledger account, controlling any subsidiary records 
 cf stock, would, where the direct method of ascertaining the 
 consumption is in force, appear as follows : 
 
 Materials and Supplies 
 
 Inventory, beginning. $20,000 
 Purchases 1S7O00 
 
 $35,000 
 
 Consumption $7,000 
 
 Inventory, end 28,000 
 
 55>°°° 
 
 inventory, new $28,000 
 
 Consumption Account 
 
 Materials and Supplies $7,000 | 
 
 The third method of arriving at the consumption it will be 
 remembered contemplated both an inventory account and a pur- 
 chase account. The inventory account would show the inventory 
 at the beginning on the debit side with the inventory at the end 
 on the credit side. At the time of placing the inventory at the 
 end on the credit side it would be carried down on the debit side 
 to constitute the opening inventory for the next period. The 
 balance in the inventory account would be carried to the purchase 
 account. The effect of this procedure would be to increase or 
 decrease the purchases for the period, depending upon whether 
 the inventory at the end were larger or smaller than at the begin- 
 ning. The purchase account thus adjusted would be closed out 
 to the manufacturing cost account or to the account for cost of 
 goods sold. Using again the same figures as heretofore the ac- 
 counts would appear as follows: 
 
 121 
 
Principles of Accounting 
 Inventory Account 
 
 Inventory, beginning $20,000 
 Balance to purchases. 8,000 
 
 Inventory, end . . . . $28,000 
 
 $28,000 
 
 Purchase Account 
 
 Purchases 
 
 $15,000 
 
 Increase in inventory. $8,000 
 
 
 $15,000 
 
 $15,000 
 
 Consumption Account 
 
 Materials and Supplies $7,000 | 
 
 The latter method just described is illustrated in the state- 
 ment of income and profit and loss wherein, the section dealing 
 with cost of goods sold, shows first the purchases and second the 
 application of the inventory. This form of presentation is fre- 
 quently difficult for the student to understand because of the 
 terms used. Unless they be analyzed as to their meaning they 
 strike one off-hand as being somewhat contradictory. The con- 
 fusion seems to arise when the expressions add decrease of in- 
 ventory and deduct increase of inventory are used. This point 
 might be cleared up if one would stop to reason as follows : The 
 cost of the materials and supplies consumed for the period is 
 $7,000. This is represented by purchases amounting to $15,000, 
 and an increase in inventory of $8,000, which is deducted from 
 the purchases of $15,000. Why do we deduct the increase in 
 inventory? Because of the fact that there has been consumed 
 not the amount purchased, $15,000, but $15,000 less the $8,000, 
 which remains unconsumed and appears in the inventory at the 
 end of the period, $28,000. Conversely the same thing would 
 be true. If the purchases for the period were the same $15,000, 
 the inventory at the beginning being $28,000, and the inventory 
 at the end $20,000, then the cost of the materials and supplies 
 
 122 
 
Working and Trading Assets 
 
 consumed during the period would be $23,000, represented by 
 purchases of $15,000 plus a decrease in the inventory of $8,000. 
 This may be reasoned out by following the facts which show that 
 while $15,000 worth of materials were purchased during the 
 period, $8,000 worth more have been used and have been deducted 
 from the inventory at the beginning of $28,000, making the 
 inventory at the end $20,000. 
 
 It is to be noted that applying the difference in inventory 
 method to the materials and supplies, goods in process, finished 
 parts to complete goods in process and finished goods, taking 
 into consideration any purchases, will give the cost of the goods 
 sold during the period. To illustrate this let the following series 
 of transactions be followed: Inventories at the beginning; ma- 
 terials and supplies, $10,000; goods in process, $40,000; finished 
 parts, $8,000; finished goods, $75,000; purchases of materials and 
 supplies, $20,000. Inventories at the end ; materials and sup- 
 plies, $5,000; goods in process, $12,000; finished parts, $2,000; 
 finished goods, $34,000. The account with the materials and 
 supplies inventory would show an opening balance of $10,000, 
 a closing balance of $5,000, with $5,000 carried to the materials 
 and supplies purchase account. This latter account, amounting 
 now to $25,000, would be closed out to the goods in process 
 account. The goods in process account, opening with a balance 
 of $40,000, would show a debit of $25,000 for materials and 
 supplies, a debit of $6,000 coming from the account for finished 
 parts or total debits amounting to $71,000. The credits in the 
 goods in process account would comprise $12,000, the closing 
 inventory and $59,000 transferred to the finished goods account. 
 The finished goods account would show an opening balance of 
 $75,000, a debit of $59,000, credits of $34,000, covering the new 
 inventory, and $100,000, which would be transferred to the 
 account for cost of goods sold. If instead of tracing the transac- 
 tions through the above named steps in the respective account 
 the differences in inventories were to be carried direct to the cost 
 of goods sold account, it would show various debits comprising 
 difference in inventory of materials and supplies of $5,000, pur- 
 chases $20,000, difference in inventory goods in process $28,000, 
 difference in inventory of finished parts $6,000, difference in 
 inventory of finished goods $41,000, or a total of $100,000. 
 
 Of the miscellaneous items found in this group of assets, such 
 
 123 
 
Principles of Accounting 
 
 as stationery and printing, postage, etc., comparatively little need 
 be said apparently. In some concerns stock accounts are kept 
 with those items and the amount chargeable to operations deter- 
 mined by requisitions issued. In other cases the amount charge- 
 able to operations is determined by taking an inventory, placing 
 upon it a value and charging off the difference in the account to 
 operations. The materials and supplies, goods in process, etc., 
 are of course closely related to cost accounting. These accounts 
 serve as controlling accounts for the cost department, and where 
 such department exists are usually supported by subsidiary rec- 
 ords showing the details. 
 
 Possibly the most interesting phase of the discussion in con- 
 nection with the inventory is the values at which items like, mate- 
 rials and supplies, goods in process, and finished goods shall be 
 carried. Some proprietors insist that they shall be carried at 
 market prices. Some text-books advocate carrying them at cost 
 except where the cost is lower than the market price, when they 
 should be carried at the market price. It would seem that in 
 order to be consistent one basis should be the rule in all cases. 
 There is decided objection to carrying them, at market prices or 
 sale prices, when same is higher than cost, because of the fact that 
 such procedure anticipates profits. Materials and supplies if car- 
 ried at market prices may show either a profit or a loss when the 
 cost of the materials and supplies is compared with the market 
 price. What seems to be a fact is that materials and supplies on 
 hand will be used in the product and not sold as materials and 
 supplies if the market is above cost, or withheld from use and new 
 supplies purchased if the market is beiow cost. It would appear 
 to be a pretty good rule with regard to materials and supplies to 
 carry them in the inventory at cost. Their value if the market 
 is lower than cost may be shown on the balance sheet by opposing 
 against the cost a reserve for decline in market values. Such 
 procedure accomplishes two things. If the concern is ultracon- 
 servative and wishes to be exact, the true market value of the 
 inventory is thus stated in the balance sheet, and at the same time 
 the account for materials and supplies maintains its true relation 
 to the details of which it is composed and continues to be a con- 
 trolling account in the strict sense of the word. There is no 
 objection and in fact it is considered more nearly correct to include 
 
 124 
 
Wot king and Trading Assets 
 
 in the pricing of inventory of materials and supplies the inward 
 freight, cartage, etc., applicable to the goods remaining on hand. 
 
 With goods in process the question of valuation becomes 
 somewhat more complex. Such goods will include in addition to 
 the materials and supplies the labor and certain portions of the 
 manufacturing overhead. The question presenting itself in this 
 connection is whether or not such goods shall be carried at prime 
 cost, which includes merely materials and supplies and direct 
 labor, or whether they shall be carried at manufacturing cost, 
 which includes in addition to prime cost the manufacturing over- 
 head. The latter basis is undoubtedly the more equitable, but if 
 desired or indicated by ultraconservatism the overhead may be 
 offset by a reserve which will have the effect in the balance sheet 
 of carrying the goods at their prime cost. 
 
 Finished goods involve in their cost an item of general over- 
 head which is comprised of the selling, administrative and other 
 expenses. If it is equitable to carry goods in process of manu- 
 facture at manufacturing cost, then it would seem equitable also 
 to carry the finished goods at selling cost. The objection to this 
 lies in the fact that in so doing a portion of the general overhead 
 expense is capitalized and such procedure is questionable. The- 
 oretically it is correct to carry finished goods at selling cost. 
 Practically it is objected to because of the fact that it shows as 
 an asset a proportion of expense applicable to the unsold product. 
 It is hard to say why a distinction should be made between de- 
 ferring charges to operations for such items as insurance for the 
 unexpired proportion thereof, whereas the expenses of a given 
 period are all charged up against the product sold during that 
 period, when a portion of such expenses must in the nature of 
 things apply to product completed in one period and sold in 
 subsequent period, which period will benefit in the matter of 
 profit proportionately. It is probably true that in the case of a 
 business in which the manufacture and sale of the product is uni- 
 form that it will not make great difference. Most authorities 
 advocate carrying finished goods at manufacturing cost, but when 
 it is desirable to maintain control over underlying records by 
 carrying them at selling cost, both results may be accomplished 
 by setting up a reserve on the balance sheet for the proportion 
 of general overhead expense which the selling costs contain. 
 For References for Collateral Reading see page 353 
 125 
 
CHAPTER XXII 
 
 CURRENT ASSETS 
 
 Current assets will be remembered as those assets which are 
 immediately available or which will become available shortly for 
 the purpose of meeting current liabilities. Chief among them, 
 of course, is cash, either in hand, on deposit, or in the form of 
 working funds. Some of the others are accounts receivable and 
 notes receivable. The group also includes accruals of earnings of 
 every description, such as accrued interest on bonds, dividends 
 receivable on stocks, accrued interest on notes and accounts 
 receivable, etc. Separate accounts for each of these items will 
 usually appear in the general ledger, although cash in hand and 
 on deposits is frequently consolidated in the balance sheet. 
 
 Cash in hand is sometimes known as petty cash. Working 
 funds are sometimes known as petty cash. There should never 
 be any question as to whether or not an account for cash should 
 appear in the ledger. It is to be presumed that a general ledger 
 which has been posted up will permit of a trial balance being taken 
 from it. This would not be possible if the ledger did not include 
 a cash account and such exclusion would constitute a violation of 
 the principles upon which a general ledger is run. 
 
 It is difficult to describe any fixed rule for the handling of 
 cash and cash accounts. In some cases there will be but one 
 account for cash in the general ledger. Under such circum- 
 stances all receipts and disbursements are put through one cash 
 book and if there be petty cash accounts or other cash funds, 
 books for such classes of items will be made subsidiary to the 
 general cash book. This method of handling the cash is some- 
 what complicated. The debit side will show receipts of every 
 description, whether deposited in the bank or not. The credit side 
 will show disbursements of every kind, whether by check or in 
 actual cash. The balance of the cash account in the general ledger 
 will require for proof the adding together of the cash in bank 
 and the cash in hand. 
 
 The scheme of classifying the cash and maintaining in the 
 general ledger separate accounts for each kind or class is largely 
 used. Where there is cash in bank, petty cash and working 
 
 126 
 
Current Assets 
 
 funds, there should be separate accounts in the general ledger 
 for cash in bank, petty cash and working funds. It is highly 
 important that all cash receipts of whatever nature should be 
 deposited in the bank. If such method be followed the general 
 cash book will show only receipts on the one side and disburse- 
 ments by check on the other side. The balance in the cash book 
 will agree with the balance shown in the ledger and may be easily 
 reconciled to the balance reported by the bank. For miscella- 
 neous disbursements and the establishment of working funds 
 checks should be drawn and the amounts involved charged to the 
 respective accounts, namely petty cash and working funds. A 
 separate cash book will be kept for petty cash which will show on 
 the debit side only receipts from general cash or cash in bank 
 and on the credit side actual cash disbursements. The balance in 
 the petty cash book at the end of the month will agree with the 
 account for petty cash in the general ledger after the posting has 
 been made. Such a segregation makes it possible to control the 
 petty cash and in reality it partakes of the nature of a working 
 fund except that the amounts transferred from the general cash 
 may vary from month to month. 
 
 A working fund or an imprest cash fund is a definite sum, 
 adequate to meet the demand for disbursements which the volume 
 of transactions during a definite period necessitates, and which 
 will at all times if properly conducted show either actual cash, or 
 cash and paid vouchers, agreeing in total with the amount set 
 aside. Such provisions are frequently made for general cashiers, 
 department cashiers, traveling salesmen, or other employees en- 
 gaged in traveling, and branch office managers or cashiers. For 
 example, suppose that the expenses of the Chicago office of a New 
 York concern amounted approximately to $1,200 a month. In 
 order that the manager of the Chicago office might at all times 
 have ample funds on hand out of which to meet current expenses, 
 it is probable that not less than $1,500 would be forwarded to 
 him by check. This would constitute his working fund. The 
 amount would be charged on the general ledger at New York to 
 a Chicago fund account. The cashier of the Chicago office 
 would from time to time, as he made disbursements, replace the 
 cash with vouchers. At all times if his accounts were correct he 
 should have $1,500, either in cash or represented by vouchers. 
 At the end of the month when he made up his cash report he 
 
 127 
 
Principles of Accounting 
 
 would classify the expenses in accordance with instructions and 
 forward it to the New York office. There would of course be 
 an interval of a few days during which time he would have noth- 
 ing to show for his disbursements except a copy of the report. 
 He would, however, in effect have an account receivable from 
 the New York office for the exact amount of vouchers which 
 he had transmitted. Upon receipt of the report at the New York 
 office it might be journalized, put through a distribution book or 
 put through the voucher register. Regardless of how it was 
 handled the expenses would be charged to the appropriate account 
 and the amount of the disbursements credited to the Chicago 
 fund account. A check would subsequently be issued for the 
 amount of the disbursements to the Chicago office, thereby re- 
 storing the fund to $1,500. 
 
 The question sometimes arises as to whether the credits to 
 the working fund account for disbursements and subsequent 
 charges to the account in precisely similar amounts for reimburse- 
 ments should be shown in the ledger account for working funds. 
 It seems that this should be done if for no other than historical 
 purposes. It is true of course that the account will show the 
 amount of the fund as an opening item, with offsetting debits and 
 credits each month, resulting in a balance representing the amount 
 of the fund. This may appear to be of no value but it would 
 seem to have the effect of showing that disbursements had been 
 reported from time to time and checks for reimbursement had 
 been issued. Working funds will usually be carried in the balance 
 sheet as current assets. 
 
 Accounts receivable as a balance sheet caption may represent 
 merely accounts with regular customers or it may comprise ac- 
 counts receivable of every description. The accounts with cus- 
 tomers will usually be represented by a controlling account sup- 
 ported by underlying ledgers, whereas occasion may require that 
 separate general ledger accounts be opened with parties other 
 than customers, who are indebted to the concern. The books for 
 customer accounts vary in form and arrangement. The accounts 
 are sometimes separated into several volumes for the purpose of 
 facilitating the bookkeeping work, controlling individually the 
 work of various bookkeepers, controlling certain classes of busi- 
 ness, or certain territories. 
 
 For balance sheet purposes accounts are frequently classified 
 
 128 
 
Current Assets 
 
 as good, doubtful and bad, and reserves are introduced to provide 
 for the bad and doubtful ones. It is a matter of question as to 
 how long an account should be carried before being considered 
 bad. It is questionable further as to whether an account which 
 is considered bad shall actually be charged off against the reserve 
 until it is proven absolutely that the amount will not be collected. 
 A good account may become tainted and doubtful. It may subse- 
 quently be declared bad and impossible of collection. Such a 
 decision, however, is merely as a rule an opinion. Accounts 
 which are undisputably bad may eventually produce something. 
 A man who will not pay may be sued, a judgment secured and 
 the amount collected, if he has anything. Sometimes a man would 
 like to pay and cannot. Bankruptcy follows and the creditors 
 receive a pro rata share of their claims in liquidation. In the 
 writer's opinion an account should not be written off against a 
 reserve until such time as a judgment has been returned unsatis- 
 fied or if the account is involved in bankruptcy where the final 
 liquidation dividend has been received. Writing off accounts 
 promiscuously frequently leads to trouble, for the reason that 
 accounts written off may subsequently be collected and upon 
 receipt of the money, if no record of the account has been kept, 
 it may be appropriated by dishonest employees. If bad accounts 
 are carried on the books and adequate provision is made in the 
 reserve, it would seem to have the desired effect in so far as 
 valuation is concerned and still preclude any possibility of writing 
 off an account and having it subsequently collected without a 
 record of the collection being made. 
 
 To pacify ledger clerks, or bookkeepers on underlying ledgers, 
 accounts which are considered bad are sometimes transferred to 
 a suspense ledger. This procedure has the effect of relieving the 
 bookkeeper from including such accounts in his trial balance 
 month after month and still makes it possible to preserve the 
 record of the accounts until they are lost beyond question. Many 
 concerns provide against losses on bad accounts by carrying credit 
 indemnity or credit insurance, in which case a premium is paid 
 the same as in the- case of fire, life or other insurance. 
 
 As an asset a note is apt to be looked upon as better than an 
 account. This opinion is questionable since neither is preferred 
 over the other in bankruptcy proceedings or in liquidation. The 
 main legal difference between a note and an account is that the 
 
 129 
 
Principles of Accounting 
 
 former in effect confesses judgment as to the amount and requires 
 no further proof in this respect, whereas in bringing action to 
 collect on an account all the items making up the account must 
 be proven. Care should be taken to distinguish notes from bills. 
 This distinction is made very clear in the New York negotiable 
 instruments law which requires that the word note shall only be 
 used for the purpose of describing a promissory note, whereas 
 the word bill shall be understood to mean a bill of exchange, either 
 foreign or domestic. A bill of exchange is a draft which in reality 
 partakes somewhat of the nature of a check. It is a request ad- 
 dressed to party number one by party number two to pay a certain 
 amount of money to party number three. If accepted by party 
 number two it becomes in effect a note, except for the fact that 
 it does not usually bear interest. 
 
 Notes may be interest bearing or non-interest bearing. In 
 some cases the note will, for example, call for the payment of 
 $1,000 on a certain date with interest at 6%. In other instances 
 where it is the intention to pay interest on $1,000, instead of such 
 sum being specified in the body of the note, it might call, for 
 example, for the payment of $1,023.59 at a given date. It is im- 
 portant that notes should be scrutinized carefully in this respect 
 on account of the effect which one or the other of these conditions 
 may have upon the treatment of interest. If the balance in the 
 account of a given customer is $1,000, and the customer remits in 
 settlement of the account a note for $1,000 bearing interest at 6%, 
 upon receipt of the note one entry only is necessary; a credit to 
 accounts receivable and a charge to notes receivable. If, however, 
 (he end of the accounting period falls within the period covered 
 by the time stated in the note, then in closing the books, cognizance 
 must be taken of the interest on such note which has run from 
 the date of the note to the end of the accounting period. The 
 entry covering this accrual would consist in charging interest on 
 notes receivable and crediting interest earned on notes receivable. 
 When subsequently the note is paid with interest a somewhat 
 more involved entry becomes necessary. The amount of cash 
 received covers not only the face of the note, but the interest 
 thereon. The amount involved will presumably be greater than 
 the face of the note and accrued interest which was set up at 
 the previous closing date. Therefore the payment in reality in- 
 cludes three things, namely, the face of the note which appeared 
 
 ISO 
 
Current ^lsscts 
 
 among the notes receivable, the amount of the accrued interest 
 which was contained in the corresponding account, and an amount 
 of interest which has as yet received no treatment so far as the 
 books are concerned. Thus to cover such a transaction when 
 cash is charged, the three accounts to be credited are notes re- 
 ceivable, accrued interest on notes receivable, and interest earned 
 on notes receivable. 
 
 Where the face of the note includes the interest, the interest 
 must be credited upon receipt of the note to the interest earned 
 account rather than to the customer. In such an event care must 
 be taken upon closing the books to see that the unearned propor- 
 tion of such interest received in advance is properly set up. If 
 a note for $1,030. dated June 1st and payable six months later 
 appeared upon the books, at closing time provision should be 
 made for the unearned proportion by deferring it to a subsequent 
 period. When the note for $1,030 was received, presumably 
 notes receivable were charged with $1,030, while the customer 
 was credited with $1,000, and interest earned with $30.00. Upon 
 closing the books on June 30th, 5/6 of the interest appears to 
 have been unearned and the proper entry charging interest earned 
 on notes receivable and crediting interest unearned on notes 
 receivable would be in order. 
 
 The notes receivable are usually represented by a controlling 
 account in the general ledger in which at times the accrued inter- 
 est is included. It is thought to be better accounting, however, to 
 use a separate account for such items so that as far as possible 
 the notes receivable account will show nothing but the face of the 
 note. Various forms of subsidiary records are in use for the 
 purpose of carrying notes receivable, but whatever the form it is 
 essential that they shall show the date, amount, when due, rate 
 of interest, and the name of the maker. 
 
 Notes receivable are sometimes discounted. This happens as 
 a rule when the holders are unable to wait for the notes to mature 
 and be paid. The practice is sometimes indulged in for profit 
 where the difference in interest rates is sufficient to warrant it. 
 The taking of notes at 6% and discounting them at 4% will, if 
 the volume of transactions is sufficiently great, produce quite a 
 tidy sum in interest. This cause of notes being discounted is the 
 exception, probably, rather than the rule. The principal reason 
 for discounting them is usually the need for cash. The taking of 
 
 I3i 
 
Principles of Accounting 
 
 a note from a customer will result in a charge to notes receivable 
 and a credit to accounts receivable. If later the note is dis- 
 counted cash will be charged, and off-hand, it may appear that 
 notes receivable would be credited. There would be no objection 
 to this if a note were like merchandise and the transaction were 
 complete with the passing of title. In the case of a note the 
 promise of the customer to pay is supported by the endorsement 
 of the concern which discounts it and in the event of the custom- 
 er's failure to pay the note at maturity, the bank may hold the 
 endorser. The possibility of such an event occurring makes lia- 
 bility in connection with the note a contingency. Hence we 
 speak of the contingent liability for notes receivable discounted. 
 Here then is the objection to crediting notes receivable when 
 cash is charged. The objectors to so doing contend that an 
 account called notes receivable discounted should be credited to 
 show the contingent liability. This contention in turn is met with 
 the objection that the notes physically have passed out of the 
 possession of the company and will in nine cases out of ten never 
 again come into the possession of the company. As a compromise 
 a third method of treatment suggests ignoring each of the above 
 methods in part and making mention of the fact that they are 
 notes receivable discounted and outstanding, with the amount 
 thereof, as a foot note on the balance sheet. 
 
 In the matter of showing notes receivable discounted on the 
 balance sheet there is a choice of three ways. The first is to 
 include on the right hand side of the balance sheet among the 
 current liabilities an item for notes receivable discounted, giving 
 it the effect of an offset to the notes receivable shown on the left 
 hand side among the current assets. The second way is to with- 
 draw from the current assets and show separately on the asset 
 side, below the current assets the amount of the notes receivable 
 which have been discounted, referring in parentheses to the 
 contra account on the opposite side of the balance sheet for notes 
 receivable discounted, which item will appear below the current 
 liabilities. Both of these methods have the effect of showing the 
 contingent liability in the balance sheet proper. The third method 
 is to exclude from both the assets and liabilities the notes receiv- 
 able discounted and refer to them in a foot note at the bottom 
 of the balance sheet. The foot note might read as follows : "Con- 
 tingent liability for notes receivable discounted and outstanding, 
 $10,000." 
 
 132 
 
Current Assets 
 
 The treatment of the interest involved in notes receivable dis- 
 counted demands some little attention. To illustrate this point let 
 it be assumed that there is received from the customer a note for 
 $30,000, due in 90 days, and bearing interest at 6%. The interest 
 on such a note would amount to $450. The note would stand on 
 the books at $30,000, while no entry would be made until the end 
 of the month for the interest. At the end of the month accrued 
 interest on notes receivable would be charged and interest on 
 notes receivable credited. If the notes were to be discounted 
 after 45 days had elapsed from the date of its issue, assuming 
 that the discount were figured by the interest method rather than 
 by the true discount method, there would be received from the 
 bank $30,225. This amount is really divisible into three parts, 
 $30,000, $150 and $75. While the total of the three would be 
 chargeable to cash, $30,000 would be credited to the notes receiv- 
 able account, $150 to the account for accrued interest on notes 
 receivable and $75 to the interest earned on notes receivable. 
 
 A slight variation of these steps would result if the note 
 instead of bearing interest at 6% were to have the amount of 
 interest included in the face. Thus upon receipt, notes receivable 
 would be charged with $30,450, and $30,000 would be credited to 
 the customer and $450 to the interest on notes receivable. At the 
 end of the month interest on notes receivable would be charged 
 and interest unearned on notes receivable credited with $300. If 
 as in the preceding instance the notes were discounted 15 days later 
 and realized $30,225, cash would be charged with $30,225, notes 
 receivable would be credited with $30,225, but an adjustment 
 would be necessary between the notes receivable account and the 
 interest unearned on notes receivable in order to close out the 
 difference remaining in the notes receivable account of $225. This 
 could be most easily accomplished by an entry which would 
 charge interest unearned on notes receivable with $300 and credit 
 notes receivable with $225 and interest on notes receivable with 
 $75. For practice purposes complications may be introduced in 
 both of the above mentioned instances by taking the interest on 
 the notes at one rate and the discount at another rate. It is 
 thought that sufficient time has been given to this topic so that 
 no further illustrations on this point will be indulged in. 
 
 For References for Collateral Reading see page 353 
 133 
 
CHAPTER XXIII 
 
 PATENTS, COPYRIGHTS AND TRADEMARKS 
 
 The topics suggested by the subject of this chapter are fre- 
 quently considered along with goodwill. They seem, however, 
 to be of sufficient importance and so unlike goodwill as to warrant 
 a discussion apart from that subject. It frequently happens that 
 where a concern is taken over by a corporation, the capital stock 
 issued for the net assets of the concern does not equal the value 
 placed upon the net assets. The amount of capital stock may be 
 greater or less than the net assets. Where the capital stock is 
 smaller in amount it need not be considered for the purpose of 
 this discussion. Where it is greater it will give rise to a difference 
 on the asset side. This difference may be absorbed by a revalua- 
 tion of the assets but it is frequently termed patents, copyrights 
 and goodwill. This practice is to be censured unless such assets 
 actually exist and are reasonably worth, in the opinion of the 
 directors, the value thus assigned to them. Goodwill merits sep- 
 arate consideration and will be taken up later. The things of 
 interest concerning patents, copyrights and trademarks are their 
 nature, how much they are worth when they are acquired, 
 whether or not they may increase in value during their existence 
 and how long they may be carried at the original or at the in- 
 creased valuation. 
 
 A patent is an instrument issued by the federal government 
 through its patent office to an inventor, protecting him against 
 the possibility of having some other person make, use, or offer 
 for sale a similar device, machine, manufacturing process, or 
 composition of matter. Patents are issued for a term of seven- 
 teen years and may not be renewed except by an act of Congress. 
 
 A copyright is an instrument issued by the federal govern- 
 ment through a bureau under the control of the librarian of 
 Congress, whereby an author or artist is granted the exclusive 
 right to publish and dispose of his work for a limited time. A 
 copyright runs for twenty-eight years and may be renewed for 
 a period of fourteen years. 
 
 A trademark is an instrument granted by the federal govern- 
 ment to citizens of the United States, who, by registering in the 
 
 134 
 
Patents, Copyrights and Trademarks 
 
 patent office certain designs, insignia, symbols, marks, names, or 
 other characteristic indications whereby their goods are identified 
 and advertised for sale, are protected against the use of same by 
 others. The registering of a trademark carries this protection 
 for a period of thirty years, which may be extended for an addi- 
 tional thirty years. 
 
 The cost of securing a patent, a copyright, or registering a 
 trademark is nominal and bears no relation whatsoever to the 
 value of either of these forms of protection. That they are 
 valuable at times is undisputed. To determine their value is a 
 different matter. In the case of a growing concern which does not 
 contemplate a change of any kind it may be perfectly satisfactory 
 to carry these items at a nominal value or even not carry them 
 at all. If a change in the ownership is about to take place surely 
 as a rule the owners will wish to place a value upon them. It 
 is also possible that even when no such change in ownership is 
 anticipated, the concern owning such instruments may wish to 
 value them. There are two means of accomplishing this pur- 
 pose. One is to place an arbitrary value upon them. The other, 
 which is the more scientific, is to capitalize what may be con- 
 sidered as excess income, or the income attributable to these 
 agencies. For example, a concern, the combined capital and sur- 
 plus of which is $100,000, earns $9,000 per year. It has earned 
 9% upon the investment. Assuming that 6% is the average re- 
 turn on investment in the line of business in which the concern 
 in question is engaged, then it is clear that there is excess income 
 of $3,000, which is to be attributed to some cause or other outside 
 of the normal agencies which produce income. If there are 
 either patents, copyrights or trademarks in existence and in use, 
 what would seem more feasible then than to attribute the excess 
 income of $3,000 to the possession and use of these special as- 
 sets? On this theory the excess income is capitalized at 6% 
 and $50,000 set up as the value of the special assets in question. 
 
 Irrespective of the basis used in valuing patents, copyrights 
 and trademarks, a valuation once placed upon such assets is 
 subject in some events to extraordinary fluctuation. Patents 
 which are effective today may be so closely approximated even 
 without infringement within a short time so as to render the pro- 
 tective feature almost worthless. In a corresponding manner, 
 copyrights while their life extends over a considerable number 
 
 135 
 
Principles of Accounting 
 
 of years, cover as a rule publications, the sale of which is limited 
 and soon over. Thus while the sale of a book might be pro- 
 tected for forty-two years, in a comparatively short time in 
 many instances there is nothing to protect. The value of trade- 
 marks probably continues longer and with greater stability than 
 either patents or copyrights. However, it is not an unusual 
 thing to have the sale of an article damaged by a similar article, 
 sometimes with a trademark just sufficiently different so as not 
 to violate the law, sometimes with a different trademark when 
 the goods are of a cheaper grade or quality and sometimes when 
 the same condition exists without any trademark. For these 
 various reasons it would seem that if assets of this character 
 are set up at all, they should be written down either gradually 
 or within a short space of time. Probably no exception can be 
 taken to the plan of writing them off over the term of years 
 specified by the instrument, but it would certainly seem to be 
 better policy to write them off as rapidly as possible if acquired 
 by purchase and to carry them at a nominal value if acquired by 
 issue. 
 
 A concern which acquires patents by issue has a choice of 
 valuing them and carrying them in three different ways. They 
 may be set up at a nominal value which usually means carrying 
 them at $1.00, at an arbitrary value, or at a value based upon 
 the earning power. Obviously if carried at a nominal value 
 the question of writing them down does not arise. If they are 
 set up at an arbitrary value or on the basis of their earning power, 
 they may be written down or provision made for their depreciated 
 value over a period of seventeen years. This theory is of course 
 based on the fact that they continue in force and effect during 
 this period. 
 
 A condition may arise here, however, which is analogous in 
 its effect to that which a new machine has upon depreciation. The 
 life of a machine may be fixed at twenty years and arrangements 
 made to provide for its depreciation over that period of time. 
 If, however, the type of machine suddenly becomes obsolete and 
 is replaced by a machine of a newer type, then its loss in value 
 becomes suddenly great and the net value which is in reality 
 its book value less what it is worth as scrap must be immediately 
 written off. In the case of machinery, however, it is not always 
 the scrap value which is taken into consideration in fixing a 
 
 136 
 
Patents, Copyrights and Trademarks 
 
 value on the residue, but rather its value as a second hand ma- 
 chine. A machine which would be obsolete so far as its use 
 in the United States Steel Corporation is concerned might be 
 valuable to some manufacturing concern organized on a smaller 
 scale and doing business in some small manufacturing town. 
 If such machines were sold to small concerns the residual value 
 would be the price at which they were sold rather than their 
 scrap value, and in writing them off the sale price would be 
 the amount deducted from the amount to be written off rather 
 than the scrap value. 
 
 The analogy between machines and patents in respect to 
 their valuation is to be considered only up to a certain point. A 
 patent may be effective for seventeen years or it may become 
 ineffective or partially ineffective as a protecting agency at almost 
 any time. Manufacturer "A" may own a very valuable patent. 
 It may entitle him to make, use, or sell some new and useful ma- 
 chine, manufacturing process, or composition of material. Manu- 
 facturer "B" may appear upon the scene with a similar design 
 and although similar, sufficiently different to enable him to se- 
 cure a patent without infringement, which device may be so 
 much more up-to-date and eagerly sought after by the trade as 
 to render practically valueless the patent of manufacturer "A." 
 Even if it does not have the effect of destroying the value of the 
 first mentioned patent, it may make competition so keen as to 
 modify greatly the protective benefits which formerly accrued 
 to manufacturer "A" by virtue of the patent which he held. 
 Thus having carried his patent either at an arbitrary value or at 
 a value fixed by its earning power he is confronted with having 
 to write down the asset either wholly, or in a large measure de- 
 pending upon the extent to which the value of his patent as 
 such has been impaired. There is no residual value in this 
 case as in the case of machines. The patent has no value 
 as scrap and naturally if it is of no value to the present owner 
 it will presumably have no sales value. Thus conservatism 
 would dictate against the policy of attempting to carry patents 
 at arbitrary or scientific values on account of the contingencies 
 which may suddenly arise. 
 
 The above remarks would seem to be equally applicable to 
 copyrights and trademarks. In the latter case, however, there 
 seems to be less possibility of these contingencies arising and 
 
 1 37 
 
Principles of Accounting 
 
 stronger arguments in favor of carrying trademarks at other 
 than nominal values. 
 
 A concern which purchases or acquires patents, copyrights or 
 trademarks from previous owners is in a somewhat different 
 position. Such concerns having acquired these assets in exchange 
 for value may reasonably argue that the value is what such 
 assets cost to acquire. The policy of writing them down will 
 depend of course upon the judgment or desire of the proprietor, 
 but the period over which the depreciation should be spread will 
 be covered in the respective instances by the life of the instru- 
 ment. Obviously he is entitled to spread the depreciation over 
 the life of the respective instrument, but the conservative pro- 
 prietor will write them off as rapidly as the business permits 
 in order to insure himself against any contingencies which may 
 detract suddenly from the value of the assets. 
 
 REFERENCES FOR COLLATERAL READING: 
 
 Patents as a Factor in Manufacturing, Prindle. 
 Science of Accounts, Bentley, pages 199, 200. 
 Accounting Practice and Procedure, Dickinson, page 79. 
 Auditing, Theory and Practice, Montgomery, 129, 130, 337. 
 
 397- 
 
CHAPTER XXIV 
 
 FRANCHISES 
 
 A franchise is an instrument granted by the government to 
 individuals, corporations, or other types of legal organization, 
 giving to such organization the exclusive right to transact specific 
 lines of business within specified limits for a given number of 
 years, or to use certain natural resources of the country, in con- 
 sideration of certain sums of money, payable either all at one 
 time or in installments. In brief a franchise is a contract between 
 the government and some legal type of organization covering the 
 above mentioned rights. 
 
 Franchises may be granted by the federal government, the 
 states, counties or municipalities. The most common purposes 
 for which franchises are granted are steam railroads, street rail- 
 roads, telegraph and telephone systems, water systems, gas and 
 electric light systems, power plants. They may also include the 
 rights to obstruct water ways for reservoir purposes ; the rights 
 to use water falls and in fact the right to use any property which 
 the government owns. 
 
 It would probably not be wrong to include among the fran- 
 chise, rights for minor purposes such as the use of the streets 
 for vending purposes or the right to sell merchandise upon the 
 streets or from house to house. This form of franchise is looked 
 upon in a different manner and the recipient of such right pays 
 what is known as a license. The privilege conveyed upon him 
 in return for the tax which he pays is of a restrictive nature as 
 a rule, and can scarcely be considered as an asset since such 
 rights are usually granted to all persons who are able to pay 
 the license tax. 
 
 The distinguishing feature between a license and a franchise 
 would seem then, to be, that while in the former case the privilege 
 is granted freely to all who apply, whereas in the latter it is 
 granted only to one organization, and thereby resembles a monop- 
 oly. By virtue of having acquired a monopoly the holder thereof 
 is enabled as a rule to make larger profits. It is probable that 
 a vendor selling knickknacks on the street would not consider his 
 license as an asset. He would more properly consider it as ex- 
 
 139 
 
Principles of Accounting 
 
 pense of doing business. On the other hand a street railway 
 company holding a franchise whereby it was permitted to con- 
 struct and operate a system of tracks and cars in and about a 
 given city, would be quite justified in considering the franchise 
 as a very valuable asset. That franchises are considered as val- 
 uable assets which permit the holders thereof to operate to the 
 exclusion of all others is evidenced, by the fact, that, a tax is 
 imposed upon the corporations or individuals holding them. That 
 it is difficult to determine the value of a franchise may be seen 
 from the litigation resulting in the attempt of the State of New 
 York to impose a franchise tax upon certain corporations operat- 
 ing within the state. 
 
 From an accounting point of view the matter of valuation is 
 the principal point to be considered. If the franchise is ac- 
 quired by direct grant it would seem that the matter of determin- 
 ing its value should be decided by what it is worth. It is worth 
 what it will produce in the way of excess income. Such income 
 it would seem should be measured by the monopoly profits which 
 it brings in. To determine the monopoly profits is to compare 
 the total profits in a given case with the normal average profits of 
 a similar type of system. 
 
 Assuming in a given case that the net assets of a corporation 
 owning a franchise are carried at $1,000,000, such net assets 
 being represented by the capital stock and surplus and produc- 
 ing income of $300,000 per annum. It may be further assumed 
 that the income consistent with the kind of organization in 
 question is 10%, or $100,000. Comparison of the normal profits 
 with the profits of the monopoly shows an excess of $200,000, 
 due it may be assumed, to the franchise which the company 
 holds and which amount may be considered as the monopoly 
 profits. If the profit of $200,000 is due to the fact that the 
 company holds a franchise, then apparently the franchise is 
 worth what it will produce in the way of monopoly profits and 
 should be capitalized at $2,000,000, on $200,000, divided by 10%. 
 
 In attempting to capitalize a franchise in this manner care 
 should be taken to consider any amount or amounts which the 
 company has paid or will have to pay for the franchise and 
 the difference only in any case set up as the value of the asset. 
 To illustrate this it might be supposed in the above mentioned 
 case that the company paid $150,000 for the franchise at the time 
 
 140 
 
Franchises 
 
 it was acquired. Under such conditions the $150,000 would be 
 excluded from the net assets when determining their amount and 
 in view of the fact that $150,000 would probably already appear 
 on the books the difference only between such an amount and the 
 new amount should be added. As used above, $1,850,000 would 
 be added to the $150,000 appearing on the books, making the 
 book value $2,000,000. If for example the company were to 
 pay $50,000 a year for the franchise then $50,000 should be de- 
 ducted from the $200,000 before capitalizing it at 10%, so that 
 in this case the franchise would be valued at $1,500,000. 
 
 In both of the above cases the element of time appears and 
 should be taken into consideration in the accounts. A franchise 
 granted for any time less than perpetuity, is theoretically a wast- 
 ing asset. Its value would be affected by the period of time 
 for which it is granted. It is quite plain that a franchise granted 
 for ten years unless renewable, is of no value at the end of the 
 tenth year. A provision therefore should be made for depreciat- 
 ing its value either by writing it down or through the medium of 
 a reserve ; preferably by the latter method. The rapidity with 
 which it is written off will depend upon the life of the fran- 
 chise. 
 
 If a franchise is acquired from a former owner the matter of 
 its valuation may differ from the cases above referred to. Where 
 acquired by purchase rather than by direct grant they may be 
 carried at cost, valued as above indicated, or carried at an arbi- 
 trary value. They are many times treated the same as patents, 
 trademarks, goodwill, etc., and made to represent the difference 
 between the net assets of the old concern and the capital stock 
 of the new concern. This is to be objected to because of the 
 reason that it does not usually represent the fact, but is merely 
 an expedient for making the books balance. Under any cir- 
 cumstance provision should be made for depreciating such as- 
 sets in accordance with the life of the franchise. 
 
 REFERENCE FOR COLLATERAL READING: 
 
 Engineering Value of Public Utilities and Factories, Foster, 
 Chapter XII. 
 
 j''4(t 
 
CHAPTER XXV 
 
 GOODWILL 
 
 In discussing goodwill, it will be necessary to say something 
 about the meaning of the term, the origin of goodwill, its valua- 
 tion, its duration and its disposition. 
 
 By goodwill is meant, that intangible possession or qualifica- 
 tion which is capable of producing recurring income or by virtue 
 of which recurring sales may be made. It is the influence 
 which the proprietor or his organization has upon the purchas- 
 ing public through which he is enabled to attract and retain 
 patronage. In some cases it may be the power of controlling 
 certain patronage. It is that peculiar power of attraction whereby 
 the proprietor causes the buyer to seek him or his place of busi- 
 ness when in the market for the kind of goods which the pro- 
 prietor has for sale. 
 
 Goodwill may be due to one or more of several causes. Pos- 
 sibly the manner of the proprietor or his sales force may be 
 pleasing. Politeness, patience and general efficiency on the part 
 of employees are important factors in the establishment. The 
 uniform quality of goods, variety from which to select, and the 
 privilege of returning goods which are unsatisfactory are all 
 things which appeal to many customers and make them feel kindly 
 towards the merchant. Honest goods and honest prices have 
 built up many a business. Among other contributing causes 
 may be mentioned, easy terms, attractive display of goods, at- 
 tractive advertising, a level of prices slightly under the average, 
 good location, facility with which goods may be found, per- 
 manent location for goods and lastly, general reputation. One 
 of the oldest and largest department stores in New York City 
 is probably not only losing goodwill but gaining ill-will through 
 a recently introduced policy of frequently shifting goods from 
 one part of the store to another. On the other hand, in a city 
 like New York, general reputation has a great deal to do with 
 the promotion of goodwill. A stranger coming to New York 
 to live is undoubtedly influenced by a friend or acquaintance in 
 favor of stores which have reputations for certain things. Most 
 housekeepers in New York will tell you that for general trading 
 
 142 
 
Goodwill 
 
 a certain Fifth Avenue store is unsurpassed, while for muslins 
 a Fourteenth Street establishment stands at the head. 
 
 Measuring goodwill, or placing a value upon it, is a much 
 more difficult task than either defining it, or discussing the causes 
 underlying its creation. The occasions for valuing it are prac- 
 tically three: to reduce the rate of return on capital investment; 
 to dispose of it by sale or consolidation; to give a proper value 
 to an established business before the admission of a new partner. 
 
 In connection with the first, a proprietor with a small capital 
 investment might by means of goodwill be enjoying profits out 
 of proportion to his nominal investment. The ratio of return 
 to nominal capital might be abnormally high. For business 
 reasons it might be to his advantage to increase his capital in 
 accordance with the goodwill acquired and thus decrease the 
 ratio of return to investment. 
 
 In the same manner, a corporation might find it advantageous 
 to reduce the apparent return on its capital stock by setting up 
 goodwill and distributing the surplus arising therefrom through 
 a stock dividend. 
 
 In the second case, a concern about to sell out, to con- 
 solidate with another concern or to incorporate may very justly 
 and reasonably wish to capitalize its goodwill. 
 
 In a similar manner a concern into which a partner is about 
 to enter will undoubtedly value its goodwill before coming to 
 an agreement with the new partner if he purposes buying an 
 interest in the business. 
 
 As to the methods of placing a value upon the goodwill in 
 any case, it must of course be admitted that in many instances 
 the figures representing it show price instead of value. Such 
 price may be fixed at what it is expected the prospective pur- 
 chaser will be willing to pay. This is not placing a value upon 
 it. There are two scientific methods of valuation generally in 
 use. They are widely divergent and the application of the 
 two methods to the same figures produces surprisingly different 
 results. Both have as their basis of calculation what is known 
 as the excess income. 
 
 It is conceded that every proprietor receives a certain normal 
 share of trade in the line in which he is engaged. The normal 
 share is assumed to be that which will yield him the average 
 return on his investment. The average return for the line of 
 
 143 
 
Principles of Accounting 
 
 business in question is perhaps six per cent. Any excess above 
 that, which 6% on the capital, or capital stock and surplus, 
 will produce is attributed to goodwill. 
 
 To illustrate the first method, take as an example The Jones 
 Manufacturing Company, engaged in the retail cloak business 
 with a capital of $1,000,000. Such a concern might be imagined 
 as having profits of $78,000 for the year. By net profits is 
 meant the sum available for distribution as dividends, or the 
 amount to be credited to surplus after every known charge ex- 
 cept dividends has been deducted from the income. Ordinarily 
 perhaps, the capital would be expected to yield but $60,000. The 
 excess of $18,000 is attributable to goodwill and the capitaliza- 
 tion of this amount at the average rate of interest determines 
 the value of the goodwill. More specifically dividing $18,000 by 
 six (6) per cent gives as a result $300,000. It would not be 
 advisable to use the excess income of one year for this purpose 
 since the income might have fluctuated considerably. The aver- 
 age excess income of periods extending from three to five years 
 would seem to be a more conservative basis, although periods less 
 than a year have at times been used. 
 
 The second method while based on the excess net income, 
 proceeds in a manner quite different from the former method. 
 It should be pointed out that the results obtained by the second 
 method would theoretically be of value only where the sale 
 or similar disposal of goodwill was involved and would not serve 
 as a basis for adjusting the rate of return on investment. The 
 factors are, an estimated excess income, recurring annually for 
 an estimated number of years. For example, in the case of 
 The Jones Manufacturing Company, the excess income was 
 $18,000. If it might be estimated that the goodwill could be 
 sold and conserved for a period of ten years, the value would 
 appear to be, ten times eighteen thousand dollars (10 x $18,000) 
 or $180,000. This conclusion is based on the assumption that 
 the goodwill would continue to yield annually for a period of 
 ten years an excess income of $18,000. This is capitalizing, 
 without regard to interest by what is known as the years' 
 purchase method. 
 
 As a means of valuing goodwill this method seems funda- 
 mentally wrong. It looks too much like valuing the estimated 
 productivity of the "hen which lays the golden eggs" without 
 
 144 
 
Goodwill 
 
 giving any attention to the hen. Who would think of saying 
 that the value of a twenty year gold bond of $1,000 paying 
 interest at 6% per annum was $1,200, because there were twenty 
 interest payments of $60 each? On the other hand, who would 
 say that the value of a piece of property estimated to produce 
 $600 per year for the next five years was $3,000? Would it not 
 be more logical to consider such a piece of property worth $6,000 
 since real estate ordinarily nets 10% on the investment? 
 
 If the method were allowed to pass without attack from this 
 standpoint it should be criticized unless scientifically applied. 
 Such application would consist in finding the present worth at 
 x% of an annuity of $18,000 for ten periods. It will thus be 
 seen that at 6% the computation would give as the value of the 
 goodwill an amount of approximately $132,481. 
 
 The duration of goodwill is a variable quantity. To fix the 
 time during which it will continue to produce excess income 
 is a difficult task. Without a change of ownership even it may 
 continue or it may dwindle depending upon the attention which 
 is given to the basic factors upon which it was built. Under 
 new ownership and changed conditions it may be conserved and 
 increase in value or it may be lost in a short time. The chances 
 that its value will not diminish are greater if it is not sold. 
 
 In case of sale it may be of interest to note its treatment 
 from the accounting standpoint of both the vendor and vendee 
 and ultimately its disposition by both. The valuation of good- 
 will having been placed upon it previous to the sale, when the 
 deal has been consummated it loses its identity so far as the 
 vendor is concerned and becomes merely an item in the group 
 of assets upon which the selling price was based. That portion 
 of the amount realized on the sale which corresponds to the 
 goodwill would, in the failure to raise an account on the books 
 of the vendor for goodwill, appear as so much profit arising 
 in connection with the sale. It would probably more nearly 
 represent the facts, in the case of a corporation if two accounts 
 were to be created on the books of the vendor prior to sale, one 
 for goodwill, which would be debited, another for capital sur- 
 plus, which would be credited. Subsequently the capital sur- 
 plus would be apportioned to stockholders, whose holdings would 
 then represent the amount which each should receive upon dis- 
 tribution of the proceeds of sale. 
 
 145 
 
Principles of Accounting 
 
 The vendee is now in possession of an asset in exchange 
 for which he has parted with value no matter what the moral 
 right to carry accumulated or created goodwill prior to sale 
 may be, obviously he is entitled to show same on his books and 
 in his balance sheet. In doing so, however, he is morally bound 
 to show it at its cost to him; that is to say, at the value fixed 
 upon it by the terms of the sale. A corporation is not warranted 
 in setting up an account for goodwill which represents the differ- 
 ence in value between the net assets and the capital stock. For 
 example, in a case where physical assets at an appraised value of 
 $90,000, were taken over subject to liabilities of $10,000 and 
 capital stock in the amount of $100,000 was issued for same, the 
 corporation is not justified in charging the difference of $20,000 
 to an account called goodwill merely for convenience. That this 
 is frequently done may be seen by reference to the balance sheet 
 of almost any large industrial merger where such accounts as 
 "patents, goodwill and franchises" or "trademarks and goodwill" 
 are usually to be found. Such practice has given rise to a dis- 
 tinction being made as between real and nominal goodwill, or 
 "fictitious" goodwill, as the latter is more commonly called. Nom- 
 inal goodwill constitutes one of the elements in corporate organi- 
 zation, which is known as "water." 
 
 As to the disposition of goodwill authorities differ. Most 
 Americans consider it as an asset of diminishing value. English 
 authorities are divided in their opinions ; some of them favor 
 writing it off over a period of years; others advocate its con- 
 tinuance at the cost price irrespective of fluctuations in its value. 
 It is to be borne in mind that it may appreciate in value and the 
 question arises as to whether or not it should be revalued an- 
 nually. The tendency in the value is to decline and the safest 
 policy to adopt would probably be to make provision for a re- 
 serve to offset the item of goodwill, the annual amount of the 
 provision depending upon the number of years which the most 
 conservative estimate would fix as its life. 
 
 REFERENCES FOR COLLATERAL READING: 
 
 Good-will and Its Treatment in Accounts, Dicksee and Till- 
 yard. 
 
 Accounting in Theory and Practice, Lisle, page 134-135. 
 
 Accounts, Their Construction and Interpretation, Cole, pages 
 276-280, 307-310. 
 
 Modern Accounting, Hatfield, Chapter VI. 
 
 Auditing, Theory and Practice, Montgomery, pages 131, 338- 
 630. 
 
 IA.6 
 
Funds 
 CHAPTER XXVI 
 
 FUNDS 
 
 A fund should without exception be understood to mean an 
 asset. We think about funds as meaning cash, but we can 
 no more say that all funds are cash than that all cash belongs 
 to funds except with the introduction of the qualifying state- 
 ment that cash as we have come to look upon it in connection 
 with the balance sheet is a general fund available for the pur- 
 poses of the business. 
 
 Funds are not reserves. A reserve is never a fund. A re- 
 serve may be created for the purpose of measuring or controlling 
 a fund, but it is always in the nature of an accountability. Funds 
 should always be on the left hand side of the balance sheet. 
 Reserves should always be on the right hand side of the bal- 
 ance sheet. A fund is sometimes described as a reserve fund 
 and in fact by some people it is given the erroneous name reserve. 
 A fund may be set aside for certain purposes designated by a 
 reserve. This operation is sometimes known as the funding of 
 a reserve. This, however, does not have the effect of making it a 
 reserve. 
 
 The point, however, upon which emphasis is to be placed is 
 that funds are always assets. They may be classified as general 
 funds and special funds. When used in the first sense, cash in 
 hand or on deposit and available for general purposes, or unre- 
 stricted, cash, is meant. In the second instance the meaning 
 is the exact opposite. A special fund emphatically denotes that 
 such funds are not available for the general purposes of the 
 business and are sacred to the purposes for which they were 
 set aside. It is true of course that when the purpose for which 
 they were intended has been accomplished, any balance remaining 
 may be transferred back to the general cash, whence it pre- 
 sumably came. The use of the term special fund is not intended 
 to include such items as working funds or petty cash funds, these 
 representing merely the setting aside for convenience of a por- 
 tion of the general cash. The classification does embrace, how- 
 ever, sinking funds, special funds such as were set aside by the 
 ^as companies in compliance with the ruling of the court in 
 
 147 
 
Principles of Accounting 
 
 the matter of 80 cent gas, pension funds, emergency funds for 
 accidents and illness of employees, insurance funds and con- 
 tingent funds, etc. 
 
 The basis upon which funds are created will depend upon 
 the circumstances. At times they may be accumulated by the 
 arbitrary setting aside of fixed amounts periodically. They may 
 be accumulated by the setting aside of arbitrary amounts varying 
 in size from time to time. They may be created by setting aside 
 a fixed sum for a given purpose like the amortization of some 
 indebtedness, as in the case of a sinking fund for the purpose of 
 paying off bonds at maturity, where the terms governing the set- 
 ting aside of the sum are prescribed by the instrument of indebt- 
 edness. 
 
 In cases like the emergency fund and contingent fund above 
 mentioned it is probable that the amounts would be set aside 
 spasmodically or at the convenience of the business. Funds such 
 as the public service gas fund would be regulated by the rapidity 
 with which collections were made from customers. Such a 
 fund would accumulate automatically. Insurance funds would 
 probably be set aside semi-annually or annually and the amount 
 would be determined by the premiums which the concern would 
 be obliged to pay to the insurance company in order to carry 
 adequate insurance on the property. Sinking funds on the other 
 hand would accumulate by the setting aside periodically of fixed 
 amounts, sometimes monthly, sometimes quarterly, sometimes 
 semi-annually and sometimes annually. The periods and amounts 
 are usually fixed by the mortgage which secures the bond. The 
 sinking fund deposit might be determined by the term of the 
 bond and the amount necessary to liquidate the liability at ma- 
 turity prorated over the life of the bond. Another manner of 
 accumulating the sinking fund is to set aside semi-annually or 
 annually such a sum as will at compound interest amount at 
 maturity to the face of the bond. 
 
 In all cases where funds are involved there is also the ques- 
 tion of interest and the question becomes, whether the interest 
 attaches to the fund or whether to the general cash, thereby 
 becoming available for general purposes. The earnings from 
 funds are usually credited to income. The alternative is to 
 credit them to a reserve account. If they are credited to income 
 it has the effect of making the complimentary asset available for 
 
 148 
 
Funds 
 
 general purposes. If they are treated as a reserve it prevents 
 the use of the asset for current purposes. In the case of straight 
 funds, it is thought to be better unless otherwise provided to 
 credit the income from the funds to the operations and make 
 the interest received available for general use. Where the in- 
 terest received is to be made a part of the new deposit for sinking 
 fund purposes, obviously the income should be credited to a re- 
 serve. The effect, however, is the same as creating a reserve for 
 a sinking fund out of earnings, since the reserves ultimately 
 revert to the surplus. 
 
 To illustrate the creation of sinking funds by the scientific 
 method and show the relation which the interest earning bears, 
 let it be assumed that the American Cigar Company issued on 
 January 1st, 1908, bonds to the amount of $1,000,000, payable 
 January 1st, 1910, with interest at 6%, payable semi-annually. 
 Let it be further assumed that the bonds provide for a sinking 
 fund to be accumulated by semi-annual deposits for the purpose 
 of liquidating the bonds at maturity and that the interest allowed 
 by the depository on sinking fund deposits is 2%. The two 
 questions which present themselves are, first, what amount shall 
 be deposited in the sinking fund semi-annually, and second, what 
 disposition shall be made of the earning which attaches to the 
 interest on the sinking fund deposits. 
 
 The amount to be accumulated for liquidation purposes is 
 $1,000,000. The periods involved are four, since the deposits are 
 made semi-annually. With regard to the sinking fund payments, 
 there must first be determined what amount or annuity must be 
 deposited at the end of each period of six months, so that at the 
 end of two years the accumulation of deposits and the interest 
 thereon will amount to $1,000,000. No attempt will be made 
 herein to explain the formula whereby the proper amount is 
 arrived at, since tables showing the amounts are always available 
 for use. If information as to the formula is desired, Sprague's 
 tables of compound interest may be consulted. These tables show 
 that the amount to be deposited at the end of each of the four 
 periods is $242,623.75. This amount if deposited four times 
 would result in an aggregate of $970,495. This noticeably is 
 less than $1,000,000, and the difference of $29,505 is presumably 
 made up of the interest on the deposits. The first question which 
 will probably arise in the mind of the reader is whether the de- 
 
 149 
 
Principles of Accounting 
 
 posits begin on January ist, 1908, or on June 30th, 1908, and in 
 order to have this clearly established a study of the following 
 computations will prove beneficial. 
 
 $242,623.75 
 .02 
 
 $4,852.4750 
 242,623.75 
 
 $247,476.2250 
 242,623.75 
 
 099.9750 
 .02 
 
 $9,801.999500 
 490,099.975 
 
 901 .974500 
 242,623.75 
 
 $742,525.724500 
 .02 
 
 $14,850.51449000 
 742,525.7245 
 
 $757,376-23899000 
 
 First deposit, June 30, 1908 
 Interest to January 1, 1909 
 
 Fund, January i, 1909 
 
 Second deposit, January 1, 1909 
 
 Interest to June 30, 1909 
 
 Fund, June 30, 1909 
 
 Third deposit, June 30, 1909 
 
 Interest to January 1, 19 10 
 
 242,623.75 
 
 Fourt 
 Fund, 
 
 h deposit, January. 1, 19 10 
 
 $999,999.98899000 
 
 January i, 19 10 
 
 Interest 
 
 
 Deposits 
 
 $4,852,475 
 9,801.9995 
 14,850.51449 
 
 
 $242,623.75 
 4 
 
 $970,495.00 
 
 $29,504.98899 
 
 Deposits $970,495 . 
 
 Interest 29,504. 98899 
 
 Fund $999,999 . 98899 
 
 From the above it will be noted that the first deposit was on 
 June 30, 1908. The amount deposited at that time bore interest 
 
 *5° 
 
Funds 
 
 at the rate of 2% from June 30, 1908, to January 1, 1909, at 
 which time there was added to the original deposit, a second 
 deposit in a similar amount and the interest for the six months 
 just past. The aggregate of these amounts then became a new 
 principal, which in turn bore interest at 2% for the six months 
 ended June 30, 1909, and so on throughout the period of time 
 covered. If the various amounts of interest which accrued on 
 the deposits are segregated from the computation they will be 
 seen to amount to $29,504.98 and a fraction, which practically 
 agrees with the amount of interest determined by deducting four 
 times the sinking fund deposit from $1,000,000. 
 
 The fund it will be noticed was derived from two sources, 
 one die general cash of the company, the other, the interest paid 
 by the depository. The deposits made by the company were 
 charged to the sinking fund and credited to general cash. The 
 interest was reported by the sinking fund simultaneously with a 
 credit to an interest earned account. The disposition of the 
 interest earned account now becomes the subject for discussion. 
 There are of course three possibilities. 
 
 The first is to take it into the earnings of the company as 
 other income. This procedure seems objectionable because of 
 the reason that the cash corresponding to the earning is included 
 in the sinking fund and on account of being applied in part 
 to the liquidation of the bonds outstanding it is not available for 
 general disbursement. 
 
 The second possibility is that of crediting it to a reserve ac- 
 count for interest on sinking fund. This account would grad- 
 ually accumulate a credit balance until at the end of the second 
 year it showed $29,505. At the time the bonds were liquidated 
 the reserve would apparently be liberated and would revert to 
 surplus. Thus it is difficult to see what, if any, purpose has been 
 accomplished by accumulating this reserve. 
 
 The third possibility is that of crediting the interest earned to 
 the interest paid account. It is to be remembered that these 
 bonds bore interest at the rate of 6%. In other words, the com- 
 pany paid for the use of $1,000,000 for a period of two years, 
 $120,000. By virtue of having put aside in a sinking fund stipu- 
 lated amounts from time to time, the company has been deprived 
 of the use of the money, which, however, has earned $29,505. 
 It would thus appear that the expense to the company for the 
 
 15* 
 
Principles of Accounting 
 
 proceeds of the bonds actually available for use should be de- 
 termined by an amount representing the difference between the 
 interest paid on the bonds and interest received on such funds. 
 If this application of the earnings were made to the interest paid 
 for the use of the money, the expense to the company would 
 be $90,495. This last method it must be admitted seems the 
 more logical and equitable. 
 
 The relation of sinking funds to reserves will be discussed in 
 the chapter dealing with reserves. 
 
 REFERENCES FOR COLLATERAL READING: 
 
 Accounts, Their Construction and Interpretation, Cole, pages 
 87-89. 
 
 Science of Accounts, Bentley, pages 178-180. 
 
 Auditing, Theory and Practice, Montgomery, page 136. 
 
 Accounting Practice and Procedure, Dickinson, page 148. 
 
 Journal of Accountancy, Vol. VI, pages 394-439; Vol. VII. 
 pages 58, 185, 406. 
 
 Modern Accounting, Hatfield, Chapter XIV. 
 
CHAPTER XXVII 
 
 DEFERRED CHARGES TO EXPENSE 
 
 The items in this group are variously referred to as deferred 
 assets, deferred debits, deferred charges to operations and de- 
 ferred charges to expense. They have also been referred to as 
 "assets by courtesy." Rather more stress should be laid on the 
 nature of these items and their significance than the name by 
 which they are designated. If we are to be precise we shall 
 probably call them deferred charges to expense, since this term 
 seems most accurately to describe them. They are expense items 
 wherein the act of charging them to expense accounts, which 
 accounts will be in turn closed out to profit and loss has been 
 deferred to a subsequent period giving to them the effect of as- 
 sets. This group comprises insurance, taxes, rent, advertising, 
 organization expense, development expense, moving expense, etc. 
 
 It is quite usual to look upon these items as in the nature of 
 prepaid expenses. They may be prepaid in many cases. How- 
 ever, it should be pointed out that the matter of prepayment does 
 not enter into the proposition. They are to be considered as 
 assets if the corresponding liability has been taken up whether 
 or not it has been paid. There is no uniform rule for handling 
 them, neither is there any uniform rule for writing them off. In 
 some instances such as insurance, taxes, rent and advertising, the 
 period which they cover is defined. In other cases such as or- 
 ganization and development expenses the period covered is unde- 
 fined and must be arbitrarily fixed. They are usually pro- 
 rated over a period of time, but there are cases where their valua- 
 tion is governed by circumstances such as whether the concern in 
 question is a going concern or one about to be wound up. 
 
 There are two ways of handling deferred charges to expense. 
 One is to provide in each case two accounts, one for assets and 
 one for the expenses, and sometimes a third account for the 
 reserve. At the time of closing the books the asset account is 
 either written down to the expense account or the expense ac- 
 count charged and the reserve account credited. The other 
 method consists in treating them as the expense accounts. At 
 closing time the balance of the unexpired assets is treated as 
 
 153 
 
Principles of Accounting 
 
 an inventory and applied to the expense account thereby convert- 
 ing it into an asset through the inventory, which is brought down 
 while the balance in the account is closed out to profit and loss. 
 The first named method is the clearer of the two and is to be 
 preferred. It is clean cut at all times and greatly facilitates effi- 
 cient work. 
 
 With regard to insurance the amount shown as the asset is 
 the premium on the policy. It matters not whether the pre- 
 mium has been paid so long as the invoices for same have been 
 received and the amount is included among the liabilities. Here 
 the period covered is defined by the policy. It may be for three 
 years, or for one year or a shorter period of time. Arrangements 
 should be made to write off the premium over the life of the 
 policy charging to each period's operations or expenses its pro- 
 rata share. For example, if on January 1st a company insures 
 some of its property and the premium on the policy is $1,200, 
 there should be charged off to expense each month $100. It 
 is not customary in the case of insurance to create a reserve. 
 The preferable method is to charge expense or insurance and 
 credit insurance premiums or unexpired insurance as the title 
 of the account appears. 
 
 The procedure is comparatively simple in the ideal case just 
 mentioned. It would become somewhat more complex when 
 there are a great many policies in force covering different periods 
 and maturing at different dates. There is not much help for 
 this complication if the company closes its books monthly, quar- 
 terly or semi-annually, but it may be avoided if the books are 
 closed but once a year by arranging to have policies written for 
 one year or fractions thereof and having them all expire, for 
 example, on the 31st of December. This last mentioned practice 
 is somewhat helpful even when policies are written for periods 
 greater than a year. 
 
 In many concerns the question of insurance is of sufficient 
 importance and the policies so numerous as to warrant the keep- 
 ing of an insurance register wherein the policies are entered with 
 their descriptions and columns are provided so that the amount 
 of the premium can be prorated and the amount corresponding 
 to each month shown in the appropriate column. Thus it be- 
 comes possible to determine by footing up the various columns 
 the amount for all premiums chargeable to expense each month. 
 
 154 
 
Deferred Charges to Expense 
 
 Care must be exercised in this as in other cases to see that 
 cancellation and return premiums are properly prorated and 
 deducted. This is very often accomplished by using red ink and 
 making the entries either above or below the original entries. 
 
 The question of cancellation brings to mind the basis upon 
 which such cancellations are made. A premium of $1,200 cover- 
 ing insurance for a year, if cancelled at the end of six months will 
 not result in a refund of $600, although such would seem reason- 
 able. The insurance company considers that it is entitled to a 
 higher premium for carrying a policy six months than for carry- 
 ing it a year. Accordingly if a policy as above mentioned were 
 cancelled at the end of six months the company would only 
 allow what is termed the short rate, and which in the case of 
 the policy in question would be $360. Short rate tables are 
 issued by the National Board of Fire Underwriters and show 
 the short rates on amounts from $1.00 to $1,000 for periods 
 up to twelve months. 
 
 The question may be asked after the above statements, "Is it 
 proper and consistent to carry the unexpired insurance on the 
 pro-rata basis?" The point is perhaps debatable. If it is true 
 that after one-half the period covered by the premium has ex- 
 pired and the company will not return the other one-half if the 
 policy is cancelled, then the unexpired proportion would seem 
 not to be worth one-half of the amount paid, but a somewhat 
 smaller amount. In order to substantiate this valuation it is 
 necessary to introduce the everlasting hypothetical question, 
 "what would the policy be worth if the company were to cancel 
 it?" Were the "if" in this case to be considered the policy 
 should undoubtedly be valued on a short rate basis. In view of 
 the fact that the company expects to use the insurance and not 
 cancel the policy, the expense of the policy will be proportionately 
 less on account of the long time and the unexpired proportion 
 worth more. Practice dictates the use of the latter method. 
 
 There is one expection to the foregoing rule of which cog- 
 nizance should be taken. It will be noticed that mention was 
 made of the fact in the preceding paragraph that the company 
 expected to make use of the insurance, which reason was given 
 for justifying the prorating of the premium. Where a concern 
 is in bankruptcy or about to go into liquidation or any situation 
 arises in which the unexpired insurance will not be used, then 
 
 iS5 
 
Principles 'of Accounting 
 
 the unexpired proportion might very properly be valued on the 
 short rate basis. 
 
 The amount of premiums paid by companies carrying large 
 amounts of insurance becomes so great at times as to warrant 
 their taking the risk themselves and instead of paying the pre- 
 miums to the insurance companies depositing them in a fund out 
 of the accumulations of which any replacements of property 
 destroyed by fire may be made. This has the effect of carrying 
 the risk instead of placing it upon an insurance company and 
 is often practicable where the possibility of destruction through 
 fire is small. It means many times a saving of money to the 
 company and the procedure may be a highly successful one. 
 There is always the danger, however, of a conflagration, in which 
 case it will be wished with regret that the property had been 
 insured in a company able to stand the loss. 
 
 There is not much to be said concerning taxes and rent. 
 They are understood to be items either paid in advance or the 
 liability for which has been acknowledged. They should be 
 written down over the period which they cover. • Care should 
 be taken in the case of taxes to observe the effect which the 
 tax bill has, at the time of its receipt, upon the expense and 
 accrual accounts. 
 
 Assuming a tax bill for the year ended December 31st amount- 
 ing to $600 to have been received on the 15th of October and 
 to have been entered in the voucher register but to be unpaid 
 at October 31st. If the taxes had been accrued monthly on 
 the basis of $600, upon closing the books at October 31st there 
 would have been charged to the expense account for taxes $500 
 and a credit in an equal amount made in the taxes accrued. The 
 question may now be asked, how should the tax bill be treated 
 in the books at October 31st? Taxes for the year are due the 
 first week in October, therefore if the bill is taken up for the 
 full amount, taxes for two months, will at October 31st, have 
 been for all practical purposes prepaid. Without question the 
 liability will be $600, and the prepaid proportion will amount to 
 $100. If the bill for $600 were to be charged to taxes paid in 
 advance and credited to accounts payable there would be a double 
 liability by virtue of the fact that $500 had already been accrued. 
 To prevent this possibility when the credit for $600 was made to 
 accounts payable the charge should be divided; $500 should be 
 
 156 
 
Deferred Charges to Expense 
 
 charged to taxes accrued and $100 to taxes paid in advance. Sub- 
 sequent to October 31st the account for taxes paid in advance 
 should be written down to taxes in equal monthly installments. 
 
 Advertising is somewhat different from the above mentioned 
 items. The question to be decided and which bears on the 
 writing down of the asset seems to be rather the rapidity with 
 which the advertising is used than the period covered. A con- 
 cern which paid for advertising in advance to the extent of 
 $96 would be justified in carrying that amount as an asset until 
 the advertising was used, the fact that a year was the period 
 covered by the contract would have no bearing on the matter. 
 It is true that the copy might be spread over a year in twelve 
 numbers, in which case one-twelfth of the amount paid would be 
 written off monthly. If, on the other hand, the $96 was for one 
 page of space there would be no reason why the amount should 
 be written off except as space up to one page was used. In 
 any of these cases the entry would consist in charging advertising 
 expense and crediting advertising prepaid. 
 
 Organization expense and development expense are of much 
 the same nature. A pile of bricks lying by the side of the road 
 has not much significance. If an architect draws plans for a 
 house and the bricks through the application of careful plan- 
 ning and labor are worked into a house, there will not be much 
 question about the propriety of charging to the cost of the 
 house the fee that is paid to the architect for preparing the 
 plans and supervising the work of construction. Neither will 
 the expense of directing the labor, organizing and superintending 
 the work of construction be objected to as not properly included 
 in the cost. All of these items have added to the value of the 
 bricks. As component parts none of the elements were worth 
 as much as when they became organized into a structure. 
 
 Consequently there is no more reason why the expense of 
 organizing a corporation or any other company should be ob- 
 jected to as not adding value to the organization. The benefits 
 to be derived from the organization of a corporation extend over 
 a period of years. The benefits do not inure entirely to the 
 first year. It may almost be said that they extend over the life 
 of a charter in the case of a corporation. There is no fixed 
 rule as to the extent, nor is there any fixed rule as to the term 
 of years over which they should be spread. Ultra-conservative 
 
 157 
 
Principles of Accounting 
 
 corporations where the profits immediately after organization are 
 large, charge them off against the first year's profits in order to 
 be rid of them. Other organizations spread them over a period 
 of five years; some over ten years and some even as long as 
 twenty years. It is probable that ten years is the average. Or- 
 ganization expenses will consist of various items, such as com- 
 pensation and expenses of officers or stockholders prior to in- 
 corporation ; legal and other expenses incident to the organization. 
 The account sometimes includes the bonus paid to promoters. 
 The amount as ultimately determined should be written down 
 over the term fixed by the officers or directors, by charging or- 
 ganization expense written off and crediting organization expense. 
 The same thing can be accomplished by charging organization 
 expense written off and crediting reserve for organization expense. 
 The latter is perhaps to be chosen because of the fact that it per- 
 mits the original asset to stand, thus showing at all times what 
 the expense of such organization was. When the reserve equals 
 the asset one may be closed out against the other if desired. 
 
 Development expense is usually found in connection with 
 mining companies where it is treated in a manner similar to that 
 described above in connection with organization expense. 
 
 Moving expense is sometimes found as a deferred charge. 
 This may happen where it becomes advisable for a plant to move 
 from one place to another and it is thought that the benefits 
 resulting from the change of location are sufficiently great to war- 
 rant the expense thereof being charged to a deferred account. It 
 is thought few concerns will be found which capitalize this item, 
 for the reason that they are less justified in deferring the charge 
 on an expense of this kind than in almost any other case imag- 
 inable. 
 
 REFERENCES FOR COLLATERAL READING: 
 
 Journal of Accountancy, Vol. VIII, page 401. 
 
 158 
 
CHAPTER XXVIII 
 
 CONSIGNMENTS 
 
 The whole subject of consignment must for the purpose 
 of discussion be divided into two parts, namely, consignments 
 received and consignments shipped. A consignment may be 
 defined as goods delivered by the party of the first part to the 
 party of the second part for the purpose of sale by the party 
 of the second part for account of the party of the first part. The 
 party of the first part is known as the consignor. The party of 
 the second part is known as the consignee. In dealing with 
 the subject it must be looked at from two points of view, first, 
 that of the consignee and, second, that of the consignor. 
 
 In treating the subject of consignments from the point of 
 view of the consignee there must be considered the consignment 
 invoices, the books to be kept, the procedure which the account- 
 ing follows and the manner of showing the accounts both on the 
 books of the consignee and upon the balance sheet. All of these 
 will depend upon several things. 
 
 A consignment invoice will at times take two distinct forms, 
 depending largely on whether or not the sales prices of the goods 
 have been agreed upon by the two parties. If there has been 
 no agreement as to the sales prices it is probable that the goods 
 will be invoiced as so many units without any accompanying 
 price and consequently without any value. If there is an agree- 
 ment as to the prices the invoice may show the prices and the 
 value resulting or it may show merely the quantities without 
 prices and value. 
 
 It may be of interest before discussing the subject further 
 to trace an invoice of consigned goods from the time of their 
 receipt until such time as they are sold and accounted for. Upon 
 receipt of the goods there is the possibility that the consignee will 
 be obliged to pay certain charges for freight, insurance, cartage 
 and possibly duty. Whether these charges are to be borne by 
 the consignee or the consignor will depend upon the contract 
 between the two parties and would seem unimportant to the 
 discussion at this moment. The goods will be put in stock and 
 subsequently sold. In connection with their sale there may be 
 
 -59 
 
Principles of Accounting 
 
 expenses such as outward cartage and freight, trade discount, 
 allowances and in some cases cash discount.- At the end of the 
 month or at some intervening date the consignee will render to the 
 consignor an account for the goods sold, which is technically 
 known as an account sales. Such an account will show the 
 gross sales less the charges or expenses which are to be borne 
 by the consignor, together with a further deduction which has 
 been agreed upon for the commission to the consignee, and as a 
 balance closing the statement the amount which the consignor 
 is entitled to receive. 
 
 Two main questions are presented. The first one is whether 
 cognizance shall be taken in the accounting, of the consigned 
 goods from the time they were received. The second one is 
 whether no attention shall be given to the goods so far as 
 their effect upon the general accounts is concerned until such 
 time as they have been sold and accounted for. In discussing 
 the first question the invoice will have to be taken into considera- 
 tion. The procedure is somewhat simplified if the consignment 
 invoice shows the price at which the goods are to be sold. It 
 becomes more difficult if no prices are given in the invoice. In 
 such an event prices must be placed upon the goods in order to 
 establish a basis for the accounting. These must needs be arbi- 
 trary figures because of the reason that where prices are not 
 shown there is the possibility that the goods will not be sold at 
 fixed prices and the price may vary in accordance with the extent 
 to which competition exists in the trading. 
 
 To illustrate this point a consignment of motor cycles may 
 be received without any price being shown on the invoice. The 
 understanding may be that they are to be sold for $250, with, 
 however, the qualification that they may be sold for more or less. 
 To take them up at time of receipt means that they must be 
 priced at $250 and carried in the accounts at such figure. If 
 perchance they are not sold at $250 then the original pricing must 
 be adjusted and the corresponding accounts affected also ad- 
 justed. If, however, the price is fixed and the consignee has no 
 discretion in selling the goods this difficulty is overcome. 
 To summarize briefly the foregoing and to afford a basis for 
 further discussion it may be said then, that goods received on 
 consignment may be taken up at the time of receipt or at the time 
 of accounting regardless of whether prices are or are not shown 
 
 160 
 
Consignments 
 
 on the invoice and that if not shown the goods must be tempo- 
 rarily priced at a figure which may or may not require adjustment 
 in accordance with the agreement by the two parties. 
 
 The question of books will depend largely on whether the 
 goods are to be taken up at time of receipt or at time of sale. 
 To illustrate the procedure in these two cases, let the following 
 be considered : first, as to goods taken up in the general books 
 at the time of their receipt. The invoice may be considered as 
 covering ten motor cycles priced at $250, with the value of $2,500 
 attached. The bookkeeping operation will consist in charging 
 an account called consignments or consignments received and 
 crediting an account with the consignor. This process would not 
 differ from the treatment of the ordinary purchase invoice except 
 that the credit account should be designated in some way to 
 show that it is not a liability account. The invoice would be 
 entered in the purchase journal or voucher record. If controlling 
 accounts are kept the credits to consignors should be entered in 
 a separate credit column or marked in some way for the purpose 
 of facilitating their elimination at the end of the month from the 
 total column in order that such amounts will not be included in 
 the credit to the controlling account for accounts payable. Where 
 consignments are numerous they will usually be put through the 
 purchase journal or voucher record. If they occur infrequently 
 they may be taken up through the general journal charging 
 consignments and crediting the individual account with the con- 
 signor. 
 
 Next would come any charges for inward freight, cartage 
 or insurance. As before stated these charges may be stood by 
 the consignor or consignee depending upon the contract, but pre- 
 sumably by the consignor. In the instance in hand let it be as- 
 sumed that such charges amount to $20. The consignee upon 
 paying these charges or upon taking up a liability for them would 
 instead of charging his own freight and cartage account charge 
 an account called "freight, cartage, etc., on consignments." 
 
 Upon the sale of the goods the consignee would issue a sales 
 invoice to his customer. The customer would be charged, but 
 instead of the amount corresponding to the invoice being credited 
 to the general sales account of the consignee it would be credited 
 to the asset account for consignments. In concerns where a mixed 
 business is conducted the sales of consigned goods are segregated 
 
 161 
 
Principles of Accounting 
 
 from the sales of owned goods by having a separate column foi 
 same in the sales book. 
 
 It might be assumed in this instance that the motor cycles 
 were sold for $2,500, the fixed price. The terms to the customer 
 might provide for a trade discount of 10% and a further dis- 
 count of 2% from the net amount for cash in 10 days. The 
 trade discount would amount to $250. The cash discount will be 
 determined later. It might also occur that the customer would 
 make a claim for allowance of $10 for certain defects in one of 
 the wheels and $15 for freight which he had paid on account 
 of the wheels having been shipped to him collect. Assuming 
 these allowances to be made the customer will without question 
 have to be credited in corresponding amounts and the accounts 
 to be charged when the customer is credited will depend upon 
 the terms of the contract as to whether the charges are to be 
 sustained by the consignee or consignor. Since the consignee is 
 acting purely in the capacity of an agent transacting business 
 for the consignor in return for a commission it is probable in 
 most cases that the charges will be sustained by the consignor. 
 Thus the item charges mentioned would be charged respectively 
 to allowances on consignments and delivery charges on consign- 
 ments. If the reverse conditions existed these items would be 
 charged to the respective general accounts of the consignee and 
 would affect his expense of doing business. 
 
 Looking at the customer's account it would be seen that it 
 was charged with $2,500 and credited with three items, namely, 
 $250 for trade discount, $10 for allowances on account of defec- 
 tive goods and $15 for delivery charges. The net debit balance 
 in the account would be $2,225, which if subject to a cash dis- 
 count of 2%, would be further reduced in the amount of $44.50. 
 
 Up to this point the account with a consignor has not been 
 affected since the original credit of $2,500. This amount repre- 
 sents the gross figure which must be accounted for to the con- 
 signor by the consignee. The goods having been sold the agent 
 is now liable to his principal for the proceeds of sale. In order 
 to determine the extent of this liability the consignor's account 
 must be adjusted by the various charges for freight, discount, al- 
 lowances, etc., and the commission which the agent is entitled 
 to for his services in selling the goods. The commission is 
 probably without exception figured on the gross selling price, 
 
 162 
 
Consignments 
 
 which may have been predetermined or fixed by the actual sale. 
 If in this case the agent is to receive a commission of 5%, such 
 commission would amount to $125. 
 
 In attempting to determine the liability to the consignor's 
 several accounts, which are in the nature of offsets to the $2,500 
 originally credited to the consignor's account, must be closed out 
 and charged against it. These items are inward freight on con- 
 signments $20, trade discount $250, allowances for defective 
 goods $10, delivery charges $15, cash discount $44.50. The 
 consignor's account would also further be subject to a charge of 
 $125 for commission. It is to be borne in mind that when 
 this commission is computed and charged against the consignor 
 a commission earned account will be credited with $125. This 
 as will be seen later constitutes the agent's earning or income 
 in connection with the transactions. The customer's account will 
 presumably have been closed by a credit of $2,180.50, which 
 will have been charged to the agent's cash account when credited 
 to the customer. 
 
 If we may look now at the consignor's account we shall find 
 it credited with $2,500 and charged with several items aggregat- 
 ing $464.50; a net balance of $2,035.50. This amount repre- 
 sents the liability of the agent to his principal, and its treatment 
 at this point may be considered for a moment from a purely 
 technical point of view. Originally it existed as an accountability. 
 It has now been transformed into a liability and the question to 
 be decided is whether or not the balance of $2,035.50 shall be 
 allowed to stand in the account and the account closed by a 
 charge in a similar amount when the cash is paid over to the 
 consignor, or whether the account shall be closed by a charge of 
 $2,035.50, transferring the balance to a liability for accounts 
 payable. Technically the latter method is the more correct. Prac- 
 tically the first mentioned method may be more convenient and 
 no objection can reasonably be raised to its use where the transac- 
 tions pertaining to the consignment are complete. An objection 
 to this method does arise, however, where the transactions are 
 not complete or where a partial accounting for goods sold becomes 
 necessary. It will probably be apparent where such conditions 
 exist that the balance in the account represents a mixed situa- 
 tion, namely, one of accountability and one of liability. Where 
 this occurs there will probably be no question about the desirabil- 
 
 163 
 
Principles of Accounting 
 
 ity of transferring the completed portion to a liability account 
 and closing same out subsequently through a debit at the time 
 the cash is paid. 
 
 If we are now to go back for a moment and look at the 
 accounts we shall find a debit balance of $2,180.50 in the cash 
 account representing the cash received from customers and credit 
 balances in the consignor's account and the commissions earned 
 account, amounting respectively to $2,035.50 and $125. If now 
 settlement is had with the consignor he will receive a check for 
 $2,035.50, thus closing his account and there will be a correspond- 
 ing credit to the cash of $2,035.50 resulting in a debit balance 
 in the latter account of $145. At this point two accounts per- 
 taining to these transactions will be open, namely, cash and 
 commissions earned. To analyze the balance in the cash ac- 
 count of $145 it is found to be made up of two items, one of 
 $125 representing the commission earned by the agent and $20 
 representing the amount advanced by the agent on account of 
 inward freight and for which he has been reimbursed by a de- 
 duction in settlement with the consignor. 
 
 It sometimes happens where there are numerous accounts 
 with the consignors and partial settlements are made, that the 
 accounts with the consignors are allowed to reflect both the ac- 
 countability and the liability until the books are closed, when 
 such portions of the accounts as are ready for settlement are 
 taken out of the consignors accounts and transferred to corre- 
 sponding liability accounts. This facilitates somewhat the prep- 
 aration of the financial statements in that it makes it possible to 
 show on the balance sheet the distinction between accountabilities 
 and liabilities. 
 
 In the case of consignments taken up at the time of receipt 
 where the invoices are not priced, there will be no variation of 
 the above described procedure except in so far as the value at 
 which the consignment is carried. No price being shown on the 
 inventory there are two possible variations which may need to 
 be explained. In the case just illustrated the goods were taken 
 up at $2,500. The two possible variations to be examined are 
 first the assumption that a value of $200 had been placed upon 
 each wheel and second that a value of $275 had been placed 
 upon each wheel. In the first instance the consignment account 
 would have been charged with $2,000 and the consignor's account 
 
 164 
 
Consignments 
 
 credited in a similar amount. Then if it is to be assumed that the 
 wheels were actually sold on a basis of $250 each, or $2,500, there 
 will be seen that two accounts must be adjusted in order to keep 
 the books in balance and make the accounts truthfully record 
 the transactions. Since the consignment account has been charged 
 with only $2,000 and the consignor's account credited with $2,000 
 upon sale of the wheels for $2,500, the adjusting entry neces- 
 sarily would consist in charging the consignment account with 
 $500 and crediting the consignor's account in an equal amount. 
 If, on the other hand, a value of $275 each had been placed upon 
 the wheels the consignment account would have been charged 
 with $2,750 and the consignor's account likewise credited. If 
 again these wheels were sold on a basis of $2,500, it would be 
 noted that the consignment account as well as the consignor's 
 account was originally charged and credited respectively with 
 $250 too much and an adjusting entry charging the consignor 
 with $250 and crediting the consignment account with the same 
 amount will consequently be necessary. 
 
 The other general proposition concerning the treatment of 
 consignments involves their disposition when they are not taken 
 up until time of sale. Under these circumstances no entry is 
 made in the general or financial books at the time of their receipt. 
 They are carried on a memorandum book or stock record which 
 has nothing whatsoever to do with the financial accounts. They 
 are not considered at all in such accounts until they are sold. 
 The only possibility in connection with them which will require 
 an entry on the general books is when any charges are paid or 
 advances or charges are made against the consignor by the agent 
 As example of this there may be payments made by the agent 
 for inward or outward freight and cartage or other similar items. 
 Notwithstanding the fact that the agent has made no entry en 
 his books for the consignments, he will of necessity charge the 
 consignor's account with any such amounts. At the time of sale, 
 or subsequently, an account sales would be made up showing 
 the net proceeds on the consignment exclusive of advances and 
 commissions and the amount of such net proceeds will be credited 
 to the consignor's account. There will subsequently be made 
 a charge for commission computed as before upon the gross sales 
 price and this amount will be charged to the consignor's account 
 simultaneously with the credit to the account for commissions 
 
 165 
 
Principles of Accounting 
 
 earned. The consignor's account will at this point show the net 
 balance which he is entitled to receive and which will be wiped 
 out by a charge when the cash is paid. 
 
 Such is the effect upon the books of the two methods of 
 treating consignments. This whole subject is one upon which 
 accountants generally disagree. It is another instance in which 
 no set rule can be given. The bookkeeping method should be 
 determined largely by the merits of individual cases. At times 
 it will be more convenient and practicable to handle them upon 
 receipt in the memorandum form. At other times circumstances 
 will dictate that they be taken up in the books at the time of 
 their receipt. 
 
 Regardless of the bookkeeping there is still a subject which 
 causes considerable discussion, namely, that of the manner in 
 which the subject shall be shown on the balance sheet. If the 
 consignments are not taken up until time of sale there can of 
 course be no possibility of any discussion arising for the reason 
 that if they have been sold the liability becomes evident and is 
 properly included among the accounts payable in the balance 
 sheet. If perchance they have been taken up at time of receipt 
 and all have been sold at the date of the balance sheet, the same 
 thing will be true since there will be the same liability as in the 
 preceding case. The condition which causes the trouble is that 
 there are goods remaining on hand at the time of preparing the 
 balance sheet. Some accountants insist that even though carried 
 on the books they shall not be shown either on the asset or 
 liability side. The supporters of this argument claim that they 
 are neither assets nor liabilities and that the only item in con- 
 nection with consignments which may ever appear upon the 
 balance sheet in connection with consignments received is a 
 deferred charge against the consignor which may have arisen in 
 connection with advances on account of consignments in which 
 the account-sales has not yet been rendered. 
 
 The supporters of another argument hold that a balance 
 sheet is a statement or financial condition taken from the general 
 ledger after the books have been closed. If the ledger shows a 
 debit for consignments and a credit for consignors they maintain 
 that these items must be shown on the balance sheet in order to 
 have this statement agree with the books. They argue further 
 that such purpose is accomplished by showing the items on the 
 
 1 66 
 
Consignments 
 
 balance sheet and there can be no possible objection to it so 
 long as they are ear-marked as contras and not made to repre- 
 sent either assets or liabilities. 
 
 It is probable that in most cases it will be found more con- 
 venient to carry them on memorandum and not include them 
 in the general books. It is probably also more correct from a 
 technical point of view to exclude them from the balance sheet 
 upon the theory that they are neither assets nor liabilities of 
 the concern whose balance sheet is exhibited and that 'they are 
 carried on the general books merely as a matter of convenience 
 and the proper control of the accounts. 
 
 The other instance in which the question of consignments 
 arises is that where goods are shipped on consignment instead 
 of being received. This question can be settled with facility 
 by dividing it for discussion into two parts, namely, cases wherein 
 goods are invoiced at specific prices and where they are shipped 
 only on memorandum. Where they are invoiced at a price the 
 effect upon the accounts must be looked into. Here the invoices 
 will take the form of any other invoice for goods actually sold. 
 The goods will be charged to the consignee, but they must not 
 be credited to the sales account, for the reason that a sale has 
 not actually taken place and it would be anticipating profits to 
 include such invoices in the sales account. Upon being charged 
 to the consignee they should be credited to a consignment sales 
 account. This is frequently made possible by using a separate 
 column in the sales book for such items. They are thus credited 
 to a consigned sales account which is in the nature of a deferred 
 credit to income. They must not, however, be taken into income 
 until such time as they are sold. 
 
 In treating them in this manner there must be taken out of 
 the cost of the goods actually sold, an item representing the cost 
 of goods shipped on consignment. In a case where the con- 
 signment sales value is for example $2,500, and the cost of such 
 goods $2,000, the following entry will serve: 
 Consignee : 
 
 To Consigned Sales $2,500 
 
 Cost of goods consigned : 
 
 To Cost of goods sold $2,000 
 
 Upon the sale of the goods and the subsequent report of the 
 consignee in the form of an account-sales the matter will have 
 
 167 
 
frmciples of Accounting 
 
 to be adjusted. If we may assume that the consignee is entitled 
 to deductions covering freight and other charges and commission 
 amounting to $300 then the entry will be as follows : 
 
 Consigned sales $300 
 
 Cash 2,200 
 
 To Consignee $2,500 
 
 The account for consigned sales will have been reduced by a 
 debit of $300 and may thereafter be released from its deferred 
 status and closed out to the sales. Thus it will be seen that 
 merged in the sales for the period there will be an item of $2,200 
 and merged in the cost of the sale there will be an item of $2,000. 
 Thus merging in the gross profit on sales for the period an item 
 of $200. 
 
 It is sometimes found desirable instead of merging these 
 items with general sales and cost of sales of the company to 
 close such portions of the consigned sales account and corre- 
 sponding cost of consigned goods sold into a separate trading 
 account for consigned sales in order to show the profit on such 
 transactions separately from the general sales transactions of the 
 company. This is done usually for statistical purposes in cases 
 where it is desirable to ascertain whether or not it is more 
 profitable to sell goods through agents than to establish branches 
 for the conduct of such business. 
 
 If the invoices for consignments shipped are not priced at 
 time of shipment and charged to the agent the manner of handling 
 them becomes very much simplified. There are two distinct 
 ways of doing this. One is to ignore entirely the matter of 
 charging agents from the general books and merely taking up 
 the net proceeds as sales when the account sales is received. This 
 of course accomplishes the desired result, but it leaves no trace 
 on the books of the goods themselves. When cash is received 
 sales are credited. The corresponding cost of these sales will 
 of course be merged in the cost of goods sold. The other 
 method is to credit the purchase account and charge a consignee's 
 account with the cost of goods or the estimated cost at time 
 of shipment and upon receipt of the sales report, at which time 
 sales are credited to make the necessary transfer from the con- 
 signee's account to the cost of goods sold. 
 
 REFERENCES FOR COLLATERAL READING: 
 
 Accounting, Practice and Procedure, Dickinson, pages 133-143. 
 
 TfiS 
 
CHAPTER XXIX 
 
 CAPITAL LIABILITIES 
 
 This term is used to denote that class of liabilities incurred 
 in connection with the acquisition of funds for capital purposes. 
 Emphasis is to be placed upon the word liabilities. Capital 
 invested by the proprietor as represented by the proprietor's 
 capital account or by capital stock is not included in this class. 
 Capital invested is to be considered as an accountability rather 
 than a liability. Capital liabilities usually take the form of bonds, 
 debentures, long-term notes or the so-called bonds and mort- 
 gages. 
 
 It is a difficult matter to define a bond in such manner that 
 it will be distinctive. There are, however, some common grounds 
 on which all can agree as to the definition of a bond. It is an 
 instrument containing a promise to pay a definite sum of money 
 at a time which is fixed or determinable, with interest at a given 
 rate. When this has been said a bond has been defined. The 
 definition does not differentiate it, however, from every other 
 class of instruments. An attempt to differentiate it results in 
 an academic discussion. 
 
 For practical purposes a bond seems to have been sufficiently 
 described. A discussion, however, of the theoretical phase of 
 the subject brings out some very interesting facts in connection 
 with bonds. There appears offhand to be some distinguishing 
 features to bonds. One of these is that a bond is secured by a 
 mortgage on certain property. If we accept this as conclusive 
 someone raises the question as to whether or not collateral notes 
 are secured by a mortgage on certain property. If we attempt 
 to say that the interest on bonds is payable at a fixed rate per 
 annum we are confronted with the fact that in the case of 
 income bonds the interest is only paid when earned. Some authors 
 give as the distinguishing feature of a bond the fact that it is 
 issued as a part of a series of like tenor and amount and in 
 most cases under a common security. The flaw which can be 
 picked in this distinction is that collateral notes meet this require- 
 ment. The point of formality is sometimes introduced to distin- 
 guish a bond from a note. It is said, for example, that a bond 
 
 169 
 
Principles of Accounting 
 
 is more formal than a note and in its common law form resembles 
 a deed through seal and witnesses. These facts are all true of 
 collateral notes. 
 
 From the above the difficulties which surround the task of 
 defining a bond will be apparent and no impregnable definition 
 seems possible. A happy solution of the academic question may 
 possibly exist in saying of a bond that it is an instrument con- 
 taining a promise to pay a definite sum of money at a future 
 time which is fixed or determinable with interest and when so 
 referred to within, or upon the face of, the instrument. From a 
 practical standpoint it is really of more importance to be familiar 
 with the effect of the bond upon the financial condition of a 
 concern and the treatment of the ramification of bonds in the 
 form of interest, than with determining just what it is. 
 
 In considering the relation of the capital liabilities to the 
 financial condition the principal point of interest is whether such 
 liabilities are, or are not, secured. It matters little whether the 
 obligation is called a bond, a collateral note or a collateral trust 
 certificate if the obligation is secured by a mortgage upon certain 
 assets of the organization. It is important to distinguish between 
 liabilities which are secured and those which are unsecured, the 
 latter being represented by such instruments as debentures and 
 income bonds. 
 
 A debenture is a long-term note. It is similar to a bond in 
 every respect, except as to the matter of security. A debenture 
 is unsecured. It would seem incongruous to use the term deben- 
 ture bond. Doubtless no one will dispute that a bond is secured 
 and while the definition of a bond was controverted because 
 of the fact that other instruments were secured it does not seem 
 proper to include under bonds an instrument which is unsecured. 
 A debenture may be defined as an unsecured instrument which 
 contains a promise to pay a definite sum of money at a time 
 which is fixed or determinable with interest and when so referred 
 to within, or upon the face of, the instrument. 
 
 Concerning income bonds it may be said that they are usually 
 unsecured. They sometimes acquire mortgage rights if the inter- 
 est is unpaid and are sometimes secured in a way by the pledging 
 of net earnings after interest on prior claims has been met. The 
 vital point regarding income bonds is that the interest is not 
 paid unless earned. The determination of this earning is largely 
 
 170 
 
Capital Liabilities 
 
 m the hands of the directors and on account of the contingency 
 connected with the payment of interest they are not a very 
 desirable class of instrument to offer to the public for the purpose 
 of obtaining funds. 
 
 Bonds, long-term notes, debentures, income bonds, etc., have 
 to be considered with regard to the order in which they rank. 
 Bonds and secured notes will at all times take preference over 
 debentures and income bonds. Bonds considered separately will 
 rank in accordance with the priority of the mortgage which accom- 
 panies them. 
 
 One thing is true of all instruments, regardless of whether 
 they are secured or unsecured. It is possible for all, although 
 not probable in some cases, for them to be sold or disposed of 
 either at a premium or at a discount. The accountant is con- 
 cerned with the disposition of such premium or discount and as 
 usual two methods of handling such items are available. 
 
 Taking up first the case of a bond or other instrument sold 
 at a discount, three questions may be asked : first, "Shall the 
 discount be charged immediately to profit and loss?"; second, 
 "Shall the discount be charged annually 'direct to profit and 
 loss ?" ; and third, "Shall it be treated as addition to interest paid 
 annually on bonds and charged to such interest account?" Very 
 few concerns probably would charge such an item immediately 
 to profit and loss. It is thought that most accountants would 
 favor spreading the discount over the life of the bond. If this 
 point may be considered as having been settled, then the question 
 remains, "Shall the discount when it is written off annually be 
 charged to the interest account which will subsequently be closed 
 out to profit and loss, or charged direct to profit and loss?" It 
 is quite true that the ultimate result would be the same in both 
 cases. There is then a further question, "What is to be accom- 
 plished by first charging the amount written off each year to the 
 interest account?" It can be answered by saying that in so doing 
 you show the actual expenses in one place of using the money 
 acquired through the bonds. 
 
 A $1,000 bond payable 20 years hence bearing interest at 6% 
 and sold at 98 would necessitate the setting up of a discount 
 account with a debit of $20. When the bond was sold the entry 
 covering the transaction would show two charges, one of $980 
 to cash and one of $20 to discount. These entries would be offset 
 
 171 
 
Principles of Accounting 
 
 by a credit to bonds payable. The interest on this bond for one 
 year would be $60. Among the nominal accounts there would 
 appear one for interest on bonds payable. This account prior to 
 closing would show a debit balance of $60. The accounts would 
 ultimately be closed out to profit and loss. In closing the accounts 
 for the year some cognizance must be taken of the account for 
 discount, showing a debit balance of $20. If this account is 
 written off direct to profit and loss annually, it will practically 
 ignore the fact that the maker of the bond has paid $61 for the 
 use of the money rather than $60. Discounting the bond is not 
 at all different from discounting any note, except that by the 
 terms of most bonds the interest runs with the bond. Discount 
 has the effect of increasing the interest paid. It is in connection 
 with instances of this kind that we hear of bonds being bought 
 at 98 to yield 6.1%. The man who buys a bond at 98 receives 
 not only 6% computed on the face of the bond, but in addition 
 $20 which will be paid to him at maturity. 
 
 After the foregoing discussion it would seem best in charging 
 off discount to charge it to the interest account and thus make 
 such account show the true expenses of the borrowed capital. 
 The accounting procedure would be somewhat similar except 
 reversed as to actual operations where bonds are sold above par or 
 at a premium. In this case the bonds might be sold at 102, mean- 
 ing that in each instance the maker of the bond would receive 
 $20 more than he would have to pay at maturity. The premium 
 has the effect of decreasing the yield on a bond and therefore a 
 corresponding effect upon the expenses of securing funds. For 
 this reason it would seem desirable to follow the same practice 
 indicated in the case of discount, namely, to credit the premium 
 on bonds sold to an account so designated and amortize the 
 premium by entries, annually or oftener, extending over the life 
 of the bond. Thus the amount, whatever it may be, will be 
 charged to the premium account and credited to the account called 
 interest on bonds payable. 
 
 There is still to be considered in connection with bonds the 
 manner of treating the interest. If the books were run on a 
 cash basis we should expect to find the interest on bonds and 
 similar instruments charged to the interest account for such in- 
 struments at the time it was paid and credited to cash. It is not 
 probable that a concern sufficiently large to have outstanding 
 
 172 
 
Capital Liabilities 
 
 bonds would make use of the cash basis. In fact it is perhaps 
 this very matter oftener than any other which makes a concern 
 realize the importance and necessity of running their books on 
 the accrual basis. When in connection with a bond we see the 
 expression January ist and July ist, it means that such dates are 
 the dates on which the interest is due and payable. The use of 
 such expression should never convey the idea that the interest 
 is not to be booked until paid. Regardless of the date of payment 
 the interest continues to accrue and even though not payable 
 until January ist there would be in the case of interest payable 
 January ist and July ist, six months' interest accrued at the close 
 of the business on December 31st. The correct way of treating 
 interest is to accrue it in accordance with the time elapsed, thereby 
 charging the expense account for interest and crediting the lia- 
 bility for the interest accrued. A distinction is sometimes made 
 in the balance sheet as between interest accrued and due and 
 interest accrued not due, for the reason that such a distinction 
 renders a balance sheet more comprehensive and useful in 
 attempting to base administrative judgment thereon. It seems 
 scarcely necessary to say in discussing the question of accruals 
 that having charged interest and credited interest accrued, when 
 the interest is paid, charge is made against the interest accrued 
 account. 
 
 REFERENCES FOR COLLATERAL READING: 
 
 Accounting, Practice and Procedure, Dickinson, pages 39, 87, 
 108, 148-150, 258-260. 
 
 Accounting, Theory and Practice, Lisle, pages 118, 119. 
 Accounts, Their Construction and Interpretation, Cole, pages 
 171, 214, 217, 199-202, 333. 
 
 Science of Accounts, Bentley, pages 53, 54, 62, 104-108, 135- 
 
 136, 144-151. 196-197- 
 
 Auditing, Theory and Practice, Montgomery, pages 141, 172, 
 
 195- 
 
 Philosophy of Accounts, Sprague, Chapter IX. 
 
 Modern Accounting, Hatfield, Chapter XIII. 
 
 17Z 
 
CHAPTER XXX 
 
 RESERVES 
 
 A reserve is a portion of proprietorship which has been set 
 aside for some specific purpose. This view is perhaps a some- 
 what novel one in that the definition includes all classes of 
 reserves. The word as used here is intended to be interpreted in 
 its strict sense. It is not intended to cover bookkeeping entries, 
 or accounts, made or raised, as a matter of convenience for the 
 purpose of showing some asset in memorandum form. By this 
 is meant memorandum charges which require a credit in order 
 to keep the books in balance. 
 
 Reserves should without exception be found upon the right- 
 hand side of the balance sheet. It is probable that more confusion 
 exists with regard to reserves than any other nomenclature which 
 is the subject of confusion. Unfortunately few persons under- 
 stand without discussion what is meant by a reserve. It is a 
 most common thing to be asked when a reserve is mentioned, 
 "Do you mean a reserve or do you mean a fund ?" This question 
 is usually followed by the question, " Do you mean the account 
 on the right-hand side of the balance sheet or the one on the 
 left-hand side of the balance sheet?" 
 
 The trouble is probably due in a large measure to the practice 
 established years ago by the comptroller of the currency in accord- 
 ance with the national bank law of requiring national banks to 
 report their reserve funds. It is probably true that the word 
 "reserves" was first used to denote reserve funds, in the state- 
 ments of resources and liabilities of national banks. This was 
 perfectly proper when taken in connection with accounts of 
 national banks and for the purpose which it was intended to 
 serve. The origin of the banking reserve dates back to the time 
 when it was first discovered that upon certain occasions more 
 than the ordinary number of depositors might apply at one time 
 for the money which they had on deposit. The liability to de- 
 positors was recorded by an account called individual deposits. 
 The account was originally opened when an individual deposited 
 cash. When cash was received the depositor was credited. If 
 the bank used its cash for the purpose of making loans, the 
 
 174 
 
Reserves 
 
 general cash was credited and "notes and discounts" was char"-M. 
 If the account of this one depositor were magnified to represent 
 that of several thousand, it will be seen that out of the cash 
 received from depositors, there might be set aside an amount 
 which would be sufficiently large to meet any reasonably large 
 combined demands for withdrawals on the part of depositors. 
 Such funds were held in reserve and accordingly received the 
 name of reserve funds or reserves. This provision, it will be 
 noticed, was for the purpose of providing for the liquidation of a 
 liability just as a sinking fund would be accumulated for the pur- 
 pose of redeeming outstanding bonds at maturity. 
 
 The term sinking fund has become so common that it is prob- 
 able no one ever thinks of calling a sinking fund a reserve. There 
 would not appear to be any reason why, when it is well known 
 that this confusion of terms exists, care should not be taken in the 
 use of terms and only such terms used as are descriptive of the 
 subject and at the same time commonly accepted and understood 
 without question. This it seems might be accomplished by calling 
 a fund "a fund" and a reserve "a reserve." The use of the word 
 reserve should be avoided on the asset side wherever possible. 
 The word fund should never appear on the liability side. 
 
 The purposes which reserves serve are numerous. One is to 
 safeguard the business from detriment through the withdrawal of 
 capital. Another is that of increasing the value of an asset with- 
 out increasing the capital or proprietorship. Reserves are also 
 used as a means of providing for future losses in a specific asset 
 without at the time of loss affecting the capital or proprietorship. 
 In a similar manner they are used as a means of providing for 
 future losses of any kind without at the time of loss affecting 
 the proprietorship or capital. Where a corporation takes over 
 another concern and the net assets of the concern taken over 
 exceed the par value of the stock issued for same, the excess is 
 sometimes represented on the books of the corporation by a 
 reserve. Such a reserve is as a rule temporary in its existence and 
 stands on the books pending a revaluation of the assets. Another 
 use for reserves is that of serving as a bookkeeping expedient 
 for reducing proprietorship without altering the asset account 
 affected. Still another use to which reserves are frequently put 
 is that of controlling or measuring the extent of an asset such 
 
 175 
 
Principles of Accounting 
 
 as a fund. They are also used to measure appropriations of 
 capital or surplus. 
 
 A construction company entered into a contract with a certain 
 municipality. A holding company to which the construction 
 company was subsidiary guaranteed satisfactory performance on 
 the part of the construction company. The bookkeeper of the 
 holding company was instructed to make an entry which would 
 record the transaction. He found some difficulty in making the 
 entry because of the fact that he could not determine the amount 
 for which the entry was to be made. He saw that it was neces- 
 sary to record the contingent liability in favor of the municipality. 
 He also decided that the offset to the contingent liability was a 
 contingent asset in the nature of a claim against the construction 
 company. Since it was necessary to make an entry and no amount 
 was available he selected the nominal value one dollar ($1.00) 
 and made an entry charging "Guarantee — Columbus Construction 
 Company" and crediting "Reserve for Guarantee — Columbus 
 Construction Company." This it will be seen was purely a 
 memorandum entry and did not affect proprietorship in any way. 
 The entry was made in order that the facts should not be lost 
 sight of. The use of the word reserve in this instance was 
 obviously a misuse. 
 
 Two partners were engaged in a manufacturing business. 
 They agreed between them that 50% of all profit should be 
 reserved and not available for drawings. The capital was small, 
 unequally invested and drew interest. The reserves did not 
 draw interest. It was the purpose in establishing the reserves 
 to build up the business and strengthen it ; to protect it from the 
 inroads of excessive drawings. The account on the books was 
 called "Partners' Reserves." In this case there was somewhat 
 more justification for the use of the word than in the other 
 instance cited. The reserve was a part of proprietorship. It 
 seems, however, to have been placed in an account other than 
 those of the partners simply because of the fact that it was non- 
 interest bearing. 
 
 An industrial corporation placed a mortgage on its property 
 and sold bonds. The bonds contained a clause which stated that 
 a reserve should be created annually out of profits. The reserve 
 was created and at maturity equalled the amount of the bond 
 issue. The company had from time to time been investing its 
 
 176 
 
Reserves 
 
 surplus funds in securities. At maturity these were sold and the 
 outstanding bonds redeemed. The account was called "Reserve 
 for Redemption of Bonds." The account represented a true 
 reserve, but it was not appropriately named. Redemption of an 
 outstanding obligation cannot be effected through an account on 
 the same side of the books. The bonds were redeemed out of 
 the proceeds of the securities sold.. The account should have 
 been called "Reserve for Protection of Bonds." This is not 
 suggested as an improvement of the accounting nomenclature 
 now existing; rather as describing the conditions in this case. 
 The reserve in reality served as a protection to the bond issue 
 in that it prevented the surplus funds of the company from being 
 withdrawn as dividends. 
 
 Another corporation was desirous of revaluing certain land 
 which it owned in accordance with values in the surrounding 
 neighborhood. Some of the directors favored increasing the 
 value of the land and crediting the amount of the increase to 
 surplus. Others opposed this proceeding on the ground that 
 land values fluctuate and the value might decrease. They con- 
 tended that if the credit were made to surplus the amount would 
 be available for dividends ; the dividends might be paid and 
 the value subsequently decline. It was finally decided to revalue 
 the land and credit the increase to a "Reserve for Appreciation 
 of Land." 
 
 Many concerns make provision for losses on accounts by 
 charging profit and loss and crediting a reserve for such purposes. 
 Consequently we frequently see the account, "Reserve for Bad 
 Debts." It is not an uncommon occurrence to find a reserve for 
 contingent losses. The two reserves are similar. One is for a 
 specific purpose. The other is for a general purpose. 
 
 A firm of contractors and builders decided, on account of 
 labor troubles, etc., to incorporate. The combined capital invest- 
 ment of the partners was approximately $100,000. In order to 
 escape the state tax on corporations, it was decided to incorporate 
 for $25,000 and have the partners take notes of the corporation 
 for the balance of their old capital. As taken over by the cor- 
 poration, the plant and equipment was appraised and was found, 
 together with the other assets, to exceed the liabilities and capital 
 stock by about $25,000. This amount was credited to an account 
 called "Reserve for Capital Surplus." While the amount prob- 
 
 177 
 
Principles of Accounting 
 
 ably would have been available, as surplus, for dividends, it was 
 the desire of the partners to have it reserved as surplus. This 
 had the effect of withholding the amount from both the capital 
 stock account and the partners' note accounts as well as prevent 
 its use for distribution as dividends. 
 
 A reserve for depreciation is merely an expedient for esti- 
 mating the decrease in the value of an asset without affecting the 
 asset account. It is the reverse of writing down the asset on 
 account of depreciation. The former method is to be preferred 
 since it permits the account to show the facts with regard to the 
 asset without the introduction of any indefinite factor such as 
 depreciation. If the depreciation is excluded the account will 
 show the original cost of the asset, with subsequent additions 
 and deductions at cost. Such a reserve is merely the setting 
 aside of capital, in an amount which corresponds to the estimated 
 depreciation of the asset, for the purpose of showing the esti- 
 mated value of the asset. 
 
 A coal company obtained a part of its land in which mines 
 were located through borrowed capital. The capital was obtained 
 through the sale of bonds secured by a mortgage on the property. 
 The mortgage provided that a reserve equal to ten cents (ioc.) 
 a ton should be created annually out of earnings and that an 
 amount equal to the reserve should be deposited with a sinking 
 fund trustee for the redemption of the bonds. 
 
 A certain hospital decided to devote the income from certain 
 sources to the erection of a building for housing its nurses. It 
 will be noted that, given the commonly accepted meaning, the 
 income would not accomplish such purpose. The receipts corre- 
 sponding to the income would, however, provide the necessary 
 fund. The income may have taken the form of subscriptions. 
 The payment of the subscriptions may have followed. The reserve 
 in this case, as in that of the coal company, had the effect of 
 measuring the fund and restricting its use for special purposes. 
 
 The government, federal, state, and municipal, is in the habit 
 of apportioning its revenues for various purposes by appropria- 
 tion. The appropriation bill usually reads "and there is hereby 
 appropriated out of any moneys not otherwise appropriated the 
 sum of * * *." This has the effect of restricting the general 
 surplus and confining the application of the appropriation to a 
 specific purpose. The respective appropriation reserves have the 
 
 178 
 
Reserves 
 
 effect of measuring the various funds, or of determining the 
 equity of each appropriation in the funds appropriated. 
 
 In a similar manner, a mercantile concern may appropriate a 
 part of its surplus for a specific purpose. Some concerns have 
 created reserves for pensions and sick benefits among employees 
 out of their surplus. Where the concern is sufficiently well 
 established and has sufficient cash available at any time to meet 
 payments to employees, it is not considered necessary to fund the 
 reserve. The funds are allowed to remain in the business ; the 
 company pays interest for their use ; the amount due to the fund 
 is determined by the reserve to which the interest is credited. 
 
 A well-known biscuit concern distributed its product to dealers 
 in elaborate tins. The dealers were obliged to deposit with the 
 company seventy-five cents (75c.) for each tin. Receipts of 
 this kind were charged to cash and credited to a reserve. The 
 money was used in the business in the same manner as a bank 
 uses its deposits. In the panic of 1907, the streets for blocks 
 around the plant of this company were filled with trucks return- 
 ing empty tins. The reserve had not been funded. No cash had 
 been set aside for this purpose. This was a contributing factor 
 in the failure of the company which followed in a short time. 
 
 Reserves are created in two ways. One is by charging profit 
 and loss or surplus and crediting the reserve. The other is by 
 charging an asset and crediting the reserve. As examples of the 
 first we have : partners' reserves, reserves for losses, reserves for 
 depreciation, reserves for sinking funds, and appropriation 
 reserves. As illustrating the second method there are-: reserves 
 for appreciation, reserves for capital surplus, reserves for con- 
 tributions. It is claimed by some that reserves may only be 
 created out of surplus. This may be conceded if all additions to 
 assets are considered as accretions of capital and are first credited 
 to capital in spite of the fact that they are subsequently to be 
 set up as reserves. 
 
 The use of reserves can scarcely be considered without look- 
 ing at each with regard to the purpose for which it was created. 
 A reserve for safeguarding the business against withdrawal of 
 capital will presumably stand the same as a capital account, until 
 such time as the business has become sufficiently strong to with- 
 stand its apportionment among partners. A reserve for losses 
 will be credited with future additions and charged with any 
 
 179 
 
Principles of Accounting 
 
 losses. A reserve for depreciation will increase through credits 
 until it equals the book value of the asset which it offsets. This 
 statement must of course be qualified with the remark that 
 consideration will be made for the residual value of the asset 
 if there is any. A reserve for a sinking fund will increase until 
 it equals the obligation, broadly speaking, which the sinking fund 
 is to liquidate. Appropriation reserves are as a rule more stable 
 on the credit side. They may in mercantile concerns fluctuate 
 en both sides. As used by governmental bodies there is usually 
 one credit. This of course assumes that there are no deficiency 
 appropriations. The frequency with which the debits occur will 
 depend upon whether the appropriation is for capital or revenue 
 purposes. If for the latter, charges will be made against the 
 appropriation reserve as disbursements, or charges which will 
 subsequently result in disbursements are made. If the appro- 
 priation is for capital purposes the reserve will probably be 
 closed by one debit closing the appropriation reserve into capital 
 surplus. Where appropriation reserves are used by mercantile 
 concerns both the debits and credits may fluctuate by additional 
 appropriations and interest credits on the one hand and charges 
 for payments on the other. Cases are known where mercantile 
 concerns have made appropriations for capital purposes. The 
 effect of such procedure is only to tie up the surplus and acts 
 as a commitment to improvement or extension before dividends 
 are declared. 
 
 Reserves for appreciation may likewise fluctuate. They are 
 set up with a credit. If the asset declines in value they are 
 subject to charge. Reserves for capital surplus are subject to 
 the same remarks. Reserves for contributions are credited when 
 the contribution is received. If received for current purposes 
 the reserve is charged as frequently as disbursements are made. 
 If for capital purposes, the reserve is charged only at such time 
 as the capital asset has been acquired and becomes a part of the 
 general fund. As long as the contribution exists as a special 
 fund so long will there be no charge against the reserve for the 
 purpose of transferring it to the capital surplus. 
 
 The disposition of reserves is, broadly speaking, the same in 
 each case. They serve the purpose for which they were set up. 
 Created out of surplus they revert to surplus if they have not 
 Leen obliterated by use. A reserve for losses will be charged 
 
 1 80 
 
Reserves 
 
 with the losses. If the estimate for the losses has been too great, 
 the balance in the reserve may be closed out to surplus. If, 
 however, the reserve were too small an additional credit would be 
 necessary, if the practice of providing a reserve for losses were 
 to be consistently followed. The same thing might be said of 
 reserves for depreciation so far as the adequacy of the reserve is 
 concerned. The disposition, when the reserve account equals 
 the asset account, is largely a matter of choice. The reserve may 
 be debited and the asset credited, or the asset may be credited and 
 the reserve debited. One consists, technically, in closing out 
 the reserve against the asset ; the other closing out the asset 
 against the reserve. A sinking fund reserve will be closed out 
 to surplus after the sinking fund has been used to liquidate the 
 liability shown by the bond account. Appropriation reserves will 
 be reduced by charges when set up for revenue purposes. Any 
 unrequired balance will revert to surplus as will any reserve for 
 capital appropriations. 
 
 Reserves for appreciation will usually stand until the increased 
 value has been determined beyond a doubt. When such has 
 taken place the reserve may be closed into surplus. Reserves 
 for capital surplus are very similar. As long as they represent 
 tentative values they should stand. When the value of the assets 
 which they represent is unquestionable they may apparently be 
 closed into surplus. The question concerning this matter is, 
 whether or not the surplus so acquired, and without doubt avail- 
 able for dividends, has been earned. The Consolidated Laws of 
 1909 (chapter 59, section 28, volume 5, folio 4004) provide that 
 "It shall be unlawful for the directors or managers of any incor- 
 porated company in this state (New York) to make dividends 
 excepting from the surplus profits arising from the business of 
 such corporation.'' 
 
 The law does not state whether the "dividends" shall be paid 
 in cash or in stock ; neither does it define "surplus profits." These 
 t.vo points, however, are practically settled by the case of Wil- 
 liams vs. Western Union Telegraph Company (93 N. Y., 162). 
 
 The Western Union Telegraph Company declared a stock 
 dividend out of surplus and a stockholder brought suit to prevent 
 the payment of the dividend. The court held that the action of 
 the company was not in violation of the law. After defining 
 surplus as being the excess of assets over liabilities and capital, 
 
 181 
 
Principles of Accounting 
 
 the decision continues: "Such surplus belongs to the corporation 
 and is a portion of its property, and, in a general sense, may be 
 regarded as a portion of its capital, but in a strictly legal sense 
 it is not a portion of its capital, and is always regarded as surplus 
 profits." 
 
 It would thus appear that a reserve for capital surplus need 
 only stand until such time as the value of the offsetting asset has 
 been definitely determined when the reserve may be closed into 
 the surplus proper. 
 
 A reserve for contributions will depend so far as its disposi- 
 tion is concerned upon the purpose to which the fund is devoted. 
 If the fund is used for revenue purposes, the reserve will be 
 closed by charges from time to time as disbursements are made. 
 If it is used for capital purposes the reserve will be closed out 
 to surplus or general reserve, as it is sometimes called in institu- 
 tions, when the disbursements have been made for such purposes. 
 
 Reserves often are the subject of discussion on account of 
 their location on the balance sheet. Generally speaking, there are 
 two ways of showing them : one is as deductions from assets, the 
 other is on the liabilities side, either as a separate group or as a 
 part of capital. An explanation of the reason for placing them 
 on the right hand side of the balance sheet will probably explain 
 also why they should not be deducted from assets on the left- 
 hand side. 
 
 Reserves are considered as restricted capital. Capital is the 
 excess of assets over liabilities. Capital is the equity in the assets 
 taken collectively, providing, of course, that there are liabilities. 
 To admit that one particular asset belongs to the proprietor while 
 some other particular asset belongs to the creditors would be 
 unusual. Since reserves are a part of capital and capital is an 
 equity, it seems somewhat unwarranted to deduct a portion of 
 capital from a specific asset. 
 
 It has sometimes been stated that one purpose in avoiding the 
 deduction of reserves from assets was to prevent an admission 
 of depreciation of property in the case of a fire. Theoretically 
 it was maintained that if the reserves were deducted from the 
 assets it was an admission of the depreciation, whereas the 
 reverse was true if the reserves were set up broad. 
 
 The standard fire insurance policy usually contains the fol- 
 lowing clause : "The insured, as often as required, shall exhibit 
 
 182 
 
Reserves 
 
 to any person designated by this company all that remains of any 
 property herein described and submit to examinations under oath 
 by any person named by this company and subscribe the same; 
 and as often as required, shall produce for examination all books 
 of account, bills, invoices, and other vouchers, or certified copies 
 thereof, etc." It would thus appear that a mere formality so far 
 as the balance sheet is concerned would not serve as a protec- 
 tion against a searching investigation on the part of the insur- 
 ance company which it is assumed would determine the value of 
 the property destroyed. 
 
 REFERENCES FOR COLLATERAL READING: 
 
 Journal of Accountancy, Vol. XI, pages 261, 421. 
 
CHAPTER XXXI 
 
 THE RELATION OF FUNDS TO RESERVES 
 
 The word fund as used herein is intended to be representative 
 of a special fund ; one which has been set aside out of the general 
 assets to be devoted to some specific use. The reserve in question 
 must have been created out of proprietorship. The discussion 
 revolves very largely around the question of whether, in practice, 
 one is essential to the other. 
 
 If in institutional or municipal organizations certain receipts, 
 for example, donations for laboratory equipment in a school of 
 chemistry, or the receipts of certain fines in the municipal courts, 
 were to be set aside and devoted solely to the purposes specified, 
 there would be no question about the necessity for crediting a 
 reserve, every time the fund was debited. This would be neces- 
 sary in order that the fund might be controlled and its use 
 restricted. 
 
 If in an industrial corporation the employees should contribute 
 jointly with the management to a fund for pensioning aged and 
 injured employees, which fund was to be carried as an account on 
 the books of the corporation there would be no question about the 
 propriety of making similar entries. The corporation becomes 
 practically a trustee for the fund and is not entitled to show the 
 fund as an asset which in part represents proprietorship. The 
 corporation is accountable to its employees for the fund and there- 
 fore must set up a reserve to protect it. 
 
 On the other hand, suppose that the mortgage securing an 
 issue of corporate bonds states that "there shall be set aside 
 annually, out of profits, the sum of fifty thousand dollars ($50,- 
 000) to retire said bonds at maturity," then two questions arise. 
 The first one is, just what the clause says ; the second, is what 
 it means. 
 
 Profits are understood to mean the excess of income over 
 expense. They are shown by nominal accounts which measure 
 through a summary called the profit and loss account the extent 
 to which the assets collectively have increased. That portion 
 of the assets which corresponds to profit cannot be identified as 
 such, as a rule, although the profit is indisputably vested in the 
 
 ^,4 
 
The Relation of Funds to Reserves 
 
 assets. Thus it may be reasoned that disbursements cannot be 
 made out of profits; they may be made out of cash in amounts 
 equal to certain measurements of profit. Obviously such a 
 clause must have been drawn by someone unfamiliar with tech- 
 nical accounting expressions. 
 
 To determine the meaning of the clause is perhaps more diffi- 
 cult than to decide just what it says. Is it the intention to 
 provide for a sinking fund, or a reserve, or both ? It appears as 
 if the only satisfactory manner of settling this question would 
 be to ask the man who prepared the mortgage containing said 
 clause. 
 
 For the purpose of discussion the question may be asked, 
 "What would be the effect of either or both of these provisions 
 upon the parties in interest?" Such parties are the bondholders 
 and the corporation. 
 
 The object of a sinking fund is to provide the cash necessary 
 to redeem at maturity certain bonds outstanding. The bond- 
 holder is interested, net in whether he is paid out of profits or 
 otherwise, but in receiving cash for the bonds which he holds. 
 He is willing to accept nothing else, as a rule. 
 
 The mere creation of a reserve in this case does not produce 
 the cash necessary to pay the bondholder. It limits or restricts 
 the free equity of proprietorship in the assets. Regardless of 
 the object, the effect is that of reducing the profits available for 
 distribution as dividends or addition to proprietorship. 
 
 During the accumulation of the fund the profits are made 
 to suffer annually to the extent of the deposit. The reserve 
 increases as the fund accumulates. Finally, as the fund equals 
 the indebtedness and the bonds are redeemed, the reserve is 
 released and reverts to surplus or proprietorship. Apparently 
 the stockholders are deprived of these profits until the bonds 
 have been paid off. 
 
 One of the most striking illustrations of the application of 
 the sinking fund principle is that of a mine. The land is pur- 
 chased for the mineral which it contains. The location of the 
 land, or character of its surface, many times prevents its use for 
 anything after the mineral has been extracted. The buildings, 
 machinery and shaft equipment are practically worthless after 
 the mine is exhausted. The stock in trade is the mineral. If 
 capital is invested in the mineral and the mineral is sold care 
 
 l8q 
 
Principles of Accounting 
 
 must be taken that the proceeds are not erroneously considered 
 as representing profits entirely. No merchant will consider that, 
 having sold an article for fifteen dollars which cost ten, he 
 has made fifteen dollars. No mining concern should consider 
 the mineral which is extracted as being pure profit. There is 
 usually an element of cost and if the cost is not reckoned with 
 depleted capital will result. If the capital is contributed, the 
 stockholders may be surprised to learn that the apparently ex- 
 cessive dividends have been made up in part of capital which 
 was being returned to them. If the capital is borrowed and, for 
 example, secured by a mortgage on the property, the bondholders 
 may find that while during the life of the bond they have been 
 receiving the interest regularly, at maturity the company defaults 
 on the principal, and the property, on which the mortgage was a 
 specific lien, has dwindled into so much earth without any value. 
 
 The variation in effect of the above mentioned methods of 
 procedure may be seen in three propositions based on practically 
 the same hypothetical case. The case is as follows : 
 
 The Lawtimer Coal Company with a paid in capital of 
 $25,000 represented by capital stock, purchased a tract of coal 
 land for $100,000. The land was paid for with $25,000 in cash 
 and an issue of 6% twenty-year bonds, secured by a mortgage on 
 the land, amounting to $75,000. The land was estimated to yield 
 and did yield 50,000 tons of coal. 
 
 The first proposition assumes that: 
 
 a. The mortgage made no provision for a sinking fund. 
 
 b. Fifty thousand (50,000) tons of coal were sold at 
 
 five dollars ($5,00) a ton. 
 
 c. The expenses of operation for the period of twenty 
 
 years amounted to $35,000. 
 
 d. The profit after deducting $90,000 for interest on the 
 
 bonds was distributed as dividends. 
 
 e. At the maturity of the bonds there was a balance of 
 
 $100,000 in accounts receivable. 
 
 Skeleton ledger accounts showing the transactions would 
 appear as follows : 
 
 Cost of Land Bonds Outstanding 
 
 $100,000 $100,000 $75,000 
 
 186 
 
The Relation of Funds to Reserves 
 
 Capital Stock 
 
 Accounts Receivable 
 
 525,000 
 
 $250,000 
 
 $250,000 
 
 $150,000 
 100,000 
 
 $250,000 
 
 Cost of Sales 
 
 Sales 
 
 100,000 $100,000 
 
 $250,000 $250,000 
 
 Cash 
 
 Operating Expenses 
 
 $150,000 
 
 $35>°°° 
 90,000 
 25,000 
 
 $35,000 
 
 $35,000 
 
 $150,000 
 
 $150,000 
 
 
 Interest on Bonds 
 
 Dividends 
 
 Cost of sales 
 
 Operating expenses. . 
 Interest on bonds . . . 
 Dividends 
 
 $100,000 
 
 35.°°° 
 90,000 
 25,000 
 
 $250,000 
 
 J.250,000 
 
 {250,000 
 
 Balance Sheet 
 
 Assets 
 Accounts receivable . $100,000 
 
 Total assets $100,000 
 
 Liabilities and Capital 
 
 Capital stock $25,000 
 
 Bonds outstanding. . 75,000 
 
 Total liabilities and 
 capital $100,000 
 
 187 
 
Principles of Accounting 
 
 The yield of the mine was 50,000 tons. The cost per ton was 
 accordingly $2.00 per ton. The cost of sales was made up of 
 50,000 tons at $2.00 per ton, or $100,000. The depletion, as the 
 charge was made to cost of sales, gradually reduced the cost of 
 land until at maturity it was entirely wiped out. The position of 
 the company at the end of the period is no worse than at the be- 
 ginning. The cost of land at $100,000 at the beginning has been 
 replaced by accounts receivable in the same amount. The position 
 of the bondholders is not so favorable. At the beginning the 
 bonds were secured by a mortgage on the land which contained, 
 as subsequently developed, coal which sold for $250,000. At 
 the end the bonds are still secured as to payment of principal by 
 a mortgage on the land, but the valuable contents of the land 
 have been removed. The specific property upon which the mort- 
 gage operated as a lien has been stripped of its value. The 
 desire of the company to redeem the bonds may be above ques- 
 tion. The ability to do so is hampered by lack of cash. The 
 bondholders are at the mercy of the company. 
 
 The second proposition assumes that: 
 
 a. The mortgage provides for a sinking fund of $1.50 
 
 a ton. 
 
 b. Fifty thousand (50,000) tons of coal were sold at five 
 
 dollars ($5.00) a ton. 
 
 c. The expenses of operation for the period of twenty 
 
 years amounted to $35,000. 
 
 d. The profit after deducting $90,000 for interest on 
 
 bonds was distributed as dividends. 
 
 e. At the maturity of the bonds there was a balance of 
 
 $100,000 in accounts receivable. 
 /. The company had borrowed on notes payable and was 
 still owing at the maturity of the bonds, $75,000. 
 
 The skeleton ledger accounts setting forth the transactions 
 under this proposition follow : 
 
 Cost of Land Bonds Outstanding 
 
 $ioo,oco $100,000 $75,000 
 
The Relation of Funds to Reserves 
 Capital Stock Accounts Receivable 
 
 $25,000 
 
 $250,000 
 
 $250,000 
 $100,000 
 
 5150,000 
 100,000 
 
 £250, 000 
 
 Cost of Sales 
 
 Sales 
 
 100,000 $100,000 
 
 General Cash 
 
 250,000 $250,000 
 
 Sinking Fund Cash 
 
 $150,000 
 75,000 
 
 $225,000 
 
 $75,000 
 
 35>°°° 
 90,000 
 25,000 
 
 $225,000 
 
 $75,000 
 
 Notes Payable 
 
 Operating Expenses 
 
 Profit and Loss 
 
 Cost of sales 
 
 Operating expenses. . 
 Interest on bonds . . . 
 Dividends 
 
 $100,000 
 
 35« 00 ° 
 90,000 
 25,000 
 
 Sales $250,000 
 
 $250,000 
 
 Balance Sheet 
 
 $250,000 
 
 Assets 
 
 Accounts receivable . $100,000 
 Sinking Fund cash. . 75,000 
 
 Total assets $175,000 
 
 Liabilities and Capital 
 
 Capital stock $25,000 
 
 B onds outstanding . . 7 5 , 000 
 
 Notes payable 7 5, 000 
 
 Total liabilities and 
 
 capital $175,000 
 
 189 
 
Principles of Accounting 
 
 The situation as represented by the above balance sheet is, it 
 will be noted, decidedly more favorable to the bondholders. The 
 land has disappeared, the same as in the first case, but so much 
 of it as represented borrowed capital has been replaced by a 
 sinking fund. This fund the company is bound by the provision 
 of the mortgage to devote to the retirement of the bonds. 
 
 The company is as well off as in the preceding instance. The 
 bonds are due, but the cash is available with which to redeem 
 them. There are notes outstanding to the extent of $75,000, but 
 they should be amply provided for as the accounts receivable are 
 realized. 
 
 One fact must be brought to the attention in this proposition. 
 That is the fact that the payment of dividends was made possible 
 through the borrowing power of the company. Dividends might 
 have been declared quite easily since there was sufficient profit 
 to warrant them. To obtain the cash necessary to pay the divi- 
 dends is another matter. The presumption should exist, it seems, 
 that if the profits are bona fide and accordingly are vested in 
 sound assets, sooner or later the same assets will be realized and 
 the payment of dividends would seem to depend entirely upon 
 the ability of the organization to borrow the necessary cash if 
 perchance such borrowing should become necessary. There does 
 not seem to be any reason why the establishment of the sinking 
 fund, which in this case is merely a setting aside of a part of the 
 cost, should interfere with the payment of dividends, which is a 
 distribution of funds representing the profit. 
 
 The third proposition assumes that: 
 
 a. A reserve for replacement equal to $1.50 a ton is to 
 
 be created out of profits before any dividends are 
 declared. 
 
 b. Fifty thousand (50,000) tons of coal were sold at five 
 
 dollars ($5.00) a ton. 
 
 c. The expenses of operation for the period of twenty 
 
 years amounted to $35,000. 
 
 d. The interest on the bonds was $90,000. 
 
 e. At the maturity of the bonds there was a balance of 
 
 $100,000 in accounts receivable. 
 
 In this case the skeleton ledger accounts show the transactions 
 as follows: 
 
 190 
 
The Relation of Funds to Reserves 
 Cost of Land Bonds Outstanding 
 
 $100,000 $100,000 
 
 $75,000 
 
 Capital Stock 
 
 Accounts Receivable 
 
 
 $25,000 
 
 $250,000 
 
 $150,000 
 100,000 
 
 
 $250,000 
 
 $250,000 
 
 Cost of Sales 
 
 Sales 
 
 100,000 $100,000 
 
 General Cash 
 
 $250,000 $250,000 
 
 Reserve for Replacement 
 
 $150,000 
 
 $150,000 
 $ 25,000 
 
 $35,000 
 90,000 
 25,000 
 
 $150,000 
 
 $25,000 
 
 Interest on Bonds 
 
 $35,000 $35,000 
 
 D,000 
 
 ,000 
 
 Profit and Loss 
 
 Cost of sales $100,000 
 
 Operating expenses. . 35,000 
 Interest on bonds. . . 90,000 
 Prot dsion for reserves 25,000 
 
 Sales $250,000 
 
 $250,000 
 
 Balance Sheet 
 
 $250,000 
 
 Assets 
 
 Cash $ 25,000 
 
 Accounts receivable. 100,000 
 
 Total assets. 
 
 . . $125,000 
 
 Liabilities and Capital 
 
 Capital stock $25,000 
 
 Bonds outstanding. . 75,000 
 
 Reserve for replace- 
 ment 25,000 
 
 Total liabilities and 
 
 capital $125,000 
 
 ly. 
 
Principles of Accounting 
 
 Here as in the first proposition the bondholders are in an 
 undesirable position. The reserve for replacement has been 
 created, not, however, to the extent intended. The reserve should 
 have amounted to $75,000. It amounts to only $25,000. The 
 reason is that the profits were not sufficiently large to permit of 
 its creation in the amount originally planned. It so happens 
 in this case that the cash equals the reserve. 
 
 It is a coincidence in this case since there is no connection or 
 relation in practice between the two accounts. Profits, it should 
 be remembered, are vested in all the assets. The reserve for 
 replacement has in this case taken the place of profits and repre- 
 sents therefore merely the extent to which the profits in the 
 assets exist. 
 
 The company lacks funds with which to meet its outstanding 
 bonds. The reserve does not provide these funds. It has no 
 connection with the funds." All that it has accomplished is to 
 prevent the declaration of dividends because it reduced the profits 
 so that there were none left out of which they might be declared. 
 Obviously if dividends are not declared there can be no divi- 
 dends paid. 
 
 A fourth proposition might combine both sinking fund and 
 reserve provisions. In such a case the balance sheet would be 
 the same as in the third proposition except that the sinking fund 
 cash in the amount of $75,000 would replace the general cash of 
 $25,000 and there would be a liability of $50,000 for notes pay- 
 able. This would prevent the declaration of dividends until 
 such time as the bonds were redeemed and the reserve released. 
 
 REFERENCES FOR COLLATERAL READING: 
 
 Modern Accounting, Hatfield, Chapters VIII-XI-XII. 
 
 IQ2 
 
CHAPTER XXXII 
 
 PROPRIETORSHIP 
 
 Proprietorship is usually understood to mean ownership. In 
 connection with business organization it signifies ownership of 
 the assets. If there were no liabilities outstanding this would 
 be strictly true. Such a condition rarely exists. There are few 
 concerns which have no liabilities. The existence of liabilities 
 has the effect of merging with the proprietor's interest in the 
 assets that of the creditors. It may, therefore, be said that pro- 
 prietorship is that ownership of the assets of a business organi- 
 zation which is measured by the assets, or, where liabilities exist, 
 by the excess of assets over liabilities. Proprietorship is also 
 called capital. 
 
 Proprietorship may be represented by various accounts, de- 
 pending upon the legal type of organization. Within the different 
 classes of organization the proprietary account may be subdivided 
 for convenience in classification. In sole proprietorship, copart- 
 nership, or joint venture, the capital is represented by the proprie- 
 tors' accounts. Thus there may be found accounts such as- "John 
 Marshall, Proprietor," or "John Marshall, Capital." This account 
 may show not only the original investment of "John Marshall," 
 but any subsequent credits for profits, salary, interest or capital. 
 For convenience, separate accounts are often set up for profits, 
 salary or interest, so that the capital account shows the invest- 
 ment of capital with subsequent additions to or deductions from 
 same. Accounts for salary, interest or profits should be consid- 
 ered as adjuncts of the proprietor's account. 'They may, quite 
 properly, appear on the books, but should not appear in the 
 balance sheet as such. They constitute a part of the proprietor- 
 ship as much as that represented by the proprietor's account. 
 If, technically speaking, the rule of bookkeeping relative to the 
 closing of books were complied with, they would be closed out 
 to the proprietor's account before the final trial balance were 
 taken. In joint associations and corporations, the proprietary 
 accounts are those of capital stock, divided as occasion requires 
 to represent various classes of stock, and with adjuncts for 
 undivided profits or for surplus. Unlike sole proprietorship and 
 
 193 
 
Principles of Accounting 
 
 copartnership, separate accounts are maintained with the adjuncts 
 as well as with the capital stock. This is, in a measure, due to 
 the fact that a corporation has its capital stock fixed by law. 
 Without the consent of the proper representative of the State 
 the capital stock may neither be increased nor decreased. The 
 capital stock is presumed to represent the investment of capital. 
 By reason of the fact that it is fixed, any excess of assets over 
 liabilities and capital stock is called surplus or undivided profits. 
 
 There is little distinction made between the two words. If 
 a shade of difference in meaning is observed, undivided profits 
 may be taken as profits which will be distributed within a rea- 
 sonably short time as dividends, whereas surplus consists of 
 undivided profits which have passed through the stage of avail- 
 ability for distribution and have been allowed to remain vested 
 in the assets to strengthen the corporation. Surplus is rather 
 an accumulation of profit. There can be no doubt that undivided 
 profit and surplus attach to the capital, thereby constituting 
 proprietorship. They are, however, kept separately in the books, 
 for purposes of convenience, and shown separately in the balance 
 for purposes of information. 
 
 Capital stock is evidence of share ownership in the net assets 
 of a corporation. By net assets is meant the excess of assets 
 over liabilities. The documentary evidence is a mere piece of 
 paper on which certain officers of the corporation have certified 
 to the fact that the party named in the certificate is the owner 
 of a certain number of shares. The certificates are printed 
 because they may be issued in large numbers, and much unneces- 
 sary writing, is thus avoided. The ownership is expressed in 
 shares because of simplicity. In a corporation, for example, 
 with one thousand shares outstanding, the owner of five hundred 
 shares is one-half owner. There is no apparent reason why such 
 fact could not be stated in the certificate. It would be perfectly 
 easy to do so if the fractions were always small, but they are 
 not. One might imagine the complication which would arise, 
 for instance, in the U. S. Steel Corporation, where there are 
 ten million shares. If the share ownership were expressed in 
 fractions, the certificate of a party holding 362 shares would 
 read 362-io,ooo,oooths of the capital stock. 
 
 The par of capital stock varies in different companies. One 
 hundred dollars is probably the most common amount. Stocks, 
 
 194 
 
Proprietorship 
 
 the par value of which is fifty dollars and twenty-five dollars, 
 respectively, are also frequently seen. Pennsylvania Railroad 
 stock is an example of fifty-dollar par stock. Stock is not usually 
 issued until fully paid for, although certificates are sometimes 
 seen in circulation when only part paid. The certificates, in 
 such cases, usually bear an endorsement on their face stating 
 the amount paid. 
 
 A stock issue is sometimes preceded by what is known as 
 "scrip." As used here, scrip is a receipt issued for payments on 
 account of stock subscriptions which it is intended will be re- 
 deemed in stock. In such cases, scrip occasionally circulates in 
 lieu of stock. Scrip is also issued at times for fractional shares 
 of stock. 
 
 There are one or two points in connection with stocks which 
 accountants should keep in mind when engaged in counting 
 securities, namely : to be on the alert for stocks which are not 
 fully paid and for stocks the par of which is less than one hundred 
 dollars. Failure to observe these precautions is liable to result 
 in failure to balance the par of the stocks under review. 
 
 The consideration for the issue of capital stock varies in 
 different States. In some of the most prominent States the con- 
 sideration is as follows : 
 
 Arizona — money or money's worth (general principles of 
 law). 
 
 Delaware — cash, labor done, personal property, real prop- 
 erty or leases. 
 
 Maine — cash, services rendered, property. 
 
 Massachusetts — cash, property, tangible or intangible, 
 services or expenses. 
 
 New Jersey — money, property. 
 
 New York — money, labor done, property actually received 
 for the use and lawful purposes of such corporation. 
 
 Pennsylvania — money, labor done, ■ property actually re- 
 ceived. 
 
 South Dakota — money, labor done, property actually re- 
 ceived. 
 
 West Virginia — property, services or other things of value. 
 
 Capital stock is usually classified as preferred and common. 
 The former may be preferred as to dividends, or as to assets 
 
 195 
 
Principles of Accounting 
 
 at time of liquidation, or both. As to dividends, it is sometimes 
 known as cumulative preferred. Voting power may attach to 
 either preferred or common stock or to both. 
 
 Where stock is preferred as to dividends it is understood, or 
 m fact agreed, that a certain rate per cent, of dividend will be 
 paid on the preferred before any dividends are paid on the com- 
 mon. If the preference is as to assets, it is understood to mean 
 that in liquidation the preferred stockholders will be paid off 
 in full out of the available assets before anything is paid to the 
 holders of the common stock. 
 
 In the case of cumulative preferred stock the rate per cent, 
 stipulated in the certificate accrues in favor of the stockholders, 
 whether earned and paid or not. Accumulations in favor of pre- 
 ferred stockholders in such cases must be paid in full before 
 any dividends can be paid to common stockholders. For example, 
 where the stock in question is seven per cent, cumulative pre- 
 ferred, and the dividend is unearned for a period of three years, 
 dividends to the extent of twenty-one per cent, must be paid 
 to the holders of such stock before any dividends on the common 
 stock may be declared. 
 
 Where such a condition exists, the propriety of showing a 
 liability for same in the balance sheet frequently presents itself. 
 Without giving the matter careful consideration it might appear 
 proper that such a liability should be shown. This position may 
 be taken on the ground that the dividend is in the nature of 
 interest, and accrues by virtue of what might be considered an 
 agreement on the part of the company to pay such dividends. 
 This, however, is not true. What the company does agree to 
 do is to pay a dividend equal to seven per cent., if earned. In 
 the absence of action on the part of the directors in declaring 
 a dividend no liability arises. It would, therefore, seem improper 
 to consider the cumulative dividend as accruing, since there 
 may never be sufficient surplus earnings to justify any dividend. 
 It is usually conceded that no liability for such dividends should 
 appear on the balance sheet, but a sense of honesty and fairness 
 would seem to indicate that a foot-note stating the exact situation 
 should be appended to the balance sheet. 
 
 In connection with proprietorship an important question arises 
 in cases where capital stock is donated. As previously stated, 
 proprietorship is measured by the net assets. Any increase in 
 
 196 
 
Proprietorship 
 
 the assets without a corresponding increase in the liabilities 
 carries with it an increase in the proprietorship. Capital stock, 
 if donated, is an asset. If the rule above stated were true, the 
 proprietorship would be increased. The extent of the increase 
 would depend upon the value assigned to the donated stock. To 
 fix this value is the difficulty which is presented. In the majority 
 of cases it is probable that the stock donated was issued originally 
 for patents, trademarks, good-will, or similar assets, and was 
 donated in order that it might be sold to raise cash for current 
 needs. Obviously, it is worth what it sells for, or perhaps, rather, 
 its value may be fixed at what it sells for. To the extent of 
 this value it increases the proprietorship; that is, if the assets 
 for which it was originally issued were correctly valued. 
 
 Two views concerning the treatment of donated stock obtain. 
 The first view holds that the. assets for which the stock was 
 originally issued were worth the value assigned to them, and 
 consequently the proceeds of the donated stock, when sold, 
 increase proprietorship. The second view holds that the value 
 of the assets is fictitious, and admittedly arbitrary, and that the 
 proceeds of the donated stock should be used to reduce such 
 valuation. For the purpose of illustrating the two views, let a 
 case be assumed in which capital stock to the extent of $100,000 
 is issued for patents; $40,000 of stock (par value) is subse- 
 quently donated, to be sold for the purpose of raising such cash, 
 and is sold for $25,000. 
 
 Under the procedure followed in accordance with the view 
 first expressed, patents would be charged and capital stock out- 
 standing credited in the amount of $100,000. Upon receipt of 
 the donated stock, treasury stock would be charged, and an 
 account, variously termed "donation account," "working capital" 
 and "capital surplus suspense," is credited, in the amount of 
 $40,000. At the time of sale cash would be charged with $25,000 
 and treasury stock credited in an equal amount. The treasury 
 stock account will now show a debit balance of $15,000, whereas 
 no stock remains. The donation account will show a credit 
 balance of $40,000. At this point the treasury stock account is 
 closed out to the donation account, leaving a credit balance in 
 the latter of $25,000. This balance may be allowed to remain 
 in the account, as representing capital surplus, and impliedly, 
 perhaps, not available for dividends, or it may be closed out to 
 
 197 
 
Principles of Accounting 
 
 the general (profit and loss) surplus account. There would 
 appear to be no legal objection to making this increase in the 
 surplus available for cash dividends. To do so, however, would 
 be to defeat the object of the donation ; and since the controlling 
 interest in the stock is usually held by the donor, such procedure 
 would probably never take place in practice. A stock dividend 
 for the purpose of distributing such surplus would appear more 
 logical, and would seem to be free from objection. 
 
 In accordance with the second view above mentioned, the 
 entries would be the same up to the point of closing the donation 
 account. The credit balance in the donation account, namely, 
 $25,000, is closed out against the account for patents, standing 
 at $100,000, thereby reducing same to $75,000. The accounting 
 which accords with this view is held by many to be conservative 
 practice. It is surely that, and perhaps ultra-conservative. 
 
 Those who hold this view contend that the donation of the 
 stock is evidence of the fact that the assets were not worth the 
 par value of the stock which was issued for them. Opposers 
 of this view hold that "judgment of the directors, in the absence 
 of fraud in the transaction, is conclusive as to the value of the 
 property purchased." Whether or not the value can be disproven, 
 the practice which follows the view-point illustrated in the first 
 case above mentioned has undoubtedly enabled mining and real 
 estate development companies to take advantage of unsuspecting 
 investors. 
 
 198 
 
CHAPTER XXXIII 
 
 THE INCOME-FROM-SALES GROUP 
 
 This group comprises gross sales, on the one hand, against 
 which will oppose such items as return sales, trade discount, 
 allowances, rebates, outward freight, and outward cartage. The 
 result of opposing these last named items against the first is 
 income from sales, or primary income. It is to be understood 
 that, notwithstanding the fact that a concern selling goods has 
 been selected as an illustration, the theory of accounting involved 
 would apply in cases of concerns selling services, transportation, 
 or what not. 
 
 A sale is a contract between two parties, wherein certain 
 specified goods ready for delivery have been offered and ac- 
 cepted. A sale must, therefore, comply with the legal require- 
 ments of a contract. It is not necessary for payment to be made 
 in order that a sale may take place. It is, of course, vitally 
 important to the vendor that he receive pay for his goods, but 
 for the purpose of this discussion the payment may be treated 
 as a secondary matter. If there has been a meeting of the minds 
 with regard to certain specified goods, and such goods are ready 
 for delivery, the sale has taken place. The price attached to the 
 goods fixes for the vendor the gross income from the sale. It 
 will thus be seen that there is established an item called gross 
 sales. 
 
 In certain instances, goods having been once sold are, for 
 one reason or another, returned, and accepted by the vendor. 
 This gives occasion for the account — returned sales or sales 
 returns. Such items should be considered not as reducing the 
 gross income from sales, but in effect a cancellation of the sales 
 which were originally made. It would, accordingly, seem proper 
 to deduct sales returns from gross sales and show the result as 
 the net sales. Whether or not an account is raised on the ledger 
 is immaterial ; a caption for same should appear, however, in 
 any comprehensive statement of income. If it were desired to 
 have an account for net sales on the ledger, the account would 
 be raised only at the time of the closing of the books, and would 
 serve as a sub-group account. 
 
 199 
 
Principles of Accounting 
 
 The selling price of goods is composed of selling cost plus 
 profit. Selling cost is made up not only of cost of goods before 
 the expense of selling the goods, but the expense of adminis- 
 tration and the expense of securing or protecting capital, and 
 allowances or deductions which it will be necessary to make from 
 the selling price of goods. The last named items include those 
 previously mentioned, such as trade discounts, allowances, etc. 
 These items appear to bear a close relation to the selling price, 
 and, having been considered in fixing the selling price, and it 
 having been conceded in advance that the selling price will be 
 reduced to the extent of these deductions, it would appear logical 
 to treat them as deductions from sales. It is immaterial whether 
 or not such an account be maintained in the ledger, but if such 
 were the case it would be set up only at the time of closing 
 the books, and the items embraced in this sub-group closed into 
 the account. 
 
 Trade discount is an expedient for adjusting a list price. 
 To one customer the goods might be quoted at $2.00 a dozen, less 
 10 and 5 ; to another customer the price might be $2.00 a dozen, 
 less 10 and 5 and 2. The same goods might be sold one year at 
 $2.00 less 10; another year at $2.00 less 73^2. Instead of raising 
 the list price the discount might be lowered. The question might 
 be asked, "Why not change the list price instead of going to the 
 extent of the trouble involved in changing a number of dis- 
 counts?" The objection to this would probably be seen when it 
 is realized that some concerns publish extensive and expensively 
 illustrated catalogs and price lists. By changing the discounts it 
 is not necessary to alter the catalogs or price lists. It will thus be 
 seen that trade discount is a useful expedient for adjusting prices. 
 The point especially to be kept in mind in this connection, how- 
 ever, is that the vendor concedes in advance, and takes into con- 
 sideration in fixing his selling price, the fact that he will receive 
 so much less for his goods. It has been argued by some authors 
 that an account for trade discount has no place in the general 
 ledger. The statement has even been made that such account is 
 never found in the general ledger. It is modestly suggested by 
 the author that if financial statements are to be comprehensive an 
 account for trade discount might with propriety exist. It is 
 conceded that most concerns deduct trade discount from the face 
 of sales invoices and enter such invoices in their books net. To 
 
 200 
 
The Income-from-Sales Group 
 
 enter them broad would undoubtedly involve some additional work 
 on the part of the bookkeepers. In a large concern, however, 
 where a highly developed departmental organization exists, and 
 the fixing of prices is delegated to the head of the sales depart- 
 ment or the sales manager, an account for trade discount would 
 undoubtedly serve as an index of the efficiency of the sales man- 
 ager to a certain extent. It is questionable, of course, whether 
 the expense involved in the additional work of recording the in- 
 voice broad would offset the benefits accruing to the administrative 
 officers from the information furnished by the keeping of an 
 account for trade discount. The practice to be followed should 
 be guided entirely by a decision of this kind in each particular 
 case. It is not possible to state a general rule concerning it. 
 
 Allowances may cover defective goods, or goods broken, 
 damaged or lost in transit. Allowances have the effect of reduc- 
 ing the amount which will be received from the sale of goods, 
 and will usually be deducted by the vendee in settlement. They 
 are usually represented by credit memoranda, and on account of 
 their close relation to sales, and the fact that they affect the 
 amount which will be received from sales, they are treated as 
 deductions from sales. 
 
 Rebates are of much the same nature as allowances. It may 
 appear somewhat inconsistent to even mention the subject of 
 rebates, since the practice of rebating is prohibited by law. The 
 author respectfully refrains from offering any suggestions as 
 to what should be done if rebates are actually found. It will 
 suffice, perhaps, in connection with this topic, to state that rebates 
 are, in effect, special allowances, and, if they exist, bear the same 
 relation to sales that allowances bear. 
 
 Some explanation will, perhaps, be necessary as to the reason 
 for treating outward freight as a deduction from sales. It is 
 probable that the most common practice is to treat it as a selling 
 expense. It seems, however, not to be properly included in such 
 group if a sale is conceded to have taken place when the goods 
 ready for delivery had been offered and accepted. The expense 
 appears rather to be one of delivering the goods than selling 
 them. It is argued by some that the matter of delivery is an 
 important factor in determining the sale ; that in certain instances 
 it serves as an inducement to the purchaser ; that many times, if 
 the goods were not delivered by the vendor, they would not be 
 
 201 
 
Principles of Accounting 
 
 sold. While this may be true, the fact still remains that if the 
 vendor bears the expense of delivering the goods he receives 
 that much less for his goods, and he has taken that fact into 
 consideration in fixing his selling price. 
 
 Outward cartage is in the same class with outward freight. 
 The account may contain merely items of expense in connection 
 with services rendered by some drayman, or it may contain a 
 proportion of the stable expenses, etc., of the concern which 
 ships the goods. In a case of the latter kind the stable expense 
 is divided by the tonnage hauled, and the rate thus obtained is 
 multiplied by the number of tons involved in the outward cartage 
 in order to obtain the amount applicable to outward cartage. 
 
 The relation of sales deductions to sales will be seen in the 
 following tabulation : 
 
 Gross sales $100,000.00 
 
 Less sales returns 5,000.00 
 
 Net sales $95,000.00 
 
 Deductions from sales : 
 
 Trade discount $10,000.00 
 
 Allowances : 
 
 Defective goods $100.00 
 
 Breakage 200.00 
 
 Damage 300.00 
 
 Loss 400.00 
 
 Rebates 2,000.00 
 
 Outward freight 3,000.00 
 
 Outward cartage 500.00 
 
 Total deductions from sales $16,500.00 
 
 Income from sales $78,500.00 
 
 In closing the books, the various detail accounts will be closed 
 into the group account, "income from sales," which will in turn 
 be closed into profit and loss. 
 
 202 
 
CHAPTER XXXIV 
 
 THE COST-OF-SALES GROUP 
 
 The cost of sales may be generally divided into three ele- 
 ments, namely: materials and supplies, labor, and manufacturing 
 overhead. This group corresponds to the expense-of-operation 
 group in organizations other than a manufacturing concern. The 
 materials and supplies include, in addition to the gross purchases, 
 inward freight and inward cartage, the latter item being either 
 a direct charge for drayage or a proportion of the stable expense. 
 The salaries and expenses of the purchasing department are also 
 properly chargeable to materials and supplies. 
 
 The labor is divided into direct and indirect, the latter con- 
 stituting the wages of foremen, laborers and helpers. Generally 
 speaking, nothing is gained by classifying labor as direct and 
 indirect. Where a cost system obtains, however, it is desirable 
 that this classification should be made, because of the fact that 
 one of the prime objects in cost accounting is to charge direct 
 to jobs as many items as possible. The direct labor, constituting 
 the work of the employees directly engaged in working upon the 
 product, is something which can be specifically allocated to jobs ; 
 the indirect labor, such as the work of foremen, laborers and 
 helpers, cannot be specifically allocated. Such division of labor 
 facilitates the work of the cost department and permits of agreeing 
 the cost records with the general books, by reason of the fact 
 that indirect labor is thrown into the manufacturing overhead. 
 Manufacturing overhead, or factory expense, as it is frequently 
 called, includes superintendence, salaries of clerks keeping the 
 factory records, factory office expense, heat, light and power, 
 factory supplies, repairs and renewals of shop tools and minor 
 operating equipment, depreciation of machinery and other major 
 operating equipment, etc. 
 
 In cost accounting, materials and supplies and direct labor 
 are combined, and constitute what is known as prime cost. Prime 
 cost plus manufacturing overhead equals manufacturing cost. 
 As was previously pointed out, one of the items included in the 
 cost of materials was inward freight. Theoretically, inward 
 freight is a part of the cost of materials ; practically, it becomes 
 
 203 
 
Principles of Accounting 
 
 almost impossible to connect the inward freight with the items 
 of materials and supplies which it covers. To do so it would 
 be necessary, perhaps, to distribute the freight corresponding to 
 a certain way bill over several different invoices. The share of 
 freight thus pro-rated to the various invoices would have, in 
 return, to be distributed over the various classes of items making 
 up the invoice. The distribution to classes of items having been 
 accomplished, it would then be necessary to divide the amount 
 so ascertained by the number of units pertaining to the particular 
 class in question, in order to obtain a unit cost for freight. The 
 amount of clerical labor involved in such calculations is so great 
 that it is probable that most concerns do not attempt such a dis- 
 tribution in practice. It is a widespread custom to include inward 
 freight in the overhead rather than attempt to load it to materials 
 and supplies. The same remarks apply, possibly with greater 
 force, to inward cartage. Theoretically, it is very properly 
 included in the cost of materials ; practically, it becomes a difficult 
 matter to do so. The situation will be affected proportionately 
 by the conditions which exist. If a concern has its own stable 
 organization, and does all its own hauling, the stable expense 
 must first be distributed to inward cartage and outward cartage. 
 The proportion corresponding to inward cartage will then have 
 to be pro-rated, presumably on a tonnage basis, over the incoming 
 invoices, since it is next to impossible to connect in any other 
 way the service rendered by the stable with the materials and 
 supplies hauled. 
 
 Much discussion has arisen in the past as to the proper alloca- 
 tion of the salaries and expenses of the purchasing department. 
 It has been contended, on the one hand, that the purchasing 
 officer was an administrative officer, charged with exercising his 
 judgment as to purchases, and in no way connected with the 
 technical or operating department of the organization. As such, 
 the salaries and expenses of his department would very properly 
 be charged to administrative expenses. On the other hand, it 
 is contended that the services of this office are rendered entirely 
 for the benefit of the manufacturing or technical department ; that 
 the concern in question is not engaged in buying and selling 
 materials and supplies, and that the salaries and expenses of 
 the purchasing department should be charged into the cost of 
 materials and supplies, because of the fact that such services 
 
 204 
 
The Cost-of-Sales Group 
 
 and expenses were incurred in connection with the materials 
 and supplies to be used in the manufacture of goods. The latter 
 point of view would seem to be the most logical one. It is true 
 that the purchasing officer exercises, in a way, both of the func- 
 tions above described. The latter, however, seems to very greatly 
 overshadow the former. The remarks which were made with 
 regard to inward freight and cartage apply with equal force to 
 the salaries and expenses of the purchasing department. Theo- 
 retically, they add to the cost of materials and supplies ; practi- 
 cally, it is inexpedient, on account of the clerical work involved, 
 to pro-rate them on a unit basis. They are, accordingly, included 
 in the overhead. 
 
 In connection with purchases there are several classes of items 
 which should be mentioned. Prominent among these are pur- 
 chase returns, trade discounts, allowances and rebates. These 
 items bear the same relation to gross purchases that sales returns, 
 etc., bear to gross sales. In short, they are deductions from 
 the gross purchases which result in arriving at the true cost of 
 the purchases. It will probably not be necessary to discuss them 
 here, since similar items relating to sales were discussed in the 
 preceding chapter. Neither is it proposed to discuss here cash 
 discount, rent of factory, taxes and insurance on factory property, 
 etc., for the reason that such items will be discussed under a 
 separate group, entitled "deductions from income." 
 
 In arriving at the cost of sales it must be borne in mind that 
 manufacturing cost is not cost of goods sold. Manufacturing 
 cost is affected by the difference in inventory of goods in process 
 and the difference in inventory of finished goods. The cost of 
 sales is arrived at logically by beginning with materials and 
 supplies, adding labor and manufacturing overhead, allowing these 
 three items to represent goods in process, which, when completed, 
 will be transferred to finished goods. As goods are sold they 
 are charged to cost. This method, which may be called the direct 
 method, becomes possible only when there is a cost system. Where 
 no cost system obtains, and it is necessary to procure the informa- 
 tion concerning the cost of sales from the general books, it is 
 obtained by what is known as the inventory or indirect method. 
 The respective accounts for materials and supplies, labor and 
 overhead are closed into the account for manufacturing. This 
 account represents the goods in process. If at the end of the 
 
 205 
 
Principles of Accounting 
 
 period an inventory of goods in process is taken, and this inven- 
 tory is applied to the manufacturing account, the difference will 
 constitute the cost of goods transferred to finished stock. In the 
 same way, if an inventory is taken of the finished goods, and 
 this inventory applied at the end of the period to the finished 
 goods account in the general ledger, the difference in the account 
 will then represent the cost of the goods sold. 
 
 An ideal manner of closing the books where a statement of 
 income and profit and loss is to be prepared is to ooen an account 
 called "cost of sales," and to close into it the items included in 
 this group. Beginning with the account for materials and sup- 
 plies, the first item will constitute the difference in inventory of 
 materials and supplies. The subsequent charges pertaining to 
 materials and supplies will be gross purchases, inward freight, 
 inward cartage and the salaries and expenses of the purchasing 
 department. The credits pertaining to materials and supplies 
 will be purchase returns, trade discounts on purchases, purchase 
 allowances and purchase rebates. 
 
 At this point it may be advisable to pause for a moment to 
 discuss a point with regard to the inventory of materials and 
 supplies. There will frequently be instances in which the item 
 of inward freight is sufficiently large to justify setting up a part 
 of this freight in the inventory. For example : A foundry 
 buying large quantities of pig iron, and having to pay the inward 
 freight, would be justified (if at inventory time there remained — 
 out of purchases of a hundred thousand tons — eighty thousand 
 tons,) in setting up in the inventory eight-tenths of the inward 
 freight on the pig iron. Theoretically, the same thing applies to 
 inward cartage, although the items are usually so small as not 
 to warrant this procedure. 
 
 Resuming now with the items making up the cost of sales, 
 the account for direct labor will be closed into the account "cost 
 of sales." The various items of factory expenses will be treated 
 likewise. The account for goods in process inventory, which 
 showed the inventory on hand at the beginning of the period, 
 will be treated with the inventory on hand at the end of the 
 period. The difference in this account will be closed into the 
 cost of sales. In a similar way, the account for finished goods 
 inventory, which showed on the debit side, the inventory at 
 the beginning of the period and on the credit side, the inven- 
 
 20$ 
 
The Cost-of-Salcs Group 
 
 tory at the end of the period, will be closed out to the cost of 
 sales. 
 
 It will thus be seen that the cost-of-sales account will contain 
 
 the precise information necessary to prepare the second section 
 of the statement of income and profit and loss, as follows : 
 Materials and supplies: 
 
 Gross purchases $75,500.00 
 
 Less-purchase returns 500.00 
 
 Net purchases $75,000.00 
 
 Add — Inward freight 400.00 
 
 Inward cartage 200.00 
 
 Salaries and expenses purchasing 
 
 department 1,400.00 
 
 Total cost of purchases $77,000.00 
 
 Deduct— Trade discounts on purchases. . $500.00 
 
 Purchase allowance 400.00 
 
 Purchase rebates 100.00 
 
 Total deductions $1,000.00 
 
 Net cost of purchases $76,000.00 
 
 (Add or) deduct difference in inventory 
 
 materials and supplies 5,000.00 
 
 Cost of mat'ls and supplies consumed $71,000.00 
 
 Labor — Direct 25,000.00 
 
 Factory expense : 
 
 Superintendence 5,000.00 
 
 Labor, indirect 600.00 
 
 Salaries of clerks 2,000.00 
 
 Factory office expense 400.00 
 
 Heat, light and power 750.00 
 
 Factory supplies 250.00 
 
 Repairs and renewals 50.00 
 
 Depreciation of machinery, etc 950.00 
 
 Total manufacturing cost $106,000.00 
 
 207 
 
Principles of Accounting 
 
 Add (or deduct increase or) decrease in in- 
 ventory of goods in process 10,000.00 
 
 (Add or) deduct increase (or decrease) in 
 
 inventry of finished goods 85,000.00 
 
 Total cost of sales $31,000.00 
 
 The second section of the income statement will not always 
 appear in as great detail as the above, for various reasons. Fun- 
 damentally, however, whether shown in detail or condensed, the 
 cost of sales remains as indicated. 
 
 208 
 
CHAPTER XXXV 
 
 GROSS PROFIT ON SALES AND TURNOVER 
 
 Gross profit on sales forms the subject of considerable discus- 
 sion in accounting. It is obtained by deducting the cost of sales 
 from, the income from sales. It is the first, or prime, profit 
 obtained by placing against the income derived from sales the 
 cost of the goods themselves. It does not take into consideration 
 the expense of selling the goods, the expense of administering 
 the business, nor any expense in connection with the obtaining 
 or employment of capital. The discussion which arises in con- 
 nection with gross profit is whether or not it should be shown 
 in relation to cost or to the sales price. It is quite common for 
 one to hear the expression, "The gross profit is sixty per cent." 
 It is not clear, however, when such a statement is made, whether 
 this percentage is ratio of gross profit to cost or ratio of gross 
 profit to sales. A careful analysis of the question fails to reveal 
 any specific advantage other than a desire for uniformity in 
 either method of treatment. It has been claimed that the ratio 
 should be based on cost, because of the fact that the volume of 
 sales is liable to fluctuate widely. This reason appears fallacious, 
 because of the fact that if sales fluctuate cost should fluctuate 
 accordingly. That either basis is correct so long as it is con- 
 sistent would appear to be true. As an illustration, let it be 
 supposed that the sales price is $1,000, the cost $600, and the 
 gross profit $400. It will then be true that the gross profit is 
 66 2-3 per cent, of the cost and 40 per cent, of the selling price. 
 If this one case be multiplied by the great number of transactions 
 which might be expected to enter into the accounts of a large 
 concern during the period of a year it will then be seen that if 
 this transaction is a typical one gross profits for the year should 
 be about 66 2-3 per cent, of cost, or 40 per cent, of sales. It 
 would seem to be immaterial which basis were selected. Statis- 
 tics become valuable only when they can be compared. In the 
 case under discussion at present the comparison would be either 
 with an organization engaged in a similar line of business or a 
 comparison of the figures for this period with those of another 
 period. It would not be consistent to compare the ratio of gross 
 
 209 
 
Principles of Accounting 
 
 profits in the case of organization A, if this gross profit were 
 based on cost, with the gross profit of organization B, the gross 
 profit of which was based on sales. Nor would it be consistent 
 to compare the gross profit of this period, when based on -cost, 
 with the gross profit of the next period when based on sales. 
 The basis would seem to be entirely a matter of a simple arith- 
 metical calculation. Two and two will make four; three and 
 one will make four. The ratio which either one of the compo- 
 nent parts bears to the whole will change in accordance with 
 changes in the component parts. 1 wo is 50 per cent, of four ; 
 one is 25 per cent, of four; while two is 100 per cent, of two, 
 and one is 50 per cent, of two. If four changes to five, or even 
 six, the relation of two and one, respectively, to either five or 
 six will change. If the sales increase and the cost remains con- 
 stant, the ratio of gross profits to sales will increase. If sales 
 decrease, and the cost remains fixed, the ratio of gross profits 
 to sales will decrease. This situation, however, is largely theo- 
 retical, because when sales increase or decrease they are usually 
 attended by a corresponding increase or decrease in the cost. 
 The reverse would usually be true. If cost increases or decreases, 
 it should be due to increase or decrease in sales. The percentage 
 of gross profits, whether determined on cost or sales basis, should 
 not be affected fundamentally by fluctuations in either cost or 
 sales. 
 
 Some time ago a trade journal published an article by a 
 representative of one of the largest manufacturing concerns in 
 the country. The article occupied four columns of space. It 
 was based on the following question : "A certain article cost 
 $1.00 wholesale. What will it have to be sold for to allow a 
 profit of 10 per cent, after allowing 22 per cent, for cost of doing 
 business?" It was said to be a very simple question, and one 
 that every retailer has to answer in his own business every day, 
 but that seven hundred and fifty out of one thousand retailers 
 answered it wrong. One thousand retailers would probably have 
 answered the question correctly if it had been a fair one. It is 
 a slight reflection on the intelligence of seven hundred and fifty 
 retailers that they were not sharp enough to ask the question, 
 "Is the profit of 10 per cent, on sales or on cost?" and it would 
 appear to be merely a coincidence that two hundred and fifty 
 out of the one thousand arbitrarily selected the sales basis. It 
 
 210 
 
Gross Profit on Sales and Turnover 
 
 is not at all improbable that the whole proposition was an adver- 
 tising scheme, simply to involve retailers in discussion and attract 
 attention to the concern which propounded the question. It 
 serves here, however, to illustrate the importance which attaches 
 to the subject. The only objection that the author knows to 
 using the sales basis is that the transaction will never show 
 ioo per cent, profit. Just as soon as the elements of cost and 
 expense are introduced into a sale it becomes impossible to make 
 ioo per cent, of profit on the sale. Frankly, this does not seem 
 to constitute a consistent objection to this method. The cost 
 method, seems the more logical, however, since the ordinary 
 merchant, in fixing a price upon his goods, begins with their 
 prime cost, and adds the expense of selling them and the expense 
 of administration, etc. To all of these he then adds the per- 
 centage of profit which he desires to realize, and such figures 
 constitute his selling price. Cost necessarily precedes selling 
 price. Hence it would seem illogical for a man to settle upon 
 a selling price and then deduct the profit which he desires to 
 make, in order to ascertain what his cost is to be. 
 
 The percentage of gross profit is undoubtedly a valuable 
 means of presenting comprehensive information as to profits. A 
 certain line of goods showing a gross profit of 60 per cent, for 
 the present year should, under precisely similar conditions, show 
 the same percentage of gross profit during the next year. If 
 the gross profit is different, then the cause must be sought in 
 one of two places — sales or cost. If the sales have increased 
 during this period as compared with the next preceding, whereas 
 the cost has remained practically the same, the cause of the in- 
 crease in profits may be traced either to lower purchase prices or 
 a greater number of completed sales without returns or allow- 
 ances. This indicates good judgment and efficiency on the part 
 of both the purchasing and sales departments. If the sales have 
 decreased while the cost remains constant the reverse might 
 be true. Sales remaining the same, with costs either increasing 
 or decreasing, might mean lack of initiative or ability on the 
 part of the sales force with either an increase or decrease in 
 the efficiency of the purchasing and manufacturing departments, 
 in accordance with either the increase or decrease in the cost of 
 the goods. 
 
 Statistics of this nature are not conclusive. They are merely 
 
 211 
 
Principles of Accounting 
 
 indicative. Without them the situations such as have just been 
 described would, perhaps, never be thought of. They are expe- 
 dients which are inexpensive and at the same time valuable. 
 They are made use of very largely by organizations constructed 
 on a departmental basis, for judging the capacity and ability 
 of heads of departments. They give clues, so to speak, which 
 may be investigated, and point the way to information which 
 may be of real value to the administrative force. The author 
 remembers one case in which an expedient growing, out of sus- 
 picions aroused by decreasing gross profits was resorted to to 
 apprehend a bartender who was suspected of failing to account 
 for all the liquor which he dispensed over the bar and instead 
 putting a part of the proceeds into his own pocket. Acting on 
 the suspicion, a series of tests were made to determine approxi- 
 mately what the gross profit on the various kinds of liquors should 
 be. It was ascertained that a bottle of whiskey contained approxi- 
 mately so many drinks, which could be sold for fifteen cents each. 
 The sale price of a bottle of whiskey was, therefore, ascertained. 
 It was known what the whiskey cost. Thus it became possible 
 to determine the gross profit and the ratio of gross profit to cost. 
 Similar tests were made with beer, fancy drinks and bottled 
 goods. These being used as a basis for judging the entire sales 
 of the bar, when the usual calculations for the subsequent month 
 showed the cost of sales respectively, it was an easy matter to 
 apply the respective percentages of gross profit and ascertain 
 the approximate amount of sales for the month. When the sales 
 reported and accounted for fell far short of this amount the 
 management had little hesitancy in charging the bartender with 
 the irregularity, which he admitted. 
 
 The establishment of inventories by the gross profit method is 
 frequently resorted to in the settlement of fire losses. Suppose, 
 for example, that a fire occurs at some time other than that at 
 which the inventory has just been taken. Unless detail stock 
 records have been kept and preserved the amount of stock on hand 
 at the time of the fire must be approximated. Sales records will 
 in most cases be intact because of having been put away in the 
 safe. From such records or the sales account in the general 
 ledger or both the sales since the last physical inventory may be 
 
 212 
 
Gross Profit on Sales and Turnover 
 
 established. The application of the average gross profit for three 
 or five years next preceding the fire will give a fair approxima- 
 tion of the cost of the goods sold since the last inventory. With 
 this information available a fairly accurate estimate of the inven- 
 tory at the time of the fire may be obtained. Normally, inventory 
 at the beginning of the period, plus purchases, — less inventory at 
 the end — equals cost of goods sold. From this it follows logically 
 then, that the inventory at the beginning of the period plus the 
 purchases — less the cost of the goods sold — equals the inventory 
 at the end of the period, which in the case in question means the 
 date of the fire. Such is the manner, making due allowance for 
 the goods in process, in which the estimated value of the stock is 
 arrived at and becomes the basis for fixing the amount of the loss. 
 
 Turnover is a term sometimes applied to the cost of sales. It 
 is a term which has come into use in connection with accounting, 
 and constitutes one of the many technical expressions which 
 might better be avoided. When one uses the expression "cost 
 of sales" every one understands what is meant. When one uses 
 the expression "turn-over," a discussion usually arises as to 
 whether cost of sales or something else is meant. Mr. R. H. 
 Montgomery, C.P.A., in his book on "Auditing," suggests the 
 following definition, in which the author concurs : "The turn- 
 over of a merchant or manufacturer represents the number of 
 times his capital, in the form of stock in trade, is reinvested in 
 stock in trade during a given period." Mr. Montgomery gives 
 the following formula for ascertaining the turn-over: "Take 
 the starting discovery, add the purchases or cost of manufac- 
 tured goods, and deduct the inventory at the end. Divide the 
 total by the starting inventory. The result will be the number 
 of times the capital invested in stock in trade has been turned 
 over during the period." 
 
 It will be seen that this expedient may also be used to gauge 
 the efficiency of heads of departments in a concern such as a 
 department store. The number of times which the stock has 
 been turned over will indicate the efficiency of the sales force. 
 
 In a large retail shoe store in New York City, which is 
 organized on a departmental basis, the turn-over is ascertained 
 monthly with regard to each department and is useful in admin- 
 
 213 
 
Principles of Accounting 
 
 istering the business. If the goods in a given department have 
 not been turned over as many times as they should have, an in- 
 quiry is made to determine the cause. Failure may be due to 
 a falling off in the demand for the goods offered by that particular 
 department, or by failure of clerks to satisfy the requirements 
 of customers. A little attention is then given to the department 
 in question, with a view to ascertaining the specific cause. If 
 the trouble is found to rest with the clerks, the inefficient clerks 
 are eliminated. A practical application of the turn-over is best 
 seen in organizations similar to the one just mentioned, where 
 the operations can be localized and circumscribed in departments. 
 
 The margin of profit on merchandise frequently depends upon 
 the number of times it may be turned over. Almost everyone 
 in New York City is familiar with candy at a "penny a pound 
 profit." A penny a pound would represent an insignificant profit 
 if it were not for the great number of pounds sold. No doubt if 
 one were to ask of this manufacturer how he can afford to do busi- 
 ness on this basis he would reply "because I am able to turn my 
 money over so quickly." The goods are sold for cash and the 
 profit realized as soon as the goods are sold. 
 
 A merchant with a stock of $10,000 which he sells at a profit 
 of 2% will, if he sells such a quantity and value of merchandise 
 six times in the course of a year, be at the end of the year in the 
 same position with regard to profits as the man who sells $20,000 
 worth of merchandise at 6%. Each will have made a profit of 
 $1,200. Calculate the position of the respective merchants if 
 each is obliged to borrow his entire capital at 4%. The first one 
 will realize a net profit of $800 while the second realizes a net 
 profit of $400. 
 
 The suggestion of interest raises a question which might prop- 
 erly accur to one giving thought to the subject. "Is the turnover 
 dependent upon the realization of profit in the form of cash?" In 
 answer it may be said that it is not. Profit is the difference be- 
 tween the cost and selling price of goods and may appear as vested 
 in cash, accounts or notes receivable, etc. When the goods have 
 been sold or turned over the profit arises even though not collected. 
 If goods are sold on credit, it is to be presumed that they may be 
 purchased on credit and on terms equivalent to those on which 
 
 214 
 
Gross Profit on Sales and Turnover 
 
 they are sold. If necessary to borrow funds with which to finance 
 the transaction, the expense of interest will serve to decrease the 
 amount of profit. Such a situation must not be overlooked by 
 the administration in planning the financial operations, but it 
 should not be permitted to cloud the principal issue with regard 
 to the turnover. 
 
 REFERENCES FOR COLLATERAL READING: 
 
 Journal of Accountancy, Vol. XII, page 346. 
 
 215 
 
CHAPTER XXXVI 
 
 THE SELLING-EXPENSE GROUP 
 
 This group comprises the expenses relating to the sales de- 
 partment, advertising, and such miscellaneous expense as enter- 
 taining customers. The sales department expenses may be divided 
 into those having to do with the office and those of the salesmen. 
 The office expenses will consist of the salaries of the sales 
 manager and clerks as well as the miscellaneous office expenses. 
 The expenses of the salesmen will include salaries, traveling 
 and commissions. There is nothing especially peculiar concern- 
 ing the salaries of the sales manager and clerks. At times, the 
 amount chargeable to the salary of the sales manager is a part 
 of the salary of some officer of the company whose time is in 
 part devoted to selling and the management of the sales depart- 
 ment. Neither do the salaries of the salesmen call for any 
 particular comment. Traveling expenses will include all expenses 
 from the time the salesman leaves the office until he returns 
 from his trip. Most concerns require detailed expense reports 
 from their salesmen, classifying the expenses into traveling, sub- 
 sistence and miscellaneous. Traveling includes the car or taxicab 
 which takes the salesman from the office to the train, his railroad 
 fare to point of destination, including Pullman and meals on 
 the train; also the cab or car from the station at destination to 
 the hotel. Subsistence covers his board and lodging at the 
 hotel, while miscellaneous expenses cover items like stationery, 
 telegrams, etc. It is quite the custom to advance funds to 
 salesmen for traveling expenses, the funds to be accounted for 
 either monthly, or at the end of each trip if the traveling is not 
 continuous. Where a salesman is constantly on the road, the 
 fund is carried the same as the ordinary working fund. He 
 will be advanced a sufficient amount to cover his expenses for 
 the month, for example. At the end of each month he sends 
 in his expense report, and receives in return a check in the same 
 amount. Thus, on the books of the general office he will at all 
 times be charged with the amount of his fund. 
 
 A salesman may receive not only salary but commission for 
 his services. In some cases, salesmen work entirely on com- 
 
 216 
 
The Selling-Expense Group 
 
 missions. In both these cases a somewhat unique question fre- 
 quently presents itself. To illustrate the point, take, for example, 
 the straw hats which will be sold by retailers during the coming 
 spring and summer. These same goods were probably sold by 
 salesmen representing wholesalers who were on the road, com- 
 pleted their sales, received their salaries, traveling expenses and 
 commissions prior to December 31. The question which arises 
 is this: "Is it proper to charge such expenses against one year, 
 although contracts for delivery are made in that year, when the 
 actual delivery of the goods will not be made and sales recorded 
 until the subsequent year?" Theoretically, it is not correct to 
 do so, for the reason that while legally the sale was made during 
 one year the sales were not recorded as such, in so far as the 
 operations of the business are concerned, until a subsequent 
 year. Theoretically, the income of the subsequent year profited 
 by the sales. It would also seem, as a matter of justice, that it 
 should be charged with the expenses attending these sales. Cases 
 have been known where concerns attempted to suspend salaries 
 and expenses of salesmen and apply them against the period 
 in which the sales were recorded. In the majority of cases, 
 however, it is held that one period will offset another, or that 
 the matter will be evened up in the long run, and it is generally 
 a waste of time and effort to carry these items in suspense and 
 apply them properly. 
 
 Commissions are usually computed on sales prices. In some 
 cases they are credited to the salesman's drawing account, against 
 which advances are charged. It becomes necessary in some 
 cases to keep elaborate records of commissions, because of the 
 tendency on the part of salesmen to put through orders which 
 are not bona fide, and in that way attempt to collect larger 
 commissions than they are entitled to. Concerns which have 
 commission contracts with their salesmen are put to no end of 
 trouble many times through returns and cancellations. Most 
 concerns pay commissions to salesmen only on sales which mate- 
 rialize, or, in other words, net sales. Real estate concerns and 
 insurance companies which employ salesmen and agents espe- 
 cially require elaborate books and records dealing with commis- 
 sions. The subject of agents' commissions in the insurance line 
 is sufficient for a small book in itself. It may be mentioned, in 
 passing, that the principal distinction to be borne in mind by 
 
 217 
 
Principles of Accounting 
 
 insurance companies is the payment of commissions on first-year 
 premiums and renewal premiums. The rate differs on the two 
 classes of premiums, being much greater in the case of first-year 
 than in the case of renewals. It is, therefore, important that the 
 company distinguish between the two. 
 
 Advertising is one of the most important items in this group. 
 Advertising may embrace several different forms, namely, the 
 display of advertisements in newspapers and magazines, the 
 display of advertisements on billboards, circular letters, souvenirs, 
 etc. It was also suggested to the author on one occasion that 
 the cost of a sign be charged to advertising. To this no particu- 
 lar exception could be taken. Surely no one would object to 
 charging the expense of operating an electric sign to advertising, 
 and the question of charging the cost of the sign would, in either 
 case, not be whether or not it was approximately chargeable to 
 advertising, but as to whether or not it was desired to capitalize 
 an item of such considerable cost. A well-known department 
 store, which maintains an auditorium and an entertainment daily 
 for its patrons, charges, it is understood, the expense of con- 
 ducting this feature of the store to advertising. Any legitimate 
 expense having to do directly with advertising may properly be 
 charged to the advertising account. The account has, however, 
 in some instances, become a general dumping-ground for mis- 
 cellaneous items — not excepting rebates. One instance is recalled 
 in which a small concern, doing practically no direct advertising, 
 had an expense account for advertising (rebates) running into 
 thousands of dollars. While this procedure was not illegal at 
 the time it occurred, it was not justified. The proprietor attempted 
 to justify it on the theory that this was one means of attracting 
 customers. The fallacy of such theory will be apparent after 
 a moment's thought. 
 
 The question of vital importance with regard to advertising 
 is, first, whether or not it is prepaid; and second, if prepaid, in 
 what manner and at what rate is it used? A concern engaged 
 in circularizing would not be warranted, according to the best 
 accounting practice, in charging immediately to expense the 
 cost of printing 250,000 circular letters and envelopes- It would 
 be proper, rather, to charge these letters and envelopes to expense 
 approximately as used. The rule is to charge advertising, not 
 to the period in which it is contracted for, or paid for, but to 
 
 218 
 
The Selling-Expense Group 
 
 the period in which it is used. Thus, an organization contracting 
 for $30,000 worth of advertising for a given year would not 
 charge the entire $30,000 to expense immediately, nor at the 
 time of paying for the advertising, but at the rate of $2,500 a 
 month, if the advertising were to be spread over a period of a 
 year. The value of prepaid advertising, in the case of enforced 
 realization and liquidation, will depend upon the arrangements 
 which can be made with the advertising media or agents. 
 
 The accounts representing the items making up this group 
 are closed into the account, "selling expenses," which account 
 corresponds to the third section of the statement of income and 
 profit and loss, as follows : 
 
 Sales department expenses : 
 
 Salary, sales manager $2,000.00 
 
 Salaries of clerks 1,500.00 
 
 Office expenses 500.00 
 
 Salesmen : 
 
 Salaries 1,000.00 
 
 Traveling 1,000.00 
 
 Commissions . . 1,000.00 
 
 Advertising 2,500.00 
 
 Entertainment of customers 500.00 
 
 Total traveling expenses $10,000.00 
 
 219 
 
CHAPTER XXXVII 
 
 THE ADMINISTRATIVE-EXPENSE GROUP 
 
 The principal items making up this group are salaries of 
 officers, salaries of clerks (keeping general records), directors' 
 fees, printing and stationery, postage, telephone and telegraph, 
 traveling of officers and clerks, legal expenses and miscellaneous 
 office expenses. It has been held by some that the title of this 
 group should be made broader, and called administrative and 
 general expense. It has seemed to the author that this is entirely 
 unnecessary, because of the fact that any item of expense, general 
 in its nature, is, of necessity, a matter of administration, since 
 it does not apply specifically to the manufacture nor to the sale 
 of the goods, but rather to the administration of the business. 
 It is, therefore, thought that administrative expense is sufficiently 
 broad. 
 
 With regard to the above items, it may be said that in certain 
 large organizations the internal scheme of functional adminis- 
 tration throws a peculiar light upon them. Such an organization 
 may have an internal division of administration corresponding 
 to the offices of the president and vice-president, comptroller or 
 auditor, secretary, treasurer, general solicitor, etc. The account- 
 ing department will naturally be presided over by the comptroller 
 or auditor. The cashier will naturally be subsidiary to the treas- 
 urer. Under such an arrangement the administrative expense 
 may, with respect to each department, be divided on the original 
 records into salaries and expenses. It is not uncommon to find 
 separate pay-rolls for the various offices above mentioned. It is, 
 however, uncommon to find expenses so treated. As a rule, office 
 expenses originate on the general books rather than with the 
 various offices, and are charged direct to the general adminis- 
 trative office expense account in the general ledger. The salaries, 
 likewise, while they may be kept on separate pay-rolls for the 
 purpose of classifying them, with regard to the various offices, 
 are usually charged collectively to the salaries account in the 
 general ledger. While it may be desirable, in some cases, as a 
 matter of cost, concerning the running of the various offices, to 
 distribute salaries and expenses, such distribution should be made 
 
 220 
 
The Administrative-Expense Group 
 
 a matter of subsidiary treatment, and should not be taken cog- 
 nizance of on the general books. 
 
 It is evident that many of the items appearing in this group 
 will be subject to accrual. It is doubtful, however, if many 
 concerns give attention to this matter in closing. This is prob- 
 ably due to the fact that the amounts involved are usually small 
 and unimportant, and it is not considered worth while to bother 
 with them. The most striking exception to this general state- 
 ment is probably salaries of officers and clerks. This is due 
 to the fact that the salary-roll may, at times, be of considerable 
 size and the salaries paid weekly. It is not so apt to be the case 
 in the case of salaries of officers as in salaries of clerks. Salaries 
 of officers are, as a rule, paid by the month, while salaries of 
 clerks are apt to be paid weekly. Where the clerks' roll is of 
 sufficient size, and the end of the month happens to fall on 
 Thursday or Friday, it might be worth while to accrue the 
 salaries for the period intervening between the end of the month 
 and the previous Saturday. 
 
 Separate accounts should be maintained in the general ledger 
 for salaries of officers and salaries of clerks. This is objected 
 to at times by the officers, who do not wish to see the disparity 
 in amounts which may result from an overloaded salary-roll for 
 officers. It is well, however, to bear in mind that financial state- 
 ments are sometimes required for presentation to stockholders, 
 and such division facilitates the preparation of a comprehensive 
 statement in this respect. Stockholders may be especially inter- 
 ested in seeing the relation which salaries of officers bear to 
 salaries of clerks, even though the officers are not interested in 
 this information. 
 
 Directors' fees, while of the same general nature as salaries, 
 should be kept separate. Fees are paid to directors for services 
 in attending directors' meetings. The directors, as representa- 
 tives of the stockholders, may, through their attendance at the 
 meetings, assist in the formulation of the company's policies. 
 While they receive compensation for these services, the com- 
 pensation is based upon attendance at meetings, and is slightly 
 different from a salary which is paid for regular and continuous 
 service. 
 
 Printing and stationery, as well as the other items appearing 
 in this group, such as postage, telephone and telegraph, permit 
 
 221 
 
Principles of Accounting 
 
 of little discussion at this time. Printing and stationery, like 
 postage, may be a direct charge to the expense account, in accord- 
 ance with its consumption, or as a balance remaining in the 
 account after inventory for these items has been deducted and 
 set up as an asset. Telephone . bills are usually rendered for 
 the month, in advance, and, of course, should not be accrued. 
 It will rarely occur that they have been paid in advance. What 
 usually happens, however, is that telephone bills for a given 
 month in advance will contain also the calls of the preceding 
 month in excess of the number stipulated in the contract, and 
 any long-distance charges. While these latter items are tech- 
 nically a liability at the end of the preceding month, they are 
 usually so small in amount as to not warrant any attempt to 
 provide for their accrual. 
 
 There may be times when it becomes necessary to draw the 
 line between periods with precision, and at such times it may 
 be necessary to charge excess calls and long-distance charges to 
 the preceding month, in which they belong. Telegraph bills are 
 usually rendered after the month in which the service has been 
 rendered, and, if precision is to be maintained, will have to be 
 provided for through accrual at the end of the month. 
 
 Traveling expenses of officers and clerks are to be distin- 
 guished from traveling expenses of salesmen. The latter is, of 
 course, chargeable to the appropriate account in the selling- 
 expense group. The importance of making this distinction will 
 be evident when it is observed that the traveling of officers may, 
 at times, be somewhat heavy, and unless this distinction were 
 made the salesmen's expenses would be unduly laden. This trans- 
 gression might be especially apparent where a concern maintains 
 a staff of traveling auditors. It is quite probable that the traffic 
 department of a railroad would object to being charged with the 
 expenses of the company's traveling auditors. 
 
 Legal expenses may be the expenses of conducting a legal 
 department, retainers paid to counsel, or charges for legal services 
 occurring irregularly. In connection with the last item it may 
 be remarked that under certain circumstances, where retainers 
 are of sufficient size, they may be taken into consideration in 
 closing the books, and the unearned proportion set up as a 
 deferred charge to expense. 
 
 Miscellaneous office expenses will include such items as sundry 
 
 222 
 
The Administrative-Expense Group 
 
 office supplies, maintenance of office equipment, and dinners for 
 clerks working evenings. It is, of course, probably true that 
 the overtime, if any, paid to such men should be charged to 
 the salary account, and there is no reason, as a matter of exact- 
 ness, perhaps, why dinner money should not also be charged to 
 the salary account. It is thought to be the general custom, how- 
 ever, to charge this latter item to the office expenses. 
 
 Having exhausted by classification the majority of items which 
 appear ordinarily in the administrative-expense group, there are 
 still certain expenses which have not been included, and which, 
 in the opinion of the author, should appear in this group. Such 
 items are usually referred to as general expenses, and seem 
 to be the principal reason advanced by parties who so contend 
 for making the general title of this group "administrative and 
 general expenses." The particular items in mind are those, 
 such as donations, gratuities to employees, bonuses at Christmas 
 time, and miscellaneous gratuities to outsiders whereby the com- 
 mercial comfort and work of the company is facilitated. Gratui- 
 ties to employees may be dismissed with a word, namely, that 
 such expenses are equivalent to an addition to the salary or 
 wage of the employee. It would seem that there should be no 
 reason for excluding, or considering separately, bonuses and 
 gratuities to outsiders, since administrative expense is intended 
 to cover not only the direct administrative expenses but the 
 expenses of the administration. It is true that they might be 
 .somewhat general in their nature, and not possible of inclusion 
 in the classification thus far presented. They are, however, 
 expenses which are considered necessary to the welfare of the 
 company, and, on account of being incurred by administrative 
 officers for the benefit of the company, may be logically included 
 as administrative expenses. A donation to a fire department 
 by a concern having a plant located in New Jersey, or a donation 
 to a local Y. M. C. A., would seem not to be without the scope 
 of argument in favor of treating such items as administrative 
 expenses, since on the one hand the company may expect to 
 receive indirect benefit from its contribution to the fire depart- 
 ment, and, in the same way, indirect benefit through its employees 
 from its contribution to the Y. M. C. A. A donation to charity 
 seems to be the item on which most of the argument against the 
 inclusion of such general items in administrative expense rests. 
 
 223 
 
Principles of Accounting 
 
 It is claimed that no benefit, direct or indirect, accrues to the 
 company from such a donation. This, however, seems small 
 ground for argument, since it must be admitted, it seems, that 
 the company would not make such donation except it expected 
 to be held somewhat in esteem through its general interest in 
 the affairs of the community, for which reason such an expense 
 would seem to be pertinent to the administration of the company's 
 affairs. 
 
 The items comprising this group, which constitute the fourth 
 section of the income statement, and which appear below in 
 tabular form, will, in closing the books, be closed out to the 
 group account administrative expense: 
 
 Salaries of officers $10,000.00 
 
 Salaries of clerks 5,000.00 
 
 Directors' fees 200.00 
 
 Printing and stationery 400.00 
 
 Postage 300.00 
 
 Telephone and telegraph 200.00 
 
 Traveling of officers and clerks 500.00 
 
 Legal expenses 2,000.00 
 
 Miscellaneous office expenses 250.00 
 
 General expenses 1 50.00 
 
 Total administrative expense $19,000.00 
 
 224 
 
CHAPTER XXXVIII 
 
 THE SECONDARY-INCOME GROUP 
 
 in the same manner that deducting cost of sales — from income 
 from sales — produced gross profit on sales, so the deduction of 
 cost of sales, plus selling and administration expenses, from in- 
 come from sales produces net profit on sales. This profit, in the 
 case of a manufacturing and selling organization, is known as the 
 income from operations. It corresponds to the income derived in 
 a railroad company from deducting operating expenses from oper- 
 ating revenues. 
 
 In the modern conception of organization and its attendant 
 operations capital is the medium through which the business is 
 transacted. Just as money is the medium for exchange of values, 
 so capital is the medium for the transaction of business. Theo- 
 retically, the capital of an organization should be just sufficient, 
 and no more, for its needs. Not one bit of this capital, in any 
 form whatsoever, should get into the hands of outsiders. The 
 ideal situation would be exactly the same as if the organization 
 were conducting a strictly cash business ; that it were engaged 
 in only one line of business, having no transactions foreign to 
 this line, and occupying its own plant- entirely. In such an 
 ideal organization there would be no income other than that from 
 operations. That the ideal does not exist is shown by the fact 
 that at times capital of the organization which is not required 
 for its own business is invested in stocks and bonds of other 
 companies ; that it is sometimes permitted to get into the hands 
 of outsiders, through extensions of credit, thus giving rise to 
 accounts and notes receivable; that a portion of it is always 
 deposited in the bank. It also happens frequently when goods 
 are purchased, for example, at sixty days, that there is a discount 
 offered by the vendor for the payment of cash in less than sixty 
 days. Thus, theoretically, a part of the capital is loaned to the 
 vendor. 
 
 The above transactions give rise to income from sources other 
 than sales (or primary income.) This income is called secondary 
 income, because of the fact that the concern in question is not 
 in the business of loaning capital, but rather in the business of 
 
 225 
 
Principles of Accounting 
 
 manufacturing and selling goods. The principal object of the 
 business is the manufacture and sale of goods. Therefore, the 
 primary income of the organization must be from the same 
 source. Incident to the manufacture and sale of goods there 
 are these transactions of capital, and from them income is derived. 
 While it is income, it is secondary to the principal object from 
 which income is sought. Such income exists in the form of 
 interest on bonds, dividends on stock, interest on bonds and mort- 
 gages receivable, interest on accounts receivable, interest on notes 
 receivable, interest on bank balances and cash discounts on pur- 
 chases. There is also included in this group royalties receivable, 
 commissions receivable, considerations for endorsing notes, accu- 
 mulation of discount on bonds, and rent. With regard to the 
 last-mentioned item, it should be borne in mind that the rent 
 is not that received through sub-letting a portion of premises for 
 which rent is paid. It represents, rather, rent received from 
 property not used in the operation of the business. Royalties 
 and commissions are included in this group not because they are 
 outside operations, but operations which are not related to the 
 primary purpose of the organization. 
 
 The point to be kept in mind with regard to the interest items 
 is that they should be accrued at the end of the accounting period. 
 As a matter of convenience, and in order to distinguish between 
 an asset and a liability, many accountants have adopted a tech- 
 nical terminology which indicates the distinction. This scheme 
 contemplates referring to the asset as accrued interest, while 
 the liability is called interest accrued. There would be no par- 
 ticular reason for calling the asset accrued interest, rather than 
 interest accrued, if every one were to use the same terms in 
 describing the asset ; but where some use the term interest accrued 
 for the asset and interest accrued for the liability, in connection 
 with interest expense, it is most confusing. It is, therefore, 
 an attempt to prescribe a working nomenclature, comprehensive, 
 and understood by every one, that has led accountants to use 
 certain expressions, such as the one above described, to mean 
 certain things. 
 
 Dividends on stocks owned may not be accrued at the end of 
 the accounting period. A dividend, unlike interest, is instan- 
 taneous. It comes into being with the declaration of directors. 
 At the end of a given period the net profits may be ample to allow 
 
 226 
 
The Secondary-Income Group 
 
 a return of fifty per cent, on the investment. Stockholders in 
 the corporation are, however, just as far away from a return on 
 their investment as if they held no stock. They have no right 
 whatever to consider that their investment has earned a return. 
 The situation is quite changed, however, when the directors 
 declare a dividend. The declaration of a dividend by the directors 
 gives to the stockholders a right against the company which they 
 may enforce. The enforceable right thus gives rise to income. 
 When a dividend on stock has been declared the holder of the 
 stock is entirely justified in taking the dividend into his income, 
 even though not yet collected. If the dividend has not been 
 declared there is no warrant whatsoever for so doing. Thus 
 it may be said, interest may be accrued always, but dividends 
 never. 
 
 It is possible that some question may arise with regard to 
 cash dividends on purchases. Not every one treats cash dis- 
 counts on purchases as other income. By many accountants they 
 are treated as deductions from gross purchases, the same as 
 trade discounts. By some accountants, cognizance is taken of 
 cash discounts on purchases applying to invoices which will be 
 paid during the first few days of the next succeeding period. 
 In other words, if it is the practice of the purchaser to pay cash 
 within ten days for all goods purchased, the accountant will, 
 at the end of a given period, and supposing that there are invoices 
 to the extent of $30,000, subject to discount at 2 per cent., 
 charge accounts payable and credit cash discounts on purchases 
 in the amount of $600. This procedure is entirely correct from 
 the point of view which this accountant takes. It is not correct 
 from the point of view of the accountant who follows what 
 may be called the more advanced lines of thought, namely : 
 those which consider capital as the medium for the transaction 
 of business, and recognize the income and the expense attending 
 such capital. If discount is considered in the light of interest, 
 then it will be seen that the payment of a purchase invoice before 
 it is due gives rise to interest for the use of money advanced 
 to the vendor before he was entitled to receive it. It is, there- 
 fore, apparent that the question of interest may not arise until 
 such time as the payment has been made. It is not necessary, 
 as a consequence of this theory, to provide at the time of closing 
 
 227 
 
Principles of Accounting 
 
 the book for discounts on invoices which will be paid in the 
 early part of the next period. 
 
 Another item which sometimes appears in this group is con- 
 sideration for endorsing notes. This is, perhaps, a theoretical 
 item rather than otherwise. The author has not in his experience 
 encountered an example of this kind, although such instances 
 are said to have existed. The income represents, practically, 
 a fee received for the guaranteeing of the notes of others. It 
 is, perhaps, questionable, where an item of this kind occurs so 
 infrequently, whether it ought not rather to be a credit to profit 
 and loss than a credit to income. Income is intended to represent 
 something which recurs; profit-and-loss credits comprise unusual 
 and infrequent items. 
 
 Another item in this group to which very little attention is 
 paid is the income corresponding to the accumulation of a bond 
 purchased below par. According to the most modern and scien- 
 tific theory, a bond the interest on which is 6 per cent, purchased 
 below par will yield more than 6 per cent, on the investment. 
 This is due to the fact that the maker of the bond will pay 
 not only 6 per cent, on the par principal during the life of the 
 bond, but will pay the par principal at maturity. For example, 
 a $1,000 bond, purchased at 95, would cost $950. The bond, at 
 maturity, would be redeemed at $1,000. The investor, whose 
 investment consists of $950, will receive 6 per cent, on the 
 par of the bond, but more than 6 per cent, on his investment 
 of $950. It is true, of course, that each year he will receive 
 in cash $60. At the maturity of the bond he will receive not 
 only his investment of $950, but, in addition, $50 more, repre- 
 senting the difference between his investment and par. This 
 amount, while received in a lump sum, has, in reality, been 
 earned over the period during which he has held the bond, and 
 it is quite unfair to allow the profits of the year in which the bond 
 matures to benefit by the entire amount. What should have 
 been done was to spread the $50 in question over the number 
 of years which the investor held the bond. It is, therefore, 
 apparent that the return on his investment would have been 
 greater than 6 per cent., possibly 6}4. This is called the effective 
 rate of interest, as compared with 6 per cent., the nominal in 
 this case. The excess of yield over the nominal will depend 
 upon several things, namely: the purchase price of the bond, 
 
 228 
 
The Secondary-Income Group 
 
 the nominal rate of interest, the interest periods, and the length 
 of time which the bond has to run. What happens is that the 
 interest earned on bonds will be credited not only with 6 per 
 cent, which is received in cash but J4 per cent, which is being 
 periodically added to the face of the investment. Supposing, 
 for example, that on an investment of $950 in a certain bond 
 the yield was 63^2 per cent., the earning then for the year would 
 be $61.75. At the time of closing the books the following entry 
 would be made : 
 
 Accrued interest on bonds $60.00 
 
 Bonds 1.75 
 
 To Interest on bonds $61 .75 
 
 Upon receipt of the interest the following entry : 
 
 Cash $60.00 
 
 To Accrued interest on bonds $60.00 
 
 It will be seen that the bond investment would now be carried 
 on the books at $951.75. The value of this investment would 
 increase from time to time in accordance with the amount of the 
 excess income taken into the interest account, and would con- 
 tinue to increase periodically until at the time of maturity it 
 would amount to $1,000. An entry would then be made convert- 
 ing the bond at $1,000 into cash. The process of increasing the 
 value of the bond has sometimes been called amortization. It 
 is not amortization, but the reverse of same. It is properly 
 called accumulation, the accumulation consisting of the increase 
 in the investment until, at the time of the maturity of the bond, 
 it reaches par. The term amortization presumably came into 
 use because it was considered that the discount representing the 
 difference between the investment price and par was being amor- 
 tized, or reduced. 
 
 This group corresponds to the fourth section of the state- 
 ment of income and profit and loss, which appears as follows. 
 The items representing the accounts involved are closed out 
 into the group account income from other sources : 
 
 229 
 
Principles of Accounting 
 
 Interest on bonds owned $400.00 
 
 Dividends on stocks owned $250.00 
 
 Interest on bonds and mortgages (receivable) . . 300.00 
 
 Cash discounts on purchases 75°-°° 
 
 Interest on bank balances 50.00 
 
 Interest on accounts (receivable) 75 .00 
 
 Interest on notes (receivable) 375-°° 
 
 Rent (receivable) 145-00 
 
 Royalties (receivable) 300.00 
 
 Commissions (receivable) 250.00 
 
 Accumulation on bonds 5.00 
 
 Total income from other sources. ......... $2,900.00 
 
 230 
 
CHAPTER XXXIX 
 
 DEDUCTIONS FROM INCOME GROUP 
 
 In discussing the items under this group it is again necessary 
 to consider capital as the medium whereby the business of the 
 organization is transacted. In theory, the group contains only 
 items which are in the nature of expenses of capital. Capital 
 expenses should be distinguished from capital expenditures. It 
 should be thoroughly understood that what is not meant is an 
 expenditure of the funds of the organization, which is capitalized, 
 or set up as an asset. It distinguishes the expenses in connec- 
 tion with capital from the expenses in connection with operations. 
 While capital is necessarily involved, and is employed in the 
 operations, the expenses of obtaining, using or protecting capital 
 are set up separately, in order to show what the income from 
 operations would be if there were no expenses in connection 
 with capital. 
 
 Aside from being based on sound, economic principles, this 
 theory requires a classification which greatly facilitates the com- 
 parison of different organizations. Only like quantities may 
 be compared. In the same way, only like organizations may 
 be compared. It is in the matter of items comprising this group 
 in which there is greatest conflict when comparison is attempted. 
 
 The principal items in the group are interest on bonds and 
 mortgages payable, interest on accounts payable, interest on notes 
 and loans payable, cash discounts on sales, rent (payable), insur- 
 ance expense, taxes, interest on capital and royalties (payable). 
 Of these, the interest items are probably easiest to compre- 
 hend, as coinciding with the theory advanced. Interest on bonds 
 and mortgages, accounts or notes is paid because of the fact 
 that the organization has not sufficient capital of its own with 
 which to transact business. If the owned capital were suffi- 
 ciently large there would be no occasion for borrowing on any 
 of the instruments just mentioned. It is because of the fact 
 that interest is an expense of obtaining capital that it is classified 
 in this group. 
 
 Cash discount is not so easily reconciled, because of the 
 custom which is, at the present time, perhaps, rather general, of 
 
 231 
 
Principles of Accounting 
 
 considering cash discount as a deduction from sales, the same 
 as trade discount. In order to get the proper conception of 
 the theory, as applied to cash discount, it is necessary to con- 
 sider it practically the same as interest. A merchant who buys 
 an invoice of goods makes a contract. The contract of purchase 
 and sale arises when certain specific goods ready for delivery 
 have been offered and accepted. Under the terms of the con- 
 tract, delivery may be made immediately; but the purchaser, if 
 the question of cash discount is to enter into the question, will 
 probably be permitted thirty, sixty, or possibly ninety days, to 
 make settlement. If this question of credit were not involved 
 cash discount would not enter into the problem. It is because 
 of the fact that a contract has been made, and the payment of 
 the purchase price stipulated at thirty days, or longer, that the 
 vendor offers a cash discount as an incentive to the purchaser 
 to make an earlier settlement. In other words, the vendor offers 
 to pay interest for the use of the money if he may obtain it 
 before it is due under the terms of the contract. The vendor 
 is, therefore, in the position of having borrowed money from 
 the purchaser, for which he virtually pays interest. Thus it 
 becomes perfectly logical to include cash discount on sales as a 
 deduction from income, on the theory that it is an expense of 
 obtaining capital. It need scarcely be pointed out that as a 
 matter of financial policy the offering of a cash discount is good 
 finance. To the concern engaged in a business in which the 
 profits are large the money is worth very much more than the 
 small amount of cash discount paid for its use. 
 
 There are two very good reasons for treating rent as a 
 deduction from income. The first one is that rent is considered 
 by the economist not an expense of the business but a share 
 of the profits, which the tenant turns over to the landlord 
 for the use of the premises. The second is that a concern paying 
 rent does so either because of the fact that it does not own its 
 own property, on account of lack of capital, or because it is 
 inexpedient to do so. In either case, rent seems to be analogous 
 with interest, since it is paid for the use of capital in the form 
 of property. As an expense, therefore, of capital it is properly 
 treated as a deduction from income. The question is often raised 
 as to the propriety of treating the rent of the general office of 
 an organization as deduction from income. The question is 
 
 232 
 
Deductions from Income Group 
 
 often asked, "Would you consider the rent of an office in New 
 York City in this class?" The question is probably prompted by 
 men who have in mind the thought that a great number of indus- 
 trial and mercantile organizations throughout the country main- 
 tain general offices in New York City. It seems strange to them 
 that such concerns should arbitrarily be placed in the position 
 of borrowing capital. The tendency is to consider rent paid 
 for such offices as an administrative expense. The disposition is 
 to connect the expense specifically with the department of the 
 organization for which the expense was incurred rather than 
 as an expense of capital. 
 
 Illogical as it may seem to many, there is no exception, so 
 far as the author is aware, to the treatment of rent as a deduc- 
 tion from income, under the theory that the concern is occupying 
 borrowed property or capital. True, a large industrial organiza- 
 tion may not rent an office in New York City because of the 
 fact that it has not sufficient capital to own its own building. 
 The point is that it does not find it expedient to invest the large 
 sum of money necessary to purchase or construct a building of 
 its own where it requires general offices. It is cheaper to rent 
 than to own. This view does not alter the fact that when it 
 does rent it occupies the property of another rather than tie 
 up its own capital in the investment, and, therefore, does pay a 
 rent which is analogous to interest for the use of capital. 
 
 Insurance is a premium paid for the protection of property. 
 It is a risk assumed by the company in behalf of the assured 
 against through loss by fire, theft, accident, or loss from acts 
 of nature. It is money paid for the protection of capital. It 
 is, therefore, an expense of capital, and as such is properly con- 
 sidered as a deduction from income. Here again many find it 
 difficult to disassociate insurance from the particular property 
 which is insured. Perhaps the average student of the subject will 
 insist that insurance on materials and supplies in stores is not 
 properly treated otherwise than as an expense of the operating de- 
 partment. The question often asked is, "How can you consider 
 insurance paid for the protection of your factory property as an 
 expense of capital ?" The answer is that capital is invested in the 
 factory property, and just as interest paid for the use of money 
 so employed is considered as an expense of capital, so insurance 
 paid for the protection of this capital is a similar expense of 
 
 233 
 
Principles of Accounting 
 
 capital. More than one student seeking the light, or perhaps 
 attempting to find a flaw in the reasoning advanced in accord- 
 ance with this theory, has asked the question, "Why not charge 
 the wages of the watchman at the factory to insurance, or treat 
 it as a deduction from income?" A specific answer to the question 
 might consist in saying that no money is invested in the watch- 
 man, and therefore there is no expense which can be traced 
 directly to capital. This line of reasoning, though somewhat 
 simple, will, it is believed, always produce the correct result. 
 
 Taxes are included in this group for the reason that they 
 are likewise paid for the, protection of capital. The State under- 
 takes to exercise the police power. It protects the property of 
 the citizen as well as the property of the business man. For 
 this protection it exacts a tax. The business organization with 
 capital invested is, therefore, protected. The taxes are an expense 
 of such protection. The questions raised in connection with con- 
 sidering taxes as deduction from income are generally irrespective 
 of organization taxes and the tax on net income. It is possible, 
 without a great deal of difficult reasoning, to place these items 
 in the same class. These taxes apply only to corporations. 
 Obviously, a corporation may not own capital until it has been 
 organized. If the tax is paid for organization it gives to the 
 corporation the right to own capital. The fee for this right is 
 in connection with capital, and, therefore, becomes an expense 
 of capital. The federal corporation tax law imposes on corpo- 
 rations, joint stock companies, or associations organized for oper- 
 ation and having a capital stock represented by shares, a special 
 excise tax with respect to the carrying on of or doing business. 
 It further provides that the tax of one per cent, shall be assessed 
 upon the net income over and above $5,000. Here again it will 
 be seen that the theory is logical, since, in the first place, the 
 tax is imposed by the government for the privilege of doing 
 business, in which privilege the corporation is protected; and 
 in the second place, the net income is shared with the government 
 for such privilege. It cannot be argued, it seems, that this tax 
 is a part of the cost of the goods sold, the expense of selling 
 them, or the expense of administering the business, but rather 
 a specific deduction from the income. The difficulty involved 
 in making this point clear has more than once arisen when the 
 question has been asked, Shall such taxes be considered before 
 
 234 
 
Deductions from Income Group 
 
 the net income is arrived at? Clearly this is not possible under 
 the law, any more than it is a pertinent question. In making 
 up its return to the government the corporation will determine 
 its net income. The government will then compute the tax. 
 This report, however, is something quite different from the com- 
 pany's statement of income and profit and loss. 
 
 On account of the importance of interest, insurance and 
 taxes, apart from the role which they play in disclosing true 
 economic or operating results, they will be made the subject, 
 as in the case of depreciation, of separate chapters which follow. 
 
 In preparing the statement of income and profit and loss 
 the items in this group, as appearing below, will constitute the 
 sixth section, and in closing the books will be closed into the 
 group account — deductions from income : 
 
 Interest on bond and mortgage payable $2,000.00 
 
 Interest on accounts payable 200.00 
 
 Interest on notes and loans payable 500.00 
 
 Cash discount on sales 300.00 
 
 Rent (payable) 400.00 
 
 Insurance 100.00 
 
 Taxes 200.00 
 
 Royalties (payable) 300.00 
 
 Total deductions from income $4,000.00 
 
 * Amended 1914 disallowing specific deduction of $5,000. 
 
 *35 
 
CHAPTER XL 
 
 DEPRECIATION 
 
 Depreciation may be defined as the decrease in the value 
 of an asset, due to deterioration through lapse of time, wear and 
 tear, or obsolescence. It is, under all circumstances, an estimate. 
 It has been very strikingly remarked that man and nature are 
 constantly at work seeking to destroy all physical property. All 
 physical assets are constantly undergoing deterioration as time 
 passes. With some assets it is more marked than with others. 
 It is rather difficult to recognize deterioration in the case of a 
 desk. It is easier to recognize it in the case of an iron pipe 
 which is exposed to the weather. It is, nevertheless, true that, 
 although unobserved, deterioration is constantly taking place. 
 On the other hand, man, through the use of physical assets caus- 
 ing what is known as wear and tear, is constantly decreasing 
 the value of said physical assets. In a similar way he seeks, 
 through invention, to find newer and better machines and articles 
 of equipment for the manufacture of goods and transaction of 
 business. The business man naturally turns to that which is 
 newest and best, laying aside, perhaps, that which has served 
 him faithfully, because of the saving either in money or energy 
 through the use of the new invention. It is said of Mr. Andrew 
 Carnegie that he owes his success in a very large measure to 
 his ability to recognize new machines and his courage in casting 
 aside machines which had thus become obsolete. The dictionary 
 defines obsolete very simply and specifically as something which 
 has "gone out of use." 
 
 The recognition of the existence of depreciation may be re- 
 garded as a somewhat recent one. Until a comparatively short 
 time ago accounting practice did not take into consideration the 
 element of depreciation. That it is an important element, and 
 cannot escape recognition, is borne out by the many litigations that 
 have arisen in the last quarter of a century. In the case of 
 Conville v. Shook, et al. (24 N. Y. Supp. 547, 1893), the action 
 was to recover the sum of $6,779.40 by the plaintiff from the de- 
 fendant for the former's share of the profits of the business for a 
 given year. The defendant claimed that the plaintiff's share of 
 
 236 
 
Depreciation 
 
 the profits during the year in question was greatly less than the 
 sum claimed by said plaintiff. Testimony was introduced by an 
 accountant to the effect that numerous items were improperly 
 entered on the books, the sixth one of which was depreciation of 
 the original plant. It appears to have been the practice to provide 
 for depreciation at the rate of 10 per cent, per annum. In that 
 way assets originally costing $45,000 had been reduced at the time 
 of accounting to $29,309.45. It was held by the court that there 
 was no reason why the original plant should have been carried on 
 the books for ten years at the original cost. The charge for de- 
 preciation was sustained. 
 
 In the case of Emery v. Wilson (79 N. Y. 78), Emery, 
 Wilson and a third party were copartners, sharing in the profits 
 one-tenth, four-tenths and five-tenths, respectively. Upon the 
 death of one of the partners, namely, the third party mentioned, 
 an action was brought for the accounting and settlement of the 
 copartnership affairs. A question as to whether it was proper 
 to allow for depreciation in the value of the property in ascer- 
 taining the profits arose. The referee apparently refused to permit 
 an allowance for depreciation, and was sustained by the court. 
 
 In the case of Tutt v. Sand (56 Ga. 339), it appears that 
 Tutt and Sand entered into a copartnership whereby Sand, the 
 defendant, was to furnish the stock of goods then on hand, and 
 the plaintiff, Tutt, was to render his skill, services, etc. The 
 former was to have three-fourths of the profits, the latter one- 
 fourth. The partnership was dissolved, and the plaintiff brought 
 an action for $10,000 as his share of the profits which had been 
 made. The defendant sought to set off against this amount 
 various claims and expenses, among which was an item of 
 $4,098.11, covering a depreciation of 10 per cent, on merchan- 
 dise. In this case it appears that the item of depreciation was 
 not allowed to stand as an individual matter between the part- 
 ners, or, in other words, as a set off, but was properly included 
 as an expense of the business, and borne jointly by the two 
 partners. 
 
 In the case of the San Diego Water Company v. City of 
 San Diego, the plaintiff was a corporation engaged in the busi- 
 ness of supplying water to the city of San Diego and its inhabi- 
 tants. The Common Council of the city passed an ordinance 
 fixing the water rate for the year. The plaintiff sought to annul 
 
 237 
 
Principles of Accounting 
 
 the ordinance on various grounds, one being that the rate so 
 fixed would be insufficient to pay its operating expenses and 
 fixed charges, and, therefore, afford no reward to the plaintiff 
 for furnishing water, which would be depriving the plaintiff of 
 its property without due process of law and without compensa- 
 tion. The water company appears to have sought to include 
 as an item, in making up the cost on which the rate was based, 
 a sinking fund provision for depreciation. The court held that 
 no percentage upon the investment could properly be charged 
 as a sinking fund, to be added to the operating expenses, as a 
 general provision against depreciation of the plant through use. 
 
 In a similar case, namely, the Redlands Water Company 
 v. the City of Redlands (121 Cal. 312), the city likewise adopted 
 an ordinance fixing the rate. The water company brought an 
 action to annul the ordinance on the ground that the rate would 
 be insufficient to enable it to pay the interest on its indebtedness, 
 its operation expenses and taxes, and for keeping its plant in 
 repair. It was held by the court that the water company was 
 not entitled to have the rate so fixed as to enable it to set apart 
 a certain amount each year as a sinking fund for the depreciation 
 of its plant. 
 
 In the case of Whittaker v. Amwell National Bank (52 N. J. 
 Eq. 400, 1894), one of the questions at issue was whether or 
 not dividends declared and paid by the Star Rubber Company, 
 one of the defendants in this suit, were paid out of the surplus 
 or net earnings of the company. It was held, among other things, 
 that this could only obtain by taking into account the cost of 
 repairs and a reasonable allowance for depreciation for wear 
 and tear. The court said : "It cannot be successfully contended 
 that all such machinery is not subject to depreciation from wear 
 and tear or actual use. That all machinery does not suffer alike 
 is equally plain. The testimony in this case leads me to the 
 conclusion that the depreciation was at least 2 per cent, a year." 
 
 In one of the most recent cases, namely, Cumberland Tele- 
 phone and Telegraph Co. v. City of Louisville (187 Fed. Rep. 
 637, decided April 25, 191 1), the question of depreciation arose 
 in a suit brought by the telephone company to enjoin the enforce- 
 ment of an ordinance as confiscatory and unconstitutional. In 
 this case the court took cognizance of depreciation, and said: 
 "We define depreciation to be the loss in value of some destruct- 
 
 238 
 
Depreciation 
 
 ible property over and above current repairs." There was in- 
 volved in this suit the question of what proportion of the com- 
 pany's annual earnings shall be set aside for making good the 
 depreciation and replacing the parts of the property when they 
 come to the end of their life. This question was one altogether 
 apart from and beyond current repairs. On this question the 
 court ruled as follows : "A reasonable amount to be set apart 
 in this climate for making good depreciation is 7 per cent, of 
 the value of the fixed plant, exclusive of real estate, working 
 capital and supplies in hand. The testimony clearly leads to the 
 conclusion that the average life of the combined elements which 
 make up the plant is about fourteen years, and we shall proceed 
 upon that theory. In estimating depreciation, we will reckon it 
 at 7 per cent, of $1,575,000, the value of the destructible parts 
 of the plant. Of course, our estimate cannot be based upon the 
 proposition that the per centum set apart to cover depreciation 
 would be deposited in banks or loaned out from year to year, 
 so as to accumulate, and be, at the end of fourteen years, used 
 to construct an entirely new plant. In such a case the public 
 would not only have a service that would grow worse when its 
 operation ceased altogether, but it would thereafter get no service 
 at all until a new plant, replacing the old, could be completed 
 and put into operation." 
 
 It will be seen from the last-mentioned case that it is one of 
 the latest and most modern rulings on the subject. It will also 
 be noted, in glancing over previous cases, that while there have 
 been some decisions which refused to recognize the element of 
 depreciation the tendency at the present time is toward a general 
 recognition. The Interstate Commerce Commission and the vari- 
 ous Public Service Commissions have done much to establish this 
 recognition. 
 
 Regardless of legal decisions, it must be borne in mind that 
 depreciation is a very important item, since no matter what the 
 type of organization may be, or what the nature of the business, 
 the net profits will be affected in accordance with whether or not 
 depreciation is allowed to enter into the accounts. It seems that 
 it must be considered as conclusive that physical property does 
 depreciate in value, and that if such depreciation takes place it is 
 a proper charge against the expense of the period. If this is 
 true, and depreciation has not been included as an item of expense, 
 
 239 
 
Principles of Accounting 
 
 then the net profits are incorrectly stated. Hence the importance 
 in all contracts of copartnership, and similar contracts, of recog- 
 nizing and providing for depreciation in the stating of the 
 accounts. To illustrate this point concretely, suppose that a cer- 
 tain firm should acquire a parcel of land, including a building, 
 at a cost of $25,000. Assume, if you like, the copartnership to 
 continue for thirty years. At the time of dissolution assume that 
 in the distribution of the assets A elects to take the property at 
 its cost, namely, $25,000. Assume further that the property is 
 so situated that there has been no perceptible appreciation in 
 the value of the land, and that the former partner, A, now attempts 
 to dispose of the property, and is suddenly confronted with the 
 fact that it will not bring more than $10,000. The injustice and 
 inequality of having failed to provide for the depreciation of 
 this property before the copartnership accounts were stated, and 
 the affairs settled, will be very evident. 
 
 Admitting the necessity for depreciation, it must then be 
 observed that it will vary in different localities with regard to 
 the nature of the assets, the use to which they are put, and the 
 kind of use which they receive. It will be recalled in the case 
 of Whittaker v. Amwell National Bank the court was led to 
 conclude that depreciation was at least 2 per cent, a year, while 
 in the case of Cumberland Telephone and Telegraph Company 
 v. City of Louisville depreciation was allowed at the rate o" 
 7 per cent, a year. The question may be asked, Why this wide 
 variation in rates? While the cases do not show specifically the 
 kind of property involved, it is probable that, making due allow- 
 ance for failure of the courts to employ a scientific rate estab- 
 lished by experience, there was some marked difference in the 
 nature of the asset or the use to which it was put. Obviously, 
 the rate of depreciation upon a dwelling which receives careful 
 use at the hands of its occupants will not be as high as that for 
 a taxicab which is being constantly driven about the streets, over 
 rough pavements, at a high speed. As a matter of further illus- 
 ration, a case of boilers may be mentioned. In the southwestern 
 part of the United States especially, where the water contains a 
 great amount of alkali, the boilers will scale and need replace- 
 ment at least five times as often as in the northeastern New 
 England States, where the water has little effect upon boilers. 
 To charge the same rate of depreciation in both places would 
 
 240 
 
Depreciation 
 
 be entirely incorrect. In the same way, buildings containing 
 heavy machinery, and which are subject to constant and marked 
 vibration, will depreciate much faster than buildings wherein 
 no such machinery is found. 
 
 Experience only will determine the proper rate of deprecia- 
 tion to be used in each particular case. Appraisal companies have 
 probably the best detailed information on this subject in the 
 country. Since this information constitutes in part their stock 
 in trade they are loath to make it public. That the variations 
 in rates are great will be seen in consulting tables such as those 
 compiled by Mr. George A. Cravens (published in The Electrical 
 Review, April 23, 1910, and reproduced in Montgomery's "Au- 
 diting," page 325), in which depreciation of boilers is seen to 
 fluctuate from 3^ to 10 per cent, per annum. Mr. H. S. Tiffany, 
 in his book called "Digest of Depreciations," which is probably 
 one of the most complete tables extant, places the average life 
 of a boiler at ten years, and therefore computes the depreciation 
 at 10 per cent. Mr. Tiffany's note bearing on the use of the 
 property, as follows, is interesting: "In giving the percentages 
 of depreciation on engines and boilers it is assumed that a careful 
 and competent engineer is employed, and that they are well 
 cared for. Where this is not the case the per cent, is largely 
 increased, and many cases have been known where in less than 
 five years they have been, through carelessness, rendered entirely 
 useless, and consequently worthless." 
 
 While attention is usually given, in so far as depreciation is 
 concerned, to buildings, equipment, etc., very little attention is 
 ever given to the depreciation of land. It is usually assumed 
 that land does not depreciate. This is probably true with regard 
 to all land except that used for agricultural purposes. Mr. R. H. 
 Montgomery, in his book on "Auditing," calls attention to the 
 fact that "land used for agricultural purposes may depreciate 
 through use, and does depreciate unless a certain rotation of crops 
 is followed, or unless fertilizers are used. The latter is equivalent 
 to the cost of maintenance and repairs in a factory. The price 
 of flaxseed has increased enormously because during the early 
 years of farming in the West the vitality of the land was ex- 
 hausted by raising a crop which impoverished the soil to such 
 an extent that farmers were obliged to discontinue the raising 
 of flaxseed. During this period, when this crop was using up 
 
 241 
 
Principles of Accounting 
 
 the value of the land, the farmers should have set up a reserve 
 for depreciation, and it would have been apparent that the net 
 price realized from the flax crop was not nearly so high as it 
 seemed, but that wheat, while bringing in less per acre, would 
 have been more profitable. Heretofore, text-books on auditing 
 have stated, without qualification, that land does not depreciate. 
 If it is a fact that three-fourths of the land in the United States 
 is depreciating through use, these statements should not have 
 been allowed to go unchallenged so long." 
 
 Another important matter to be kept in mind in connection 
 with depreciation is its relation to repairs. Most authors agree 
 that depreciation is something quite apart from repairs and 
 maintenance. It is true that if an asset is repaired and maintained 
 it will last longer than if such is not the case. It should be borne 
 in mind that in estimating the life of a given asset allowance 
 must be made for a reasonable amount of maintenance and 
 repairs. If repairs are neglected the life of the asset will be 
 shortened. If the asset is thoroughly maintained its life may 
 be lengthened. The point which the author is especially anxious 
 to bring out is the fact that rates heretofore and hereafter men- 
 tioned exclude any provision for repairs and maintenance; that 
 the depreciation takes place quite apart from the charge to 
 expenses which is made for repairs and maintenance. 
 
 Before proceeding to a discussion of the various methods 
 of computing depreciation some attention should be given to the 
 bases on which it is computed, namely, the cost of the asset, 
 its estimated life, and the residual value. Most assets, whatever 
 their life may be, will ultimately have a scrap or residual value. 
 This is, of course, at best an estimate, the same as the life of 
 the asset is an estimate. The existence of the residual value 
 should be recognized and an attempt made to fix it as well as 
 possible. If the residual value is recognized, it is apparent that 
 before the amount which is to be charged off or depreciated 
 can be ascertained the residual value must be deducted from 
 the original cost. The result then is the amount which is to be 
 spread over the estimated life of the asset. 
 
 With regard to the methods employed in computing the annual 
 rate at which depreciation may be charged to the operating ex- 
 penses there are two which are worthy of special mention, as 
 being entirely practicable, whereas several others may be discussed 
 
 242 
 
Depreciation 
 
 merely as a matter of interest. Most authors, writers and authori- 
 ties recognize three different methods, namely : ( i ) the fixed 
 percentage of the original value, or the flat rate, as it is frequently 
 called; (2) the fixed percentage on balances, or the reducing 
 scale basis; (3) the sinking fund. Some authors mention an 
 increasing scale, while others suggest not a percentage at all, 
 but depreciation determined by revaluation at inventory periods. 
 It is also true that mining companies base their depreciation, or, 
 in reality, depletion, on tonnage, charging off five or ten cents, 
 or whatever it may be, per ton, in accordance with the number 
 of tons extracted. This same basis might also be used in the 
 case of a foundry furnace, the lining for v/hich is constantly being 
 exhausted, and is wearing out in direct proportion to the number 
 of tons of molten metal which pass through it. Of the various 
 methods mentioned, the fixed percentage is probably the most 
 practicable and easiest of application. It contemplates dividing 
 the original cost, less the residual value, by the estimated number 
 of years of life and charging off a corresponding percentage each 
 year. In this way the depreciation is spread equally over the 
 life of the asset. The reducing-scale method is advocated by 
 adherents who claim that repairs and maintenance are heaviest 
 during the latter part of the life. They contend, therefore, that 
 in order to secure an equitable charge against the profits of the 
 respective periods a larger amount, steadily decreasing, should 
 be charged against the earlier years of the life, whereas a smaller 
 amount should be charged during the later years, when the main- 
 tenance is steadily increasing. It must be conceded that there 
 is considerable merit in this contention, and it is, perhaps, not 
 any more difficult, after the first mathematical calculation has 
 been made, than the first method suggested. The practical objec- 
 tion to it is that the ordinary layman is not sufficiently familiar 
 with algebraic formulae to determine the percentage. The fixed 
 percentage on original cost is the layman's way of computing 
 depreciation. 
 
 With regard to the sinking-fund method, it is probable that 
 this is the most scientific. It does not necessarily follow that 
 because the sinking-fund method of ascertaining the amount is 
 used a sinking fund must actually be set aside in so many dollars 
 and cents, or equivalent assets. It is based, of course, primarily 
 on the theory which the sinking-fund calculation raises, namely : 
 
 243 
 
Principles of Accounting 
 
 the sum which must be set aside annually, at compound interest, 
 in order to equal at maturity the desired amount. Such would 
 be the case with regard to depreciation if it were desired to 
 replace physically the asset depreciated. It is not necessary, 
 however, that this be done. The question to be determined is 
 what amount shall be annually charged to operating expenses. 
 The answer to the question is, therefore, such an amount as 
 would annually, at compound interest, amount to the value of 
 the asset to be written off. The marked objection to the sinking- 
 fund method is that each time there is an addition to or deduc- 
 tion from the original cost of the asset the sinking-fund calcula- 
 tion is destroyed, and it becomes necessary to revise it. The 
 following tables, charts and calculations show the relative advan- 
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 244 
 
Depreciation 
 
 
 
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 245 
 
Principles of Accounting 
 
 In connection with the methods just previously mentioned 
 it will be noted that any addition to or reduction from the original 
 asset will disturb the calculation seriously, except in the case 
 of the flat rate. Addition to a given asset will have no effect 
 upon the rate if the addition is of the same life as the original 
 asset. Naturally, a deduction from the original asset will have 
 no effect upon the rate. It will thus be seen that the life plays 
 a very important part in the calculation of depreciation. If all 
 property were of the same life, additions and deductions would 
 have no effect upon the rate. The amount would, of course, 
 change. For example : A given asset, costing $600, without 
 residual value, might have an estimated life of ten years. In 
 consequence, $60 would be the amount of the annual deprecia- 
 tion. If at the end of the second year a portion of the asset, 
 corresponding to one-third, for example, were to be sold, the 
 asset would be reduced to the extent of $200, and while the 
 amount of the annual depreciation would be decreased to $40 
 the rate would not change. It would still be 10 per cent, on 
 the remainder of $400. The converse of this proposition might 
 be illustrated by a case wherein the original cost of the asset is 
 $600, with the annual depreciation charge of $60. Again, if at 
 the end of the second year additions to the extent of $75 are 
 applied, the annual charge will be $67.50 instead of $60, corre- 
 sponding to 10 per cent, of the cost of the asset, namely, $675. 
 Attention should be drawn to the fact that in neither of these 
 cases will it make any difference whether the addition or deduc- 
 tion takes place at the end of the second or some subsequent 
 year. The vital point is that the additions and deductions must 
 correspond in life to the original asset. For this reason it becomes 
 almost impossible to compute depreciation from the asset accounts 
 in the general ledger. Where attention is given to depreciation, 
 and an attempt is made to compute it systematically, the details 
 of the general ledger property accounts will, almost invariably, 
 be found in underlying ledgers or memorandum books. Unless 
 the assets are classified with regard to their respective estimated 
 lives, when the calculation consists merely in taking the total 
 cost less the estimated residual value in each class, and applying 
 the rate determined by the estimated life, there will at once arise 
 the question as to when the life begins and whether or not the 
 beginning should correspond accurately with the date of acqui- 
 
 246 
 
Depreciation 
 
 sition of the asset. For example : In the case of a piece of 
 machinery, purchased on the twentieth of November, in a given 
 year. Shall the life begin on the twentieth of November, or 
 shall it, for purposes of convenience in the calculation of depre- 
 ciation, be considered as of the first of the following January? 
 To repeat the question in general terms, shall additions to prop- 
 erty during a given year be taken up, for purposes of deprecia- 
 tion, from the actual dates of acquisition or from the end of the 
 year in which they were acquired? Generally speaking, it is 
 proper to wait until the end of the year before putting additions 
 to property on a depreciation basis. While this will probably 
 be found to be the general practice, there will undoubtedly be 
 exceptions to the rule in special cases where certain assets depre- 
 ciate rapidly. In the case of concerns closing their books oftener 
 than once a year it is usually customary to begin the depreciation 
 as at the end of the period in which the property, or additions 
 thereto, were acquired. 
 
 As to the manner of treating depreciation in accounts, there 
 are two ways. One is to write down the asset to profit and loss ; 
 the other is to make provision for depreciation through a charge 
 to profit and loss and the creation of a reserve. In the first case, 
 granting that a certain machine cost $10,000, that the estimated 
 residual value is $500, and the estimated life ten years, the 
 journal entry at the end of the first year would be as follows : 
 
 Profit and loss or (depreciation) , $950.00 
 
 To Machinery $950.00 
 
 In the second case, where the asset is not written down, but its 
 value depreciated or offset by a reserve, the journal entry would 
 be as follows : 
 
 Profit and loss or (provision for de- 
 preciation) $950.00 
 
 To Reserve for depreciation $950.00 
 
 The second method seems to have distinct advantages over the 
 first method, in that it permits the asset to stand at its original 
 cost, plus additions or deductions, while its value is offset by a 
 reserve, whereas in the first case the balance in the account 
 results from a series of transactions representing original cost, 
 additions, deductions and amounts written off. It is, therefore, 
 
 247 
 
Principles of Accounting 
 
 difficult to determine, except through analysis, whether the credits 
 in the account are for sales, losses, or damage to the assets, or 
 amounts written off for depreciation. This would, perhaps, make 
 little difference if all the details of an asset account were carried 
 forward' from year to year, but where new books are opened 
 yearly the original cost of the asset is soon lost track of. This 
 point might be an important matter in the case of a prospective 
 sale, and while, of course, the original cost could be determined 
 by an analysis of the old accounts, it would seem to be very much 
 easier, and more satisfactory, to carry the asset forward from 
 year to year at its original cost, plus actual additions and minus 
 actual deductions, so that the cost would always appear in the 
 current books ; whereas the book value, being the difference 
 between the cost and the reserve, could also be easily determined. 
 It also happens, in certain cases, that a concern will desire 
 to put aside a fund out of which to replace the assets at the end 
 of their respective lives. Where a provision for depreciation 
 has been made through the medium of a reserve this is known 
 as funding the reserve. The idea back of this scheme is that a 
 fund will be accumulated from time to time which will be suffi- 
 cient, at the expiration of the life of the asset, to replace it. The 
 fund may, of course, be accumulated without the creation of a 
 reserve, but the effect at the expiration of the life of the asset 
 is precisely the same. In the one case, namely, where the asset 
 has been written off over a period of years to profit and loss, 
 it will, presumably, have disappeared at the end of its estimated 
 life. There will then stand in place of it the accumulated fund. 
 In the other case the asset will remain; the reserve will have 
 been created to an extent which equals the asset; the asset, at 
 the end of its life, will be closed out to the reserve; and the 
 fund will stand in place of the asset. The accumulation of a 
 fund is, of course, conservative, and offers an opportunity for 
 setting aside a small amount annually instead of being obliged 
 to provide perhaps a large amount for replacement suddenly. 
 The objection found to accumulating a fund is that almost any 
 prosperous concern can make more money through the use of 
 the cash in the business than a fund would return in the way of 
 interest. It would, therefore, be found that in a prosperous 
 concern, which might reasonably expect to have on hand suffi- 
 cient funds for replacement at any given time, the accumulation 
 
 248 
 
Depreciation 
 
 of a fund would be unnecessary. So long as the annual profits 
 are reduced by a provision for depreciation it would appear that 
 the matter had been conservatively handled. 
 
 Many text-books discuss the creation of a reserve for depre- 
 ciation, but very few have anything to say concerning its dispo- 
 sition. In the case above cited, where the cost of machinery 
 was $10,000, the residual value estimated at $500, and the esti- 
 mated life was ten years, it will be recalled that the annual 
 charge for depreciation was $950. If depreciation were to be 
 provided for through the medium of a reserve, at the expiration 
 of the life of the machinery the reserve would show credits 
 aggregating $9,500. The difference between the cost and the 
 reserve would be $500. Two things might at this time happen, 
 namely : the machinery continue in use, or be sold as second-hand 
 or scrap. Although practically written off, its usefulness, while 
 impaired, might warrant its continuance in use, and for all prac- 
 tical purposes it might apparently be worth as much to the con- 
 cern as it ever was. The accounts might be allowed to stand as 
 stated, giving to the asset a nominal value of $500. If its earning 
 power were still as great as before, the value is obviously greater 
 than $500. Such a case has sometimes been given as an example 
 of a secret reserve. This would, of course, be true whether or 
 not the accounts were allowed to stand or whether the reserve 
 was closed out to the asset and the book value thereof shown 
 as .$500. 
 
 Assuming the latter steps to have taken place, and the ma- 
 chinery to have been sold, then one of two things may result. 
 First, the asset may have been sold for more than $500; and 
 second, for less than $500. Assuming the sale to have brought 
 $800, the transaction, expressed in the form of journal entry, 
 would then appear as follows : 
 
 Cash or (accounts receivable) $800.00 
 
 To Machinery $500.00 
 
 Profit and loss 300.00 
 
 If, perchance, the asset realized only $400, the entry would be 
 as follows : 
 
 Cash $400.00 
 
 Profit and loss 100.00 
 
 To Machinery $500.00 
 
 249 
 
Principles of Accounting 
 
 In case the original asset has been allowed to stand and a 
 reserve created, the closing entry, that is, the one required to 
 bring the asset down to its residual value, would be as follows : 
 
 Reserve for depreciation of machinery. . $9,500. 
 
 To Machinery $9,500. 
 
 The balance in the account would then be $500. As such it 
 might remain or be treated as suggested in the preceding entries 
 recording the disposition. 
 
 It should be borne in mind in connection with depreciation, 
 and as a parting thought, that it is, at best, an estimate; that it 
 rarely works out as planned, and that taking it into consideration 
 is only an attempt to (a) properly state the estimated value of an 
 asset and (b) provide for proper charges to operations. 
 
 It might also be mentioned, of course, that incidentally infor- 
 mation concerning depreciation may be of value in securing accu- 
 rate cost data and determining the relative efficacy of different 
 types of construction or equipment. The fact is not to be ignored, 
 either, that the federal corporation tax law requires all corpora- 
 tions to include depreciation as an item of expense. 
 
 REFERENCES FOR COLLATERAL READING: 
 
 Modern Accounting, Hatfield, Chapter VII. 
 
 Accounting in Theory and Practice, Lisle, page 137. 
 
 Accounts, Their Construction and Interpretation, Cole, pages 
 247-257. 
 
 Science of Accounts, Bentley, pages 139-149. 
 
 Electric Light Accounts, Edwards, Chapter V. 
 
 Accounting, Practice and Procedure, Dickinson, pages 164- 
 174, 221. 
 
 Depreciation and Wasting Assets, Leake. 
 
 Engineering Valuation of Public Utilities and Factories, Fos- 
 ter. 
 
 Factory Costs, Webner, Chapter XIV. 
 
 Journal of Accountancy, Vol. XVI, page 358. 
 
 Journal of Accountancy, Vol. XV, page 106. 
 
 Journal of Accountancy, Vol. XIV, page 431. 
 
 Journal of Accountancy, Vol. IX, pages 89, 189. 
 
 250 
 
CHAPTER XLI 
 
 INTEREST 
 
 The commonly accepted definition of interest is "Money paid 
 for the use of money." The late Colonel Sprague, who perhaps 
 gave more thought to the subject of interest than any other man 
 who has written on the subject, took a somewhat different view. 
 He defined interest in substance as "The increase in principal due 
 to lapse of time." For the purposes of this discussion, however, 
 it does not seem to be necessary to attempt the reconciliation of 
 these somewhat divergent definitions, since there. is probably no 
 question in any student's mind as to what constitutes interest. 
 The reason for interest is that some one has borrowed capital or 
 funds, and for the use of these funds some one is obliged to pay 
 interest. Without regard at present as to whether interest is to 
 be regarded as an item of income or an item of expense, there 
 are certain characteristics of interest which are common to both 
 and which must be, for the purpose of discussion, first stated. 
 These characteristics are, namely : principal, rate and time. The 
 question of principal and rate require no particular discussion. 
 The question of time is the one which vitally affects the compu- 
 tation of interest and, consequently, the bases or methods of cal- 
 culation. Generally speaking, these methods, in so far as simple 
 interest is concerned, are confined to three, namely : the 360-day 
 basis, the 365-day basis and what is generally regarded as the 
 legal method. The first-named consists in dividing the interest 
 for a year by 360 and considering i-36oth as the amount appli- 
 cable to each day. The second consists in dividing the interest 
 for a year by 365 and considering 1-365^ as the amount applicable 
 to each day. The legal method, which is the construction gener- 
 ally placed upon the statutes now in force, consists in dividing 
 the interest for a year by 12 and considering i-i2th as the amount 
 applicable to each month. Odd days are treated as 365ths of a 
 year. 
 
 The legal day begins and ends at midnight. Therefore, in com- 
 puting interest for a given number of days the first day should be 
 excluded and the last day included, or vice versa. Colonel 
 Sprague advocated "counting the nights." In applying the 
 
 251 
 
Principles of Accounting 
 
 methods above described a concrete example may prove beneficial. 
 Let the statement of facts be as follows : Principal, $i,ooo ; rate, 
 6 per cent; period, February 21 to March 27. The year's interest 
 will amount to $60. Using the 360-day basis, the interest per day 
 will be $.166. The number of days elapsed between February 
 21 and March 24 will be 34. The amount of interest will, there- 
 fore, be $5.64. Using the 365-day basis, the interest per day will 
 be $.164. The number of days elapsed between February 21 and 
 March 27 will be 34. The amount of interest will, therefore, be 
 $5.57. Using the legal method the time will be 1 month, 6 days. 
 The interest for the 1 month will be I-I2th of $60, or $5. The 
 interest for the 6 days will be 6-365ths of $60, or $.98, making 
 the interest for the time elapsed between February 21 and March 
 27 $5.98. The 360-day basis is probably the most general basis 
 used, since it is easiest. Banks and brokers generally use it. 
 However, it is said of some banks and trust companies that they 
 charge interest on the 360-day basis and pay interest on the 
 365-day basis. The 365-day basis is used generally by accountants 
 whose desire it is to be as accurate as possible. The legal rate 
 is used in computing interest on judgments and wherever interest 
 is involved in judicial actions and decisions. 
 
 To take up now interest as affecting the accounts of a given 
 organization we find that interest may be related to the accounts 
 either as income or expense. As an item of income, it may appear 
 as interest on bonds owned, interest on bonds and mortgages re- 
 ceivable, interest on bank balances, interest on accounts receiv- 
 able, and interest on notes receivable. As an expense it may 
 appear in connection with bond and mortgage payable, deben- 
 tures, income bonds, accounts payable, notes payable, or loans 
 payable. In isolated cases it may appear as interest on capital, 
 especially in the case of copartnerships. It accrues over a period 
 of time, and in accordance with such accrual must be taken into 
 the accounts at closing dates whether or not it has been actually 
 paid or collected. As an earning or item of income we have it 
 charged to some asset account and taken into the income for the 
 period. As an item of expense we have it charged against the 
 expenses of the period and credited to a liability account. Sub- 
 sequent receipt or payment of the interest in cash will not affect 
 in any way the income or expense items. The cash received sub- 
 sequent to the accrual appears in the light of a realization of the 
 
 252 
 
Interest 
 
 asset, accrued interest. The payment of the cash for interest 
 subsequent to the accrual of the interest appears in the light of 
 a liquidation of the liability, interest accrued. It might be said 
 here that for convenience many accountants have adopted a 
 nomenclature which will distinguish between interest accrued as 
 an asset and interest accrued as a liability. The distinction con- 
 sists in using the word accrued before the word interest for the 
 purpose of denoting an asset, whereas for the purpose of denoting 
 a liability the word accrued follows the word interest. 
 
 To run through one or two sets of typical transactions for the 
 purpose of illustrating the entries in connection with interest, we 
 may take the following statement of facts : 
 
 Principal of a note received from customer $1,000 
 
 Rate of interest 6 per cent. 
 
 Date of note June i 
 
 Period 3 months 
 
 Basis (for convenience in illustration) 360-day 
 
 Closing date June 30 
 
 Note paid September 1 
 
 The interest on the note will be $5 per month. In closing the 
 books at June 30 the entry will be as follows : 
 
 Accrued interest $5-°° 
 
 To Interest earned $5-00 
 
 Upon the settlement of the note on September 1, the following 
 entry will appear : 
 
 Cash $1,015.00 
 
 To Notes receivable $1,000.00 
 
 Accrued interest 5.00 
 
 Interest earned 10.00 
 
 A variation of this procedure might, of course, take place if 
 before making the final entry the interest transaction were com- 
 
 253 
 
Principles of Accounting 
 
 pleted, namely : by charging accrued interest and crediting interest 
 earned with $10. The entry corresponding to the above would 
 then appear as: 
 
 Cash $1,015.00 
 
 To Notes receivable $1,000.00 
 
 Accrued interest 15.00 
 
 If the above statement of facts may be similarly used to illus- 
 trate the entries in the case of notes payable instead of notes 
 receivable, the entry at June 30 would then appear : 
 
 Interest expense $5.00 
 
 To Interest accrued $S-oo 
 
 At the time of paying the note the entry would appear: 
 
 Notes payable $1,000.00 
 
 Interest accrued 5.00 
 
 Interest expense 10.00 
 
 To Cash $1,015.00 
 
 The same variation as was above indicated in the case of notes 
 receivable might occur here, namely: that the interest might be 
 fully accrued at the time of payment before the entry for the 
 cash transaction was made. The final entry under such circum- 
 stances would then be : 
 
 Notes payable $1,000.00 
 
 Interest accrued 15.00 
 
 To Cash $1,015.00 
 
 It would seem as though this were an appropriate place to 
 discuss discount, on account of the close relation which it bears 
 to interest, being considered, in fact, as interest paid before it is 
 due. Discount is of two kinds : bank discount and true discount. 
 Bank discount is simple interest collected in advance. True dis- 
 count is compound interest collected in advance, or the difference 
 between the amount of the principal and its present worth. The 
 bank discount on $1,000 at 6 per cent, for one year would be $60. 
 The true discount on the same amount for the same time and 
 
 254 
 
Interest 
 
 rate would be $56.61. The bank discount is obtained by multi- 
 plying $1,000 by 6 per cent., whereas the true discount is ascer- 
 tained by dividing 1 by 1. 06, the result of which will give the 
 present worth of a dollar at 6 per cent, compound interest for 
 one year. The present worth of $1 multiplied by $1,000 will give 
 $943-39- This sum subtracted from the principal of $1,000 shows 
 the discount of $56.61. 
 
 Mr. H. C. Bentley, C.P.A., in his book on the "Science of 
 Accounts" makes a distinction between interest and discount 
 which is logical if somewhat novel. Mr. Bentley holds that bank 
 discount should never be called discount. He is of the opinion 
 rather that where collected in advance it should be called simply 
 interest paid in advance. 
 
 Such a distinction would help considerably to clarify matters 
 since discount would then mean but one thing. In the case of 
 the three months' note previously referred to, the interest would 
 be $15.00; the discount $14.78. The interest might be paid in 
 advance or at maturity ; discount would always be collected in 
 advance. Under such circumstances it would be unnecessary 
 to distinguish between bank discount and true discount. Why 
 banks prefer the former is not difficult to see. 
 
 If we accept the suggestion that discount should mean but one 
 thing, then the only question in so far as our accounting is 
 concerned is the relation of this discount to the accounting 
 periods. In treating with discount we must look at it from two 
 points of view — one, that of the party who pays the discount ; 
 the other, the party who receives the discount. Taking up first 
 the point of view of the party paying the discount, it then ap- 
 pears that interest has been paid for the use of money covering a 
 period which has not yet elapsed. The interest, or discount, is, 
 therefore, appropriately and properly to be considered as a pay- 
 ment in advance. Consequently, it should be treated as a deferred 
 charge to expense. As the time elapses over which this prepay- 
 ment extends the deferred charge to expense should be gradually 
 reduced by charges to expense. In the case of the note on which 
 the discount was $14.78, the original discounting of the note, 
 stated in terms of journal entries, would be as follows : 
 
 Cash $985.22 
 
 Discount 14.78 
 
 To Notes payable $1,000.00 
 
 255 
 
Principles of Accounting 
 
 The item of $14.78 will subsequently be charged to interest 
 expense, or interest on notes payable, and credited to discount 
 as the time elapses. At June 30, assuming that the note was 
 discounted on June 1, $4.87 of this amount will be charged to 
 the expense for the month, while the remaining $9.91 will appear 
 in the balance sheet as a deferred charge. 
 
 The opposite of the above is true and applies especially to 
 banks and banking institutions. If, in the first case, the man 
 who stands the discount is entitled to defer the charge to his 
 expenses in accordance with the extent to which the period 
 covered has elapsed, then surely the recipient of the discount 
 must not take into his earnings the entire amount. The bank 
 or banker discounting notes should set up discount as a deferred 
 credit to income under the head of discount unearned and take 
 same into its earnings in accordance with the lapse of time. To 
 use again the same illustration, the entry for the bank will be, 
 upon discounting the note : 
 
 Notes receivable $1,000.00 
 
 To Discount unearned $ 14.78 
 
 Cash 985.22 
 
 At the end of the month an entry should be made charging 
 discount unearned and crediting discount earned with $4.87 of 
 the discount. There would then appear in the discount earned 
 for the period $4.87 and as a deferred credit to income on the 
 balance sheet $9.91. 
 
 The question of setting up the unearned discount is not, as a 
 rule, important in a mercantile concern for the reason that, like 
 so many other items, the results of taking it into consideration 
 are not worth the energy and trouble expended in so doing. In 
 the case of a bank or banker, a large part of whose business con- 
 sists in discounting paper, the situation would be quite different. 
 It is of utmost importance in such cases that careful attention 
 be given to the matter of unearned discount. Banks which close 
 their books annually or semi-annually will tell you that the dis- 
 count will average up between periods and that it is not necessary 
 to observe the rule with regard to taking the earnings on discount 
 into income. Thus it might easily happen in the case of a bank 
 
 256 
 
Interest 
 
 closing its books monthly or quarterly that there would be a 
 marked fluctuation in the income among the different quarters. 
 The decrease in any given period would probably be attributed 
 off-hand to a falling off of business. This might, of course, be 
 true. On the other hand, it might also be true that the money 
 value of the notes discounted had increased rather than decreased, 
 but that the average term which the various notes had to run was 
 so much shorter than the average term of notes discounted in 
 the preceding period as to more than offset the increase in the 
 discount resulting from the increase in the amount of the notes. 
 If the discount were properly spread over the life of the notes 
 a situation such as the above could not exist. An increase or 
 decrease in the earnings from discount as among periods would 
 then represent the true fluctuation in the volume of notes 
 discounted. 
 
 While the matter of setting up the unearned discount is 
 one of considerable trouble to banks which are particular about 
 this point some of them have devised means of facilitating their 
 work in this respect. Ordinarily it is probable that they would 
 ascertain their unearned interest at the end of a given period in 
 the same manner in which an accountant is obliged to ascertain 
 such information when he goes in to make an audit or examina- 
 tion, namely : by listing the discounted notes and figuring on each 
 note the unexpired discount collected in advance. This then 
 would be charged to discount earned, or interest and discount, 
 and credited to discount unearned, or interest received in advance. 
 To avoid this laborious process some banks, as has just been 
 suggested, keep what is known as a discount register. This book 
 is somewhat similar to the ordinary notes payable or notes re- 
 ceivable books so common among mercantile concerns. In it the 
 notes are listed and the particulars concerning them, including 
 the amount of each and the discount on each. The discount is 
 then spread over a series of columns corresponding to the months 
 in accordance with the number of months the respective notes 
 have to run. While this practice is comparatively rare, it would 
 probably be still rarer to find a bank spreading its discount scien- 
 tifically; that is, increasing gradually from month to month as 
 the time elapsed. While admittedly not scientific, it is probably 
 satisfactory to divide the discount by the number of months the 
 note has to run and credit to each month its proportionate share. 
 
 257 
 
Principles of Accounting 
 
 It will be seen that by the use of this method all discount will be 
 credited immediately to an unearned account, but will be credited 
 to earnings monthly by an entry charging discount unearned and 
 crediting discount earned in an amount corresponding to the 
 footing in the discount register for any given month. 
 
 Another expedient for facilitating the accruing of interest may 
 also be mentioned at this time. Organizations holding numerous 
 securities on which interest accrues find the computing of the 
 interest a source of considerable trouble. Here again the interest 
 must be computed either at the end of the period on the particular 
 securities or investments owned individually or through the means 
 of a register in which the interest on each security for the month 
 is set up. As a variation from both of these methods it sometimes 
 becomes possible to classify the par principal according to the 
 various rates of interest, namely: 4 per cent., \y^ per cent., 5 
 per cent., etc., and accrue the interest on the total amount of 
 principal in each class at any time. For example : Assuming 
 that a given concern had $100,000 4 per cent, bonds, $50,000 4^ 
 per cent, bonds, $200,000 5 per cent, bonds, another $200,000 of 
 4 per cent, bonds, another $50,000 4j4 per cent, bonds, instead 
 of accruing the interest of five separate items, the two lots of 4 
 per cent, bonds would be added and the accrued interest at 4 per 
 cent, computed on the total. In the same way the 4^ per cent, 
 bonds would be added and the interest accrued on the total. Then 
 by accruing the interest on the 5 per cent, bonds there would be 
 three calculations instead of five. If this illustration may now be 
 applied to a large organization in which a great many different 
 securities are held, the value of such a method will be apparent. 
 In order to employ this method it is necessary to keep a register 
 in which the securities are entered in accordance with the rate 
 of interest which they bear. It is, of course, evident that broken 
 periods, resulting from purchases or sales of securities, except at 
 the end of the accrual periods, will upset the calculations unless 
 the items in question are deducted from the totals and the interest 
 accrued on these items separately. 
 
 In the matter of copartnerships interest of capital becomes 
 an important factor. Ordinarily it seems that nothing is to be 
 gained by charging the business with interest on capital and taking 
 it in as an earning. This has too much the appearance of doing 
 business with one's self. It would seem hardly necessary to add 
 
 2q8 
 
Interest 
 
 that no money is ever made in this way. Some economists under- 
 take to analyze the profit of a business organization and classify 
 it with regard to the factors which produce it. In this way 
 capital is shown to have earned interest. This would seem to be 
 an unnecessary procedure and tend to confusion rather than 
 otherwise. It is conceded that statistical information concerning 
 the employment of capital and the return therefrom is at times of 
 value to the administrative force. There would seem to be no 
 reason, however, why the general books and accounts of the or- 
 ganization should be burdened with carrying and showing this 
 information. It would seem rather to be a matter for independent 
 calculation. In the case of a copartnership, however, where 
 certain conditions exist, the situation becomes quite different. 
 Here many times the amount which the respective partners are 
 credited with will depend upon the matter of interest on capital. 
 The following three rules may be given concerning when it is 
 proper to charge and credit interest: 
 
 (i) When the capital is unequal and the profits are to be 
 equally divided, charge interest on capital and credit the respective 
 drawing accounts of the partners. 
 
 (2) When the capital is unequal and the profits are to be 
 unequally divided, charge interest on capital and credit the re- 
 spective drawing accounts of the partners. 
 
 (3) When the capital is equal and the profits are to be 
 unequally divided, charge interest on capital and credit the re- 
 spective drawing accounts of the partners. 
 
 Where the capital is equal and the profits are to be equally 
 divided, nothing is gained by charging and crediting interest. 
 
 The following ledger accounts will, it is hoped, make clear the 
 reasons for the above rule: 
 
 First proposition. Share profits J4 and y* ; capital unequal. 
 Interest 6%. 
 
 A B Profit and Loss 
 
 P&L $3,000 1 $60,000 P&L $3,000 
 I. 3,600 
 
 $40,000 Int.. $6,000 
 I. 2,400 
 
 A $3,000 
 B 3,000 
 
 Second proposition. Share profits 2/3 and 1/3 ; capital unequal. 
 Interest 6%. 
 
 259 
 
Principles of Accounting 
 
 B Profit and Loss 
 
 P&L $4,000 
 
 $60,000 P&L $2,000 
 I. 3,600 
 
 $40,000 Int. $6,000 
 I. 2,400 
 
 A $4,000 
 B 2,000 
 
 Third proposition. Share profits 2/3 and 1/3 ; capital equal. 
 Interest 6%. 
 
 A 
 
 B 
 
 Profit and Loss 
 
 P&L $4,000 
 
 $50,000 P&L $2,000 
 I. 3,000 
 
 $50,000 Int. $6,000 
 I. 3,000 
 
 A $4,000 
 B 2,000 
 
 Fourth proposition. Share profits yi and *4 ; capital equal. 
 Interest 6%. 
 
 B 
 
 Profit and Loss 
 
 P&L $3,000 
 
 $50,000 P&L $3,000 
 I. 3,000 
 
 $50,000 Int. $6,000 
 I. 3,000 
 
 A $3,000 
 B 3,000 
 
 REFERENCES FOR COLLATERAL READING: 
 
 Journal of Accountancy, Vol. XV, pages 231, 236, 240, 241, 
 329, 33°, 334. 427, 428, 43 1 J Vol. XVI, pages 89, 145, 22. 
 
 Philosophy of Accounts, Sprague, Chapters XII and XIII. 
 
 260 
 
CHAPTER XLI 
 
 INSURANCE 
 
 Insurance may be defined as a contract whereby, in considera- 
 tion of a premium paid by one party to another, the former is 
 protected by the latter from loss. Insurance may be of various 
 kinds : Life, fire, accident, health, marine, credit, burglary, fidelity 
 and surety, employers' liability, etc. The accountant is little con- 
 cerned with the nature of the insurance. What does affect him 
 directly is what relation a loss and corresponding settlement bears 
 to the accounting, and in a similar manner what relation the 
 premiums paid bear to the accounting. It is true, of course, that 
 he should have a more or less general idea of the nature and 
 operation of the various kinds of insurance contracts referred 
 to, for which reason they are briefly described here. 
 
 Life insurance is not usually involved in the accounts of an 
 organization. It is true that some proprietors may be found who 
 make a practice of merging their private with their business 
 affairs and accounts ; however, this is not to be countenanced as 
 good practice. In such cases, of course, instances have been 
 known where sole proprietors either charged the premiums on per- 
 sonal policies to the business as an expense or capitalized them on 
 the books of the business as an asset. This is a matter of bad 
 general practice rather than having anything to do specifically 
 with the matter of insurance. It is mentioned here, however, be- 
 cause of the fact that insurance is one of the items which sole 
 proprietors seem prone to mingle with their business accounts. 
 There has been a custom for some time among copartnerships 
 and corporations to insure its members or officers for the benefit 
 of the copartnership or corporation. The loss of a partner may 
 be very keenly felt by a surviving partner. In the same way the 
 loss of an officer or important employee to a corporation might 
 prove detrimental. It should be borne in mind strictly in these 
 cases that the insurance is taken out by the concern and not by the 
 individual, and that the concern pays the premiums. It means, 
 therefore, that the concern and not the individual should either 
 charge to expense or capitalize the insurance premiums paid. 
 As to capitalization, there can be no well-founded objection to it 
 
 261 
 
Principles of Accounting 
 
 after the third annual premium, except in the case of straight life, 
 has been paid, since the law requires that such policies shall have a 
 cash surrender value. It is, therefore, perfectly proper to cap- 
 italize the premiums at their cash surrender value. 
 
 It is doubtful if the accountant would ever come in contact 
 with health insurance in connection with the affairs of a business 
 concern. It is possible, of course, to imagine a case in which a 
 health policy would be carried by the concern on account of 
 some of its officers or employees. This, however, is not apt to be 
 the case, as a health policy is usually taken out by an individual 
 in his own behalf in order that he may be reimbursed for loss of 
 salary and expenses in case of sickness. 
 
 It might be interesting to note what would transpire in case 
 of the death of an employee of a given company. To do this 
 the application must be made, of course, to both a copartnership 
 and a corporation, since in each case the situation would be 
 slightly different. In the case of a copartnership, upon receipt of 
 the amount of the policy cash would be charged and profit and 
 loss credited. Thus the surviving partner and the estate of the 
 deceased would participate to the extent in which the partners 
 had previously been interested in the profits. Since the object of 
 the insurance is to protect the surviving partners against loss of 
 capital through the sudden withdrawal by reason of the death of 
 a partner, it sometimes happens that the policies are drawn in 
 favor of the surviving partners. In such a case it usually hap- 
 pens that each partner is equally insured for the benefit of the 
 firm, and while each stands his share of loss through the payment 
 of the premium he takes the risk of failing to survive his partner. 
 Where this situation existed, upon receipt of the cash in settle- 
 ment of the policy cash would be charged and the respective 
 capital accounts of the surviving partners credited. 
 
 While contact with life insurance problems on the part of the 
 accountant is somewhat rare, fire insurance demands his attention 
 in practically every concern with which he comes in contact- In 
 practically every instance it is the question of premiums. Occa- 
 sionally it is in connection with a fire loss. Since it is the ques- 
 tion of premiums that most frequently concerns him, they may 
 perhaps be discussed first. 
 
 A premium is paid for protection covering various periods up 
 to three years. The author's experience leads him to observe 
 
 262 
 
Insurance 
 
 that while formerly the three-year period was a popular one 
 such policies are becoming fairly scarce and the year at the 
 present time seems to be the usual period. The pertinent fact 
 in connection with the premium is that it covers a period of time. 
 It is, therefore, evident that the premium, which is to be treated 
 as an expense, should be spread over the period of time covered 
 and not charged to expense in the month or period in which the 
 premium was paid or the expense incurred. It will thus be evi- 
 dent that insurance covering a period running beyond the date 
 upon which the account period closes may be considered as a de- 
 ferred charge to expense, or, as it has sometimes been called, an 
 asset by courtesy. The problem which confronts the accountant 
 is that of determining the amount of the unexpired insurance. It 
 may be mentioned here, however, that the necessity for this cal- 
 culation may be avoided by having all policies lapse on the same 
 date, which practice, in case the date coincides with the end of 
 the accounting year, will give rise to a situation in which there is 
 no unexpired insurance involved. Having all new policies written 
 for periods ending on December 31, for example, there would be 
 no unexpired insurance at the end of the year. This will not be 
 true, of course, if the books are closed on June 30, but the unex- 
 pired insurance at such time will be one-half the annual premium 
 subject to slight adjustment perhaps on account of new policies 
 which have been written for periods less than a year. This 
 scheme has been advantageously employed in a number of cases 
 which have come under the writer's observation, and much figur- 
 ing and bookkeeping has thereby been avoided. Notwithstanding 
 the fact that the practice is a good one, it is not a general 
 one, and the accountant is called upon to value the unexpired 
 insurance. To the end that the procedure may be illustrated 
 by practical application, the following applied theory test is 
 suggested : 
 
 London, Liverpool & Globe, No. 705,965, Amount, $10,000. 
 Dated June 17, 1912. One year. Premium, $56.27. 
 
 North British and Mercantile, No. 714,837. Amount, 
 $6,000. Dated October 23, 19 12. One year. Pre- 
 mium, $31.48. 
 
 Scottish Union and National, No. 4,220,876. Amount, 
 $3,000. July 14, 1912. One year. Premium, $18.26. 
 
 263 
 
Principles of Accounting 
 
 American of Newark, No. 1,427,832. Amount, $7,ooc. 
 
 Dated February 22, 1912. One year. Premium, 
 
 $47.82. 
 Aetna Insurance, No. 528,789. Amount, $5,000. Dated 
 
 February 28, 1912. One year. Premium, $322.13. 
 
 Compute the unexpired insurance December 31, 1912. 
 
 It is probably the custom in computing unexpired insurance 
 to divide the annual premium by 365 or 366 days, as the case 
 may be, and after thus ascertaining the rate per day multiply the 
 said rate by the number of days unexpired. A computation of 
 this kind is, of course, accurate, but the process somewhat labori- 
 ous. In cases where extreme accuracy is not necessary it suffices 
 many times to take the unexpired period as so many twelfths of 
 a year, depending upon the proximity of the expiration date to 
 the end of the month. For example : A policy expiring on the 
 third of May would be treated as four-twelfths expired. 
 
 The difficulty involved in setting up unexpired insurance is 
 sometimes overcome by having an insurance register. This is a 
 book which provides for the name, number, amount, date, period 
 and premium of each policy and has twelve columns, correspond- 
 ing to the months of the year, over which each premium is dis- 
 tributed. It thus becomes an easy matter to determine by footing 
 the column corresponding to a given month what the charge to 
 expense for that month should be. When the insurance regis- 
 tered does not obtain, the method of treatment in closing the 
 books will.be to charge insurance unexpired and credit insurance. 
 But where the register is used, the procedure will be the reverse, 
 namely : having charged all premiums to an unexpired insurance 
 account, in closing the books insurance will be charged and un- 
 expired insurance credited in the amount shown by the footing of 
 the corresponding month in the insurance register. 
 
 An important question arises frequently in connection with un- 
 expired insurance. As is probably known, if a policy is canceled 
 the assured will not receive back the proportion of the premium 
 corresponding to the unelapsed time. For example: If a policy 
 on which the premium is $60 per year is canceled on the 30th of 
 September, the assured will not receive as a return premium $15, 
 but approximately $12.75. This is due to the fact that the fire 
 insurance companies make use of what is known as the short 
 
 264 
 
Insurance 
 
 rate basis. It is considered by the companies that it costs them 
 more to carry a risk for a short time than a longer time. There 
 must also be some provision for the expense of securing the busi- 
 ness, such as the agent's commissions, etc. For this reason the 
 companies make use of a short rate table in New York. For 
 example, such as is prescribed by the New York Fire Insurance 
 Exchange, which has the effect of reducing the value of the un- 
 expired insurance. The question which now arises is, Shall the 
 unexpired insurance be figured on the basis of the unexpired 
 time or on the short rate basis? The argument in favor of the 
 latter is that the amount so determined would be all that could 
 be obtained on the premium were it to be canceled. Against this 
 there is the contention that it is not expected that the policy will 
 be canceled and that, therefore, to a going concern the premium 
 has its full value and it may be with propriety pro-rated over the 
 period which it covers. It is, therefore, thought that a logical 
 answer to the question as to the basis upon which unexpired in- 
 surance should be computed consists in saying that in the case 
 of a going concern it may be pro-rated, whereas, in the case of 
 a concern about to go into bankruptcy, or in making up a stateT 
 ment of affairs, unexpired insurance should be figured on the 
 short rate basis. 
 
 A question frequently arises with regard to fire losses as to 
 the relation of the insured to the company and the rights of each 
 party to the contract. The settlement of a fire loss will depend 
 usually on whether or not the policy is a "valued" one and whether 
 or not the property is insured under what is known as the 80 
 per cent, clause. Many States have what are called "valued policy 
 laws," under which the insured receives the amount stated in his 
 policy in case of a total loss. There is an exception to this rule 
 in some States in that allowance is made for depreciation. The 
 person insured for $10,000 and having a total loss would in some 
 States receive the full $10,000, whereas in others he would re- 
 ceive $10,000 less an estimated amount for depreciation. The 
 rates of valued policies are naturally higher than on other kinds. 
 In the majority of cases the policy stipulates that: 
 
 "This company shall not be liable beyond the actual cash 
 value of the property at the time any loss or damage occurs, 
 and the loss or damage shall be ascertained or estimated ac- 
 
 265 
 
Principles of Accounting 
 
 cording to such actual cash value, with proper deduction for 
 depreciation however caused, and shall in no event exceed 
 what it would then cost the insured to repair or replace the 
 same with material of like kind and quality ; said ascertainment 
 or estimate shall be made by the insured and this company, or, 
 if they differ, then by appraisers, as hereinbefore provided; 
 and, the amount of loss or damage having been thus deter- 
 mined, the sum for which this company is liable pursuant to 
 this policy shall be payable sixty days after due notice, ascer- 
 tainment, estimate and satisfactory proof of the loss have been 
 received by this company in accordance with the terms of this 
 policy. It shall be optional, however, with this company to 
 take all, or any part, of the articles at such ascertained or 
 appraised value, and also to repair, rebuild or replace the 
 property loss or damage with other of like kind and quality 
 within a reasonable time on giving notice, within thirty days 
 after the receipt of the proof herein required, of its intention 
 so to do; but there can be no abandonment to this company 
 of the property described." 
 
 There would appear from an accounting point of view to be 
 some contradiction of terms in the above paragraph. For ex- 
 ample: "actual cash value, with proper deductions for deprecia- 
 tion." It is understood that by this is meant what the accountant 
 looks upon as book value, namely, cost less depreciation. It will 
 thus be seen that under contracts of this kind the insured will, 
 in case of a total loss, receive, not the amount stated in the policy, 
 but an amount corresponding to the value of the property de- 
 stroyed. This- would be true as a rule, except in cases where 
 the insured becomes a co-insurer under the 80 per cent, clause. 
 This clause requires that the property shall be insured for at least 
 80 per cent, of its value. In the case of failure to do this the 
 insured becomes proportionately liable for the loss to the extent 
 of the difference between what the property is insured for and 
 80 per cent, of its value. Assume, for example, that the value 
 of a certain manufacturing plant is $100,000; that the insurance 
 carried thereon is $50,000; that the loss through fire is fixed at 
 $40,000. The insured will, upon settlement in such a case, receive 
 not $40,000, the amount of the loss, but $25,000, or five-eighths 
 of the loss. The insured will have become a co-insurer with the 
 
 266 
 
Insurance 
 
 company to the extent of three-eighths and the loss will be borne 
 by the company and the insured in the proportions of five-eighths 
 and three-eights respectively. 
 
 Much discussion has occurred in accounting circles with regard 
 to the position into which the insured puts himself by providing 
 for depreciation of his property and showing same on his books 
 and balance sheets. The question of the matter of insurance has 
 very often arisen in connection with the manner of stating the 
 property and reserves for depreciation accounts on the balance 
 sheet. It has been claimed by some that the reason for showing 
 the reserves broad instead of deducting them from the asset ac- 
 counts was to avoid having fixed any book value on the assets 
 whereby the insured could be bound by the company in case of 
 a fire loss. It was argued that writing the asset down and 
 showing it net on the balance sheet, or showing the cost and 
 deducting the reserve on the balance sheet, was an admission of 
 the depreciation value of the property, whereas showing the asset 
 at its cost and placing the reserve on the liability side gave the 
 same effect to the proprietor's net worth, at the same time the 
 proprietor did not admit publicly that the reserve was anything 
 more than his estimate of the depreciation. The absurdity of this 
 contention will be apparent from the following quotation, taken 
 from the standard form of policy : 
 
 "The insured, as often as required, shall exhibit to any 
 person designated by this company all that remains of any 
 property herein described, and submit to examinations under 
 oath by any person named by this company, and subscribe the 
 same ; and, as often as required, shall produce for examination 
 all books of account, bills, invoices, and other vouchers or 
 certified copies thereof if originals are lost, at such reasonable 
 place as may be designated by this company or its representa- 
 tives, and shall permit extracts and copies thereof to be made." 
 
 It would appear from the above as though this were an ex- 
 cellent argument as to why proprietors should exercise care in 
 computing depreciation and should proceed with such computa- 
 tions scientifically. 
 
 The treatment of fire losses in the accounts presents an inter- 
 esting topic for discussion. As to the procedure, it may be said 
 that there are two forms. The first and more logical one, since it 
 
 267 
 
Principles of Accounting 
 
 follows the facts historically, would consist in relieving the 
 property account and charging the company at the time the loss 
 is determined. The other consists in deferring any entry until 
 such time as the cash is received, when the property ac- 
 count is relieved. The principle is the same in either case, 
 regardless of whether the policy is a valued one or the 
 property is or is not insured under the 80 per cent, clause. 
 The only difference in any of these variations would be the 
 extent of the loss. Assume, for example, the cost of a 
 certain piece of property to be $100,000; reserves having been 
 set up to the extent of $20,000 ; a fire occurs and the loss is fixed 
 at $60,000. Under the first procedure the reserve will first be 
 closed out against the asset account, making the balance $80,000. 
 The company will then be charged on the books with $60,000, 
 profit and loss will be charged with $20,000, and the property 
 account will be credited with $80,000, thereby closing it out. At 
 the time the settlement is actually made cash will be charged with 
 $6o,coo and the company credited. This procedure shows all the 
 steps in the transactions and is to be preferred. The second form 
 of procedure consists in deferring the entries until such time as 
 the settlement is made, when the reserve will first be closed out 
 to the property account, leaving a balance of $8o,ooo, while cash 
 will be charged in the amount of $60,000, profit and loss in the 
 amount of $20,000, and the property credited with the amount of 
 $80,000. In so far as profit and loss is concerned the reverse of 
 the above would be true if the amount of the loss were fixed at 
 a figure higher than the book value of the property. The entries, 
 as outlined above, would operate on the same principles in the 
 case of other forms of insurance, such as marine, burglary and 
 fidelity. In all cases the property lost would be replaced by the 
 amount recovered from the insurance company and the difference 
 debited or credited to profit and loss in accordance with the rela- 
 tion which the settlement bore to the book value of the property. 
 Credit insurance works out practically the same way. The com- 
 pany bases its risk on the ratio of sales to losses of the insured in 
 past years. In the case of loss the amount received from the 
 company takes the place of that which was not received from the 
 debtor, and the difference is charged to profit and loss. A well 
 organized and efficient credit department is very often cheaper 
 than credit insurance. 
 
 268 
 
Insurance 
 
 Employer's liability insurance is somewhat different from any 
 of the above mentioned. On May 30, 1908, the President of 
 the United States approved an act of Congress "granting to cer- 
 tain employees of the United States the right to receive from it 
 compensation for injuries sustained in the course of their employ- 
 ment." Similar laws have been passed by various States, among 
 the most prominent of which are Massachusetts and New York. 
 Thus it will be seen that business concerns in the various States 
 where these laws exist have become liable for damages for in- 
 juries sustained by employees in the pursuit of their work. A 
 very natural consequence of these laws was the springing up of 
 employers' liability insurance companies to take the place of and 
 relieve employers from the obligation of having to settle with 
 employees in cases of accident. When an accident occurs the 
 employer turns the case over immediately to the insurance com- 
 pany, which either makes an immediate settlement with the injured 
 workman or defends the suit in case litigation ensues. For this 
 reason the insurance company charges a premium which, pre- 
 sumably for the want of a better or more logical basis, is com- 
 puted on the amount of the yearly payroll. Since the amount for 
 the current year cannot be determined in advance, it is the custom 
 in computing the premium to base it on the payroll of the previous 
 year. The premium is then paid. At the end of the year a report 
 is made to the company, showing the exact amount of the premium 
 for the current year and the correct premium is then computed, 
 the difference between the previous premium and the correct one 
 being adjusted either by a payment to or rebate by the insurance 
 company. Here the matter of adjustments of asset accounts does 
 not enter in. There is nothing actually lost and there is nothing 
 to be replaced, for the reason that no settlement is made by the 
 company to the insured. All that the company does is to relieve 
 the insured of the risk of having to stand damage suits, and for 
 this insurance the insured pays a premium which is charged to 
 expense. It should be noted that in this case, as well as other 
 forms of insurance above mentioned, where premiums are paid 
 in advance, it is perfectly proper to set up the proportion cor- 
 responding to the unexpired time when the books are closed. 
 
 269 
 
CHAPTER XLIII 
 
 TAXES 
 
 A tax may be considered as a contribution imposed by the 
 government upon its citizens for its support. In exchange the 
 government extends its protections to the life and property of 
 citizens through its various police organizations. A tax is some- 
 what different from an assessment. An assessment is something 
 which is levied but once, usually for the purpose of some local 
 improvement. A tax recurs from year to year. 
 
 Taxes may be divided into various classes, such as federal, 
 State, county, municipal, etc. The federal government imposes 
 a tax on corporations which is equal to one per cent, on the net 
 income. So much has been written on this subject that it is not 
 thought necessary to discuss it in detail. The full text of the 
 original law affecting corporations, including the interesting cor- 
 espondence between a number of prominent accountants and the 
 Attorney-General of the United States at the time the law was 
 promulgated, as well as the interpretation of the law and instruc- 
 tions of the Commissioner of Internal Revenue will be found in 
 Montgomery's "Auditing," pages 601 to 630, inclusive. It may 
 be mentioned in this connection, however, that at the session of 
 Congress which adjourned on August 26, 1912, there was intro- 
 duced a bill extending the excise tax on net profits, as in the case 
 of corporations, to firms and individuals engaged in business. The 
 bill did not pass. Corporations are also taxed by the State for 
 capital employed within the respective States, the form of report 
 for which will be found on page 337 hereof. In some States 
 counties impose taxes for schools and roads. 
 
 In New York City there is a tax on personal property imposed 
 on corporations, as well as a tax on real estate. 
 
 In order that a clearer conception of the question of taxes may 
 be had it would probably be of interest to run through the pro- 
 cedure for computing the tax as it exists in the city of New York. 
 An authority on the subject has very aptly said that "the city's 
 money is spent before it gets it and that this fact effects the 
 financial situation and real estate taxation to some degree." The 
 budget of appropriations for an ensuing year is made in the fall. 
 
 270 
 
Taxes 
 
 The budget is based on the estimate made by the various city 
 departments and is presented to the Board of Estimate and Ap- 
 portionment. As approved by this board the budget becomes 
 effective, and with the beginning of the new year the various 
 departments begin their disbursements in accordance therewith. 
 Asessments of property having been made during the preceding 
 year, on October 15 the tax department opens its books on the 
 assessed values of real and personal property. These books, 
 which are subject to inspection and corrections by the affected 
 parties, remain open until November 15, although hearings of 
 complaints are heard until the first of February, when the books 
 are closed and the assessment rolls are made up. On the first 
 of March the assessment rolls are sent to the Board of Aldermen, 
 which fixes the tax rate, taking into consideration the budget, 
 the estimated revenues reported by the comptroller and the total 
 assessed value of real and personal property subject to general 
 taxation. As an illustration of the manner in which the tax rate 
 is fixed the figures for the year 1912 may be used: 
 
 Assessed values : 
 
 Real property $7,861,898,890.00 
 
 Personal property.. . . 342,963,540.00 $8,204,862,430.00 
 
 Appropriations : 
 
 City $170,873,102.43 
 
 County 10,604,762.66 $181,477,865.09 
 
 Less estimated revenues 30,971,807.62 
 
 Amount to be raised $150,506,057.41 
 
 Deducting $30,971,807.62 from $181,477,865.09 will give the 
 amount to be raised by general tax. By dividing $150,506,057.47 
 by $8,204,862,430 it will be seen that the ratio of the former to 
 the latter is .0183 plus, or 1.83 plus per cent. This rate, while 
 being the average for the entire city, fluctuates as among counties, 
 varying from 1.83 per cent, in New York County to 1.92 per 
 cent, in Richmond County. Taxes are now (1913) due and 
 payable in the city of New York in two instalments, the first 
 half on May 1, the second half on November 1. If the first half 
 is paid in May interest is allowed on the amount from May 1 to 
 
 271 
 
• Principles of Accounting 
 
 November i. If not paid, interest is charged for the same period. 
 In the month of November taxes are payable without interest, 
 except as to the adjustment necessary to provide for the first 
 half, while, on the first of December, a penalty of i per cent, is 
 added, and on the 15th of January interest begins to run at the 
 rate of 7 per cent. 
 
 "Whenever any tax or assessment shall remain unpaid for 
 three years or any water rent shall remain unpaid for four 
 years the tax lien on the property will be sold to satisfy such 
 arrears of taxes, assessments or water rents, and all taxes, 
 assessments and water rents up to a day to be named in the 
 advertisement of sale as stated therein." 
 
 An important point in connection with taxes is the accrual and 
 treatment of taxes paid in advance. The accruing of the taxes 
 will depend very largely on the fiscal period and the date at which 
 the books are closed. Concerns which close their books monthly 
 find it necessary to accrue from month to month if the taxes are 
 of sufficient size and importance to warrant this treatment. In 
 this way the proper charge is made to the expense accounts for 
 the month and the proper liability accumulated through the accrual 
 account. This stands until sucn time as the taxes for the year 
 are paid. The accrual account is then (in New York State) 
 automatically converted into a prepaid account, since the taxes 
 will have been paid for the entire year. For the purpose of 
 making this clear the following illustration will serve : 
 
 Assuming the assessed value of a piece of property in New 
 York County to be $100,000 and the tax rate for the year 1912 
 1.83 per cent., the tax for the year will be $1,830, or $152.50 per 
 month. If the books were closed monthly or, at least, if monthly 
 statements of income and profit and loss were prepared, then the 
 entry to be made each month would be as follows : 
 
 Taxes $152.50 
 
 To Taxes accrued $152.50 
 
 This entry would be repeated each month and the charge to 
 taxes would be closed out monthly to profit and loss. The taxes 
 accrued account would accumulate so that at the end of the first 
 
 272 
 
Taxes 
 
 six months, or at June 30, the account would show $915. If the 
 tax bill for the first six months is now paid, taxes accrued will be 
 charged and cash credited in the amount of $915. A further 
 complication may, however, in practice take place in connection 
 with the taxes for the first six months as well as those for the 
 year. Tax bills are not sent out by the city. It is necessary to 
 request them from the receiver of taxes. Assuming now that the 
 request for a tax bill for the first six months of the year has been 
 made prior to May 1, and, as a matter of fixing the date, has 
 been received on April 23, at the end of April the taxes accrued 
 will amount to $610, but the tax bill will amount to $915. This 
 means that the bill includes not only the first four months but 
 also the months of May and June. The question which now 
 arises is the treatment of the tax bill. One method of treatment 
 would be to charge taxes accrued and credit cash with $915. 
 This will convert the taxes accrued account automatically into a 
 prepaid taxes account and the prepayment will be in the amount of 
 $305. The more scientific manner of treating the matter would 
 be to charge taxes paid in advance and credit taxes accrued with 
 $305 and subsequently charge taxes accrued and credit cash with 
 $915 when the payment is made. The amount of $305 in the 
 taxes prepaid account will be disposed of in the months of May 
 and June by charging taxes in the respective months and credit- 
 ing taxes paid in advance. The second six months would, not 
 differ in any respect from the first six months except that in 
 case payment of the first six months had not been made when due. 
 Under such circumstances the principle involved would be the 
 same, but the amounts would change. The charge to the taxes 
 account would be made regularly from month to month, but the 
 taxes accrued account would increase gradually in accordance 
 therewith. If the tax bill is paid before the end of the year there 
 will be an unexpired portion to be taken care of. If not paid 
 until after the end of the year this, of course, will not be true. 
 
 The question of interest is one which sometimes causes discus- 
 sion. The question is whether interest on taxes should be charged 
 to the interest account or to the account for taxes. If the matter 
 is to be scientifically treated it is probable that the interest should 
 be charged to the interest account, since the concern under dis- 
 cussion has in effect a contract as to the dates upon which pay- 
 ments are to be made. If payments are not made and the tax- 
 
 273 
 
Principles of Accounting 
 
 payer has the use of the money he pays therefor interest. If 
 the capitalistic theory is to be consistently maintained, interest on 
 taxes will have to be charged to interest. It is very probable, 
 however, that in the majority of cases interest will be, even 
 though erroneously, added to the taxes paid. 
 
 In some States taxes are payable for the year in advance. In 
 such cases the treatment of the taxes becomes analogous with that 
 of interest paid in advance. The taxes are set up in a prepaid 
 account and charged out to the expense account as time passes. 
 
 It will be noted in many published balance sheets, and most 
 especially in the case of banks, that the taxes are shown on the 
 liability side under a caption called reserve for taxes. This would 
 appear to be merely a loose manner of expressing the situation, 
 since, as a rule, a reserve has not been created for taxes any more 
 than for any other current liability. It would seem that this 
 item might with most propriety be called taxes accrued. There 
 would be no objection and perhaps in certain instances it might 
 be desirable to make a distinction between the taxes accrued and 
 due and those accrued and not due. Difficulty is also encountered 
 at times in ascertaining the proper amount of taxes for the year. 
 This is before the tax rate is ascertained and before the tax bills 
 can be obtained. It is customary in such cases to use the rate 
 and assessed value for the preceding year. This, of course, is in 
 effect an estimated amount, and it may reasonably happen that 
 the correct amount for the year when ascertained will disagree 
 with the estimated amount. The proper method of treatment is 
 to proceed with the monthly charge to taxes and credit to taxes 
 accrued on the estimated basis until such time as the correct 
 amount has been ascertained, when the charge should be revised 
 and the adjustment necessary to put the account on the proper 
 basis be made. Thus, it might happen that in the case of a given 
 concern the amount of taxes estimated for the year might be 
 $1,500. Such an amount would mean $125 a month. If the 
 charge for taxes were made monthly, then at the end of the month 
 of April there would have been charged to taxes and credited to 
 taxes accrued $500. If now the' tax bill for the year is obtained 
 and it is found that the taxes for the year will amount to $1,830, 
 then it is apparent that instead of having charged $500, $610 
 should have been charged. It will then be necessary to make a 
 supplementary charge for the four months of $1 10, the difference 
 
 274 
 
Taxes 
 
 between $500 and $610, or the difference per month between $125 
 and $152.50. If, perchance, the estimate will in any case have 
 been too high, the adjustment necessary must be the reverse of 
 the one just described. As a practical matter, however, this is 
 not liable to occur, since taxes are inclined to increase rather than 
 to decrease. 
 
 275 
 
CHAPTER XLIV 
 
 MISCELLANEOUS PROFITS AND LOSSES 
 
 In every business there are necessarily profits more or less 
 uncommon which are not directly connected with the particular 
 line of business in which the organization is engaged. For 
 example: Sales of land or buildings, machinery or tools, horses, 
 wagons, harness, furniture or fixtures, materials and supplies, 
 scrap, etc. Such transactions are incidental and are not con- 
 templated in the scheme of business for the realization of profit. 
 That there are profits in connection with such sales, as well as 
 losses, may not be ignored. They are irregular and intermittent 
 and may not be depended upon to produce income. Only such 
 items should be considered as income as recur regularly. Such 
 is the distinction to be made between profits and income. The 
 assets above enumerated are normally held for the purposes of 
 the business. If sold at a figure either above or below their cost 
 a profit or loss results. Such profits should be classified as mis- 
 cellaneous. This group should also include, providing such items 
 are considered as profits, appreciation of land and appreciation 
 of securities. With regard to such treatment of these items, it 
 may be said that the best practice does not countenance appre- 
 ciation as being considered a profit. Profits, strictly speaking, 
 do not arise until a sale has taken place. If it is desired to show 
 such assets as land, securities or materials and supplies at their 
 market price, it would be very much better to credit the increase 
 to a reserve instead of considering such increase as a profit. The 
 practice of so treating a theoretical increase in value is responsible 
 for the well-known expression "anticipating profits." Such prac- 
 tice has nothing in its favor and everything to condemn it. The 
 items are merely mentioned here on account of the tendency of 
 many concerns to anticipate profits and, while contrary to good 
 practice, place the items in a definite class in case they are so 
 treated. 
 
 For the purpose of general classification there has been in- 
 cluded among miscellaneous profits amounts previously written 
 off — now collected. This is satisfactory so far as general classi- 
 fication is concerned, but if the refinements are to be entered into, 
 
 276 
 
Miscellaneous Profits and Losses 
 
 the item should be distinguished from the other items in this 
 group and preferably treated as an addition to surplus rather than 
 a miscellaneous profit. This item illustrates very well the dis- 
 tinguishing line between profits and surplus. Profits should cover 
 only items having to do with the present period. The recovery 
 of an item previously written off takes us naturally to surplus, 
 since it must mean that the writing off had taken place in a 
 previous period and the surplus, therefore, correspondingly de- 
 creased. If such a loss has been charged to a previous period and 
 the loss is now wholly or partially recovered, credit for same 
 should not be given to the present period but to the previous 
 period. Since the nominal accounts for the previous period have 
 been closed, there remains only surplus. Surplus should, there- 
 fore, be credited. ' 
 
 It sometimes happens that where an accounting period is a 
 lengthy one, possibly a year, there will have been written off 
 during the early part of the year certain bad or doubtful accounts. 
 It may subsequently happen that within the same year a collection 
 will be made on some of the supposedly bad accounts. In case 
 of such occurrence the credit for the recovery should be made to 
 profit and loss, or to the account for bad and doubtful accounts 
 written off, instead of to surplus. 
 
 In closing the books the procedure will depend entirely upon 
 whether separate accounts have been opened for the respective 
 miscellaneous profits or whether such items have been carried 
 direct to profit and loss. The latter is probably the most usual 
 method of treatment. If separate accounts have been raised, how- 
 ever, they should be closed out to miscellaneous profits, which 
 accounts would correspond to the seventh section of the statement 
 of income and profit and loss, namely : profit and loss credits. 
 What usually happens with these items is that either at the time 
 the sales took place or when the books are closed the credits were 
 made direct to the profit and loss account. In preparing the 
 statement it, therefore, becomes necessary to analyze the credit 
 side of the profit and loss account in order that comprehensive 
 details may be set forth in the statement. 
 
 Miscellaneous losses comprise not only the complementary side 
 of transactions enumerated above, such as sales of land, buildings, 
 etc., but also provision for doubtful accounts, depreciation of 
 
 277 
 
Principles of Accounting 
 
 buildings and miscellaneous items, such as amortization of patents, 
 trademarks or good-will, and organization expense written off. 
 
 With regard to doubtful accounts, some distinction should be 
 made between the provision for doubtful accounts and doubtful 
 or bad accounts written off. Provision for doubtful accounts 
 anticipates a loss through such causes and provides for it in 
 advance. In making such provision it is customary to base it on 
 a sales charge concurrent with the charges to accounts receivable. 
 Varying rates, ranging from 2 to 5 per cent, or even higher, 
 depending upon the experience of the organization in past years, 
 are used. The charge to profit and loss is offset by a credit to a 
 reserve for doubtful acounts. This has the effect of providing 
 within a given period for losses which may occur on accounts 
 receivable raised in connection with sales made during the same 
 period. Good practice advocates the making of this charge 
 monthly as sales are made. If losses are subsequently sustained 
 they are charged to the reserve and not to profit and loss, for the 
 reason that provision for them , has already been made through 
 a preceding charge. If ultimately there remains in the reserve 
 an amount corresponding to the provision that was not required, 
 this amount may be closed out to surplus and not to profit and loss. 
 
 It will thus be seen that there is a considerable difference 
 between providing for doubtful accounts and writing off accounts 
 which ultimately prove bad. Where the latter method is used 
 care should be exercised to determine whether the loss is on sales 
 which have taken place during the current or during a preceding 
 period. For losses on sales during the current period, profit and 
 loss may be charged. For losses on sales in prior periods surplus 
 should be charged. The reason in the latter case is that the 
 profits of the preceding period and, consequently, surplus receive 
 credit for a sale which in a succeeding period proved to be bad 
 and resulted in a loss. Concerning amortization of patents, trade- 
 marks or good-will, organization expense written off, it may be 
 said that there are two methods of treatment available for use. 
 The assets may thus be written down, in which case profit and 
 loss will be charged and the assets credited, or their value may 
 be reduced by the creation of a reserve. In the latter case profit 
 and loss will be charged and the reserve credited. 
 
 The remarks with regard to the closing of the profit accounts 
 apply with equal force to miscellaneous losses. It is not probable 
 
 278 
 
Miscellaneous Profits and Losses 
 
 that separate accounts for the respective losses will be raised. If 
 they are raised, they should be closed out to an account for mis- 
 cellaneous losses or to profit and loss. It will usually happen, 
 however, that these losses will have been charged direct to profit 
 and loss and that it will be necessary in preparing the statement 
 of income and profit and loss to analyze this side of the profit and 
 loss account in order that the details of losses may be set forth 
 in the section of the statement of income called profit and loss 
 charges. 
 
 It will no doubt have been observed that dividends payable 
 have not been included in the classification presented. While they 
 may be appropriately discussed at this point, they are not to be 
 looked upon as an item of expense. They are rather to be con- 
 sidered as a distribution of profits. Profits or losses in the case 
 of a sole proprietor or copartnership will be disclosed by the 
 profit and loss account and will be closed out to proprietorship ; 
 in accordance with the division agreed upon in the contract, in 
 the case of copartnership. In corporations profits may be dis- 
 tributed by vote of the directors from the surplus arising from 
 the business. Technically profits are closed into the surplus 
 account and the surplus distributed as dividends. After the action 
 of the directors in declaring a dividend the proper entry consists 
 in debiting "dividends declared" or surplus and crediting "divi- 
 dends payable." If the account "dividends declared" has first 
 been charged, it will be closed out to surplus. Dividends declared 
 becomes the nominal account while the liability is taken up in the 
 dividends payable account. When the liability is liquidated by 
 the payment of cash, dividends payable is charged and cash 
 credited. Some concerns do not raise the account for dividends 
 payable, waiting until the payment is made before charging the 
 nominal account. This is not thought to be the best practice, 
 since it fails to show the history of the dividend transactions and 
 may result in neglecting to show a liability for dividends declared 
 at closing time, which neglect has the effect not only of failing 
 to show this important, point but to show an augmented surplus. 
 
 279 
 
CHAPTER XLV 
 
 ACCRUALS AND CLOSING ENTRIES 
 
 Accruals are necessary in accounting if true financial condi- 
 tion and correct operations are to be shown. Some concerns run 
 their books and prepare their statements entirely in accordance 
 with the cash transactions. Operations are controlled" by the 
 receipt and disbursement of cash. Thus we hear of books kept 
 and statements prepared on a cash basis. Scarcely anything could 
 be further from the truth in so far as condition and operations 
 are concerned. Some business men will insist that they are not 
 sure of any profits until they have them in cash. With some, 
 cash seems to be a mania. They refuse to recognize the fact that 
 their financial condition is the matter of importance and that 
 financial condition is represented by both assets and liabilities. 
 They refuse to recognize the fact that cash is only one of the 
 items which make up the assets. The man who contends that 
 he has nothing except that he has it in cash cannot, it seems, 
 consistently admit that he owes anything, yet there is never very 
 much difficulty in drawing out this admission. Time is the 
 medium which measures the majority of business transactions, 
 and it is the relation of these transactions to the time which has 
 elapsed, or is to elapse, that must be taken into consideration in 
 scientific accounting. Most accounts seem to have certain loose 
 ends which must be gathered up before the books can be closed. 
 To do this consistently the accountant or bookkeeper should go 
 through the accounts one by one, scrutinizing and studying each 
 carefully, in order to determine whether there is anything about 
 it which requires treatment in order that it shall show true con- 
 dition and correct operations. Taking up the items in the order 
 that they will usually appear in the ledger, they may require 
 treatment in closing as follows: 
 
 Land may have increased in value and it may be desired by 
 the proprietor that it be shown at the increased value in the 
 books. There is, of course, a natural objection on the part of 
 the accountant to writing up land and taking the increment into 
 profits. Conservatism dictates that wherever it is necessary or 
 desirable to increase the figure ar which land is carried that the 
 
 280 
 
Accruals and Closing Entries 
 
 increase shall be offset by a reserve. This will, of course, call 
 for an entry charging land and crediting reserve for appreciation 
 of land. 
 
 Buildings will be subject to depreciation, which, in closing the 
 books, must be taken into consideration. The same statement 
 will apply with equal force to equipment, furniture and fixtures, 
 horses, wagons and harness, motor trucks, etc. The depreciation 
 may be handled in one of two ways : either by writing down the 
 asset through a charge to profit and loss and a credit to the asset, 
 or making the charge to profit and loss, or an account called 
 provision for depreciation, and crediting a reserve for deprecia- 
 tion. The latter method is to be preferred, since it leaves the asset 
 account unaffected by depreciation and permits it to show bona 
 fide additions and deductions, while the value of the asset is cor- 
 rectly shown on the balance sheet through the offset in the form 
 of a reserve. 
 
 Investments may fluctuate in value and, consequently, it may 
 be desirable to adjust their book value in closing. The rule 
 regarding investments is that they shall be shown at cost. In the 
 case of securities the rule has usually been to show them at cost 
 if cost is lower than the market, but if cost is higher than the 
 market to reduce them to the market. It is not thought advisable 
 to adjust the account in the books to keep pace with fluctuations 
 in market values, but the effect is secured by raising the 
 proper reserves. Not alone securities, but any investments which 
 fluctuate in value, may be adjusted by means of reserves. If the 
 investment has increased in value, an entry may be made charging 
 the asset account and crediting a reserve for appreciation of in- 
 vestments. If the investment has decreased, profit and loss may 
 be charged and a reserve credited, which may be called reserve 
 for depreciation of investments. 
 
 Materials and supplies, goods in process and finished goods 
 may all require adjustment at closing time. The remarks appli- 
 cable to investments will apply equally well to materials and 
 supplies. No one can object to their being carried at cost, because 
 of the fact that it is intended that they shall be used in the product 
 and not sold. Hence the market value can have little effect upon 
 them. There would be no more excuse for writing down materials 
 and supplies than for writing them up. They are written down 
 in accordance with the theory that the market has fallen and 
 
 281 
 
Principles of Accounting 
 
 they could be produced now at a lower figure than formerly. It 
 would seem to make little difference whether the excess of cost 
 over market were written down to profit and loss or whether it 
 were charged into the product at cost. On the other hand, it 
 would seem absurd to take a fictitious profit on them and charge 
 them into the cost at a higher rate if the market had risen. The 
 point at issue seems to be entirely one of whether they are to be 
 valued at what they would bring in the market or at what they 
 are worth for manufacturing purposes. Ultra-conservatism re- 
 quires that they shall be carried at cost when cost is below the 
 market, but carried at the market when the market is below cost. 
 It would seem that if it is desirable to take cognizance of the 
 relation of cost to the market price that this might be accomplished 
 through the medium of reserves for balance sheet purpose, rather 
 than upsetting the costs at which the materials and supplies are 
 to be charged into the product. 
 
 Goods in process may have included in them in certain in- 
 stances manufacturing and general overhead. Here again it may 
 be necessary to resort to reserves for the purpose of proper valu- 
 ation in the balance sheet, without disturbing the function of 
 control which is the essential of these accounts. Stationery, print- 
 ing and postage will likely require adjustment in closing, unless 
 arrangement has been made to carry both asset and expense 
 accounts for these various items. Even so, it will frequently be 
 the custom to defer the charge of these items to expense accounts 
 until just before closing the books. 
 
 The accounts representing the current assets will very gen- 
 erally call for adjustment before closing. Cash is the usual ex- 
 ception to this rule, but even it may require adjustment on account 
 of interest on bank balances and similar items. Accounts receiv- 
 able will need to be scrutinized so as to determine whether or not 
 there are among them any accounts which are bad or doubtful. 
 These should be provided for through the medium of reserves 
 rather than written off. Some accounts may carry interest, which 
 should be accrued before closing. Notes receivable are of the 
 same character and must receive attention with regard to the 
 interest which has accrued on them. 
 
 Special and miscellaneous assets, like sinking funds, etc., may 
 require adjustment, and accounts like good-will, insurance and 
 advertising paid in advance may need to be written off or pro- 
 
 282 
 
Accruals and Closing Entries 
 
 vided for. Consignments may also have to be taken care of if 
 consignments have not been carried on the general books. Ac- 
 counts sales should be made up and the proper entries made on 
 the books, usually charging the cost of sales and crediting ac- 
 counts payable in favor of consignors. 
 
 With regard to the accounts for liabilities, the interest on any 
 bonds outstanding should be accrued, as should also taxes, wages 
 and the interest on accounts and notes payable. If there are any 
 deferred credits to income they should be examined in order to 
 determine if any proportion may appropriately be taken into the 
 earnings of the period. 
 
 In a similar manner the nominal accounts should be gone 
 through, giving attention to any sales made in the period not yet 
 booked; also any returns or sales allowances pending settlement. 
 Attention should likewise be given to purchases and purchase re- 
 turns and allowance. Inventories should be applied and the proper 
 cost of purchases applicable to manufacturing or sales should be 
 determined ; salaries of superintendent, office salaries and expenses 
 of the factory accrued, in the case of a manufacturing concern, 
 and the true cost of goods sold ascertained by means of the in- 
 ventories, unless the direct method of ascertaining the cost is in 
 vogue. The accounts for salaries of salesmen, traveling expenses 
 of salesmen, commissions and advertising should be carefully gone 
 into for accruals and adjustments affecting the expenses. Salaries 
 and expenses of the general office should likewise be treated. 
 
 After the proper entries have been made in the accounts the 
 nominal accounts may be closed direct to profit and loss, or they 
 may first be closed into the respective group accounts, which in 
 turn will be closed into profit and loss. This is what is meant in 
 reality by closing the books. Although the making of the accruals 
 and the preparation of the balance sheet and statement of income 
 and profit and loss from the trial balance before closing has come 
 to be referred to technically by the same expression, it makes 
 little difference practically in the preparation of the statement of 
 income whether or not the nominal accounts have actually been 
 closed. If they have been, it will be necessary to analyze the 
 profit and loss account, or, in other words, pick the items out of 
 said account. Whereas, if the nominal accounts have not actually 
 been closed out, the statement may be prepared from the trial 
 balance or direct from the accounts. It is usually easier to pre- 
 
 283 
 
Principles of Accounting 
 
 pare the statement if the nominal accounts have not been closed 
 out. Where the accounts have been scientifically arranged the 
 preparation of the statements is greatly facilitated, since the items 
 will appear in the statements in practically the same order that 
 the accounts appear in the books. 
 
 384 ^ V 
 
CHAPTER XLVI 
 
 THE PREPARATION OF FINANCIAL STATEMENTS 
 
 Financial statements may be generally classified as follows : 
 
 Balance sheets; 
 
 Statements of income and profit and loss; 
 
 Statements of affairs ; 
 
 Deficiency accounts ; 
 
 Statements of realization and liquidation ; 
 
 Statements of receipts and disbursements. 
 
 It is not improbable that various kinds of statistical statements 
 may be included in this classification. It is thought, however, to 
 be more consistent to confine the classification to the above and 
 consider statistical tables, which are invaluable for administrative 
 purposes, as schedules supporting the above statements. 
 
 There has been much discussion concerning the various names 
 of the above-mentioned financial statements. Concerning balance 
 sheets it would seem that there need be little or no discussion. 
 The balance sheet may be general or detailed in the manner in 
 which the information is presented. It may be condensed or con- 
 solidated. Irrespective of these matters it still remains a balance 
 sheet. The question is sometimes raised as to whether it is more 
 appropriate to present it in account form or report form. There 
 would seem to be but one answer to this question, and that is : 
 whichever suits the fancy of the person who is preparing the bal- 
 ance sheet. The information is there, whether assets and liabilities 
 are presented side by side or one group above the other. 
 
 With regard to the statement of income and profit and loss 
 there is perhaps room for more discussion. One author has tabu- 
 lated the different names by which this statement is known and 
 presents some fifteen of such. It has been variously referred to 
 as the profit and loss account, the income and profit and loss 
 account, the trading and profit and loss account, the manufactur- 
 ing, trading and profit and loss account, etc., etc. The informa- 
 tion contained should be the same, no matter by which name the 
 
 285 
 
Principles of Accounting 
 
 statement is known. It will be observed that the difference seems 
 to occur in that some are known as statements and some as ac- 
 counts. The difference is usually technically referred to as that 
 which exists between the account form and the report form. The 
 account form, as its name implies, contemplates the presentation 
 of the information classified and arranged with regard to debit 
 and credit. The report form undertakes to present the informa- 
 tion more or less in narrative or running form, deducting debits 
 from credits and vice versa. The especial advantage of the report 
 form is that it is adapted to comparison. 
 
 The balance sheet is a financial statement which shows the 
 financial condition of an organization at a given moment of time. 
 
 The statement of income and profit and loss is a financial state- 
 ment which sets forth the financial operations of an organization 
 comprehensively grouped about the divisions of organization and 
 connecting the financial condition of the organization at two 
 different dates. 
 
 A statement of affairs is a financial statement setting forth as 
 an estimate the deficit and the amount which unsecured creditors 
 would receive through enforced realization and liquidation and 
 the relative positions of preferred and secured creditors. 
 
 A deficiency account is a financial statement which serves to 
 explain the manner in which a deficit has occurred and to connect 
 the deficit with the proprietorship as shown on the balance sheet. 
 
 A statement of realization and liquidation is a financial state- 
 ment which shows through the realization of assets and the liquid 
 dation of the liabilities the reduction of net assets to cash. 
 
 A statement of cash receipts and disbursements is a financial 
 statement of an organization which shows the actual cash received 
 and the actual cash paid over any given period of time, together 
 with the balances at the beginning and at the end of the period, 
 respectively. 
 
 Of the above the balance sheet and income statement are most 
 prominent. They appear in connection with a going concern, 
 whereas a statement of affairs and deficiency account arise in 
 connection with insolvency as a rule, while the statement of reali- 
 zation and liquidation shows the subsequent transactions of the 
 receiver. The purpose of the balance sheet is to set forth the 
 financial condition. The purpose of the statement of income is to 
 set forth the storv of operations. Each must be complete as to 
 
 286 
 
The Preparation of Financial Statements 
 
 content and arranged comprehensively if it is to be of use. In 
 considering this point it may be well first to look for a moment at 
 the parties at interest in an organization. These are, first, those 
 who contribute the capital or finance the organization ; second, 
 those who manage the organization ; and, third, those who develop 
 relations with the organization as debtors and creditors. The 
 classification of parties is apparently broad enough to cover any 
 contingency, since the respective parties are connected with phases 
 which are fundamental to organization. Under the head of con- 
 tributors of capital we find sole proprietors, copartners, stock- 
 holders, members, and, in the case of municipalities, taxpayers. 
 Each of these is interested in knowing that his funds have been 
 not only advantageously employed, but that they are secure. 
 Financial statements offer a means of satisfying the desire for 
 such information. To the manager they offer in the same way 
 a means of satisfactorily accounting for his stewardship, but they 
 also furnish him with excellent facilities for getting in touch arti- 
 ficially with the divisions of his organization which size or other 
 conditions prevent him from coming into personal contact with and 
 thus transcending the limits of his personal observation. Through 
 his financial statements he is offered an opportunity of extending 
 his administrative functions to the most remote and insignificant 
 portions of his plant. As to the outsiders, comparatively little can 
 be said concerning debtors. The creditors, however, play an 
 important part. Before trade creditors or banks will extend 
 credit or make loans they must know that the concern is in good 
 financial condition and what its prospective earning power is. 
 Both these facts may be disclosed by balance sheets and statements 
 of income. 
 
 In short, it would seem that financial statements which would 
 convey the proper information to the administrative officers would 
 be perfectly satisfactory to any one of the other parties at interest. 
 There has been omitted from this classification of parties the 
 government, and, while the government may be admitted as a 
 party at interest, for some reason or other it appears that state- 
 ments that are perfectly comprehensive and satisfactory to every 
 one else are not, as a rule, satisfactory to the government. It 
 seems to be customary for the government in the majority of 
 cases to insist on financial statements in the form of reports which 
 differ entirely from the usual run of financial statements and are 
 
 287 
 
Principles of Accounting 
 
 understood with difficulty by the parties who are required to pre- 
 pare them. In many cases they do not appear to follow any 
 known rules of accounting and the results obtained at times are 
 little short of ridiculous. It is difficult to see just why balance 
 sheets and statements of income and profit and loss which are 
 ordinarily accepted as being clear and comprehensive are not 
 received and used by the government. 
 
 A classified balance sheet would appear to meet the require- 
 ments of all interested parties. By classified balance sheet is 
 meant one in which the assets and liabilities are classified. Assets 
 are of several kinds, namely: capital, working and trading, 
 current, miscellaneous and deferred. Liabilities follow very much 
 the same order, namely: capital, current, miscellaneous and 
 deferred. Such a classification would give to any one interested 
 information concerning the assets and liabilities. It would also 
 enable any one to compare any group of liabilities with any corres- 
 ponding group of assets. As to the general arrangement, a great 
 deal of discussion has been had. There are those who contend 
 that the current assets should be shown first, arranging them in 
 the order in which they will be realized ; that the current liabilities 
 should appear at the head of the statement on the other side, 
 arranged in the order in which they will be liquidated. Others 
 contend that capital assets and liabilities respectively should head 
 the statement. Those who argue for preference for the current 
 assets and liabilities seem to have principally in mind the interest 
 of creditors, and they also seem to go on the assumption that the 
 business is to be liquidated. Those who prefer the capital assets 
 and liabilities seem to look at the situation from the standpoint of 
 the proprietor or stockholder. With a little care in the arrange- 
 ment it would seem that every one might be satisfied. If the 
 capital assets and capital liabilities are placed at the top of their 
 respective sides of the balance sheet the working and trading 
 assets follow the capital assets, and these in turn are followed by 
 the current assets; whereas the capital liabilities are followed by 
 the current liabilities, then, subject to consideration of miscel- 
 laneous assets and liabilities and deferred charges to expense and 
 credits to income, there may be seen at a glance not only how 
 the capital has been invested and maintained but the relation of 
 current liabilities to current assets. It is an easy matter to show 
 the logical order of assets and liabilities with regard to realization 
 
 288 
 
The Preparation of Financial Statements 
 
 and liquidation in the case of a going concern, whereas it is much 
 more difficult to attempt to state the order of realization and 
 liquidation in case a concern is to be wound up. The following 
 balance sheet, while far from exhaustive, will serve to illustrate 
 in a general way the classification and arrangement suggested : 
 
 THE HARFORD COMPANY 
 
 GENERAL BALANCE SHEET, JULY 31, I912 
 ASSETS I LIABILITIES AND CAPITAL 
 
 Plant and Property, 
 schedule No. 1 
 
 Investments, schedule 
 No. 2 
 
 Treasury stock 
 
 Patents, trademark and 
 good-will, schedule 
 No. 3 
 
 Inventories, schedule 
 No. 4 
 
 Current assets : 
 
 Cash in hand and on 
 dep., sched. No. 5, , 
 
 Accounts receivable.. 
 
 Drafts and notes re- 
 ceived and interest 
 
 Due from subscribers 
 to capital stock. . . 
 
 $140,82870 
 
 71,228.89 
 
 5,000.00 
 
 34,157-41 
 
 35,436.35 
 
 $42,757-84 
 45,036.72 
 
 9,343-72 
 197,280.00, 
 
 Total cur. assets.. $294,418.28 
 
 Sinking fund. 
 
 400.00 
 
 Deferred charges to ex- 
 pense, schedule No. 6 
 
 i3,37i-ii 
 
 Total assets $594,840 74 
 
 First mortgage bonds : 
 
 Authorized $200,000.00 
 
 Less unissued 40,000.00 
 
 Issued and outstand'g 
 
 $160,000.00 
 
 Loans payable, and int. 
 
 58,011.59 
 
 Current liabilities : 
 
 
 Taxes accrued 
 
 $73-15 
 
 Salaries and wages 
 
 
 accrued 
 
 7,832.08 
 
 Accounts payable. . . . 
 
 8,264.40 
 
 Notes and drafts pay- 
 
 
 able, and interest. . 
 
 16,307.17 
 
 Expenses accrued.. .. 
 
 500.00 
 
 Dividend payable. . . . 
 
 1,297.50 
 
 Int. ace. on 1st mtge. 
 
 
 
 800.00 
 
 Total current liabil.. 
 
 $35,074-30 
 
 Reserves, sched. No. 7 
 
 3,221.61 
 
 Capital stock — pref'd : 
 
 
 Authorized 
 
 $500,000.00 
 
 Less unissued 
 
 413,500.00 
 
 Issued and outstdg. 
 
 $86,500.00 
 
 Common : 
 
 
 
 $500,000.00 
 
 Issued and outstdg. $25,000.00 
 
 Total cap'l stock is- 
 sued & outstand'g $111,500.00 
 
 Capital stock subse'd $219,200.00 
 
 Profit and loss surplus. 2,833.24 
 Cap'l surp., donated stk. 5,000.00 
 
 Total liabil. & cap'l. . $594,84074 
 
 Exhibit "A" 
 
 289 
 
Principles of Accounting 
 
 SCHEDULES SUPPORTING GENERAL BALANCE 
 SHEET, JULY 31, 1912 
 
 Plant and property — schedule No. 1 : 
 
 Land and buildings $107,500.00 
 
 Additions to buildings 12,500.00 
 
 Plant equipment 13,200.00 
 
 Horses, wagons and motors 5,664.00 
 
 Furniture and fixtures 1,964.70 
 
 $140,828.70 
 
 Investments — schedule No. 2 : 
 
 Securities owned $64,900.00 
 
 J. M. Carlton, receiver 3,764.00 
 
 Retail department 2,564.89 
 
 $71,228.89 
 
 Patents, trademarks and good-will — schedule 
 No. 3: 
 
 Patents and trademarks $9,916.67 
 
 Good-will 24,240.74 
 
 $34,157.41 
 
 Inventories — schedule No. 4: 
 
 Stores department $3,618.39 
 
 Manufacturing department 12,272.15 
 
 Finished goods manufacturing 12,986.91 
 
 Finished goods trading 5,892.21 
 
 Subdividing department 5 2 7-84 
 
 Shipping department 56.40 
 
 Boxmaking department 20.00 
 
 Coal-oil and waste 38.95 
 
 Stable and garage supplies 8.50 
 
 Postage 15.00 
 
 $35436-35 
 290 
 
The Preparation of Financial Statements 
 
 SCHEDULES SUPPORTING GENERAL BALANCE 
 
 SHEET, JULY 31, 1912 {Continued) 
 
 Cash in hand and on dep. — schedule No. 5 : 
 
 Cash in bank $40,871.33 
 
 Imprest cash 100.00 
 
 Expense funds 525.00 
 
 Freight deposit 31.51 
 
 Deutsche Bank 1,230.00 
 
 $42,757.84 
 
 Deferred charges to expense — sched. No. 6 : 
 
 Discount on bonds $9,958.34 
 
 Legal expense deferred 1,250.00 
 
 Organization expense 995-°3 
 
 Insurance 926.00 
 
 Rent paid in advance 5.81 
 
 Advertising 208.00 
 
 Freight on consigned goods 2 7-93 
 
 $i3.37i." 
 
 Reserves — schedule No. 7: 
 
 For depreciat'n, buildings and equipment $1,340.75 
 
 For doubtful accounts 782.77 
 
 For containers 1,098.09 
 
 $3,22 1. 61 
 
 There are a number of controversial points which arise in 
 connection with balance sheets. Prominent among these is the 
 order which the current assets shall take. These should be 
 
 291 
 
Principles of Accounting 
 
 arranged in the order in which they will ordinarily be realized, 
 namely : cash, accounts receivable, notes receivable. In the case 
 of a going concern, if goods are not sold for cash they are sold 
 on account. When the customer finds out that he cannot pay 
 the account as promptly as he expected to he asks for a further 
 extension of time aiid offers his note. It should be understood 
 that the note is not any better security than the account. What 
 the note does is to effect an agreement as to the items making up 
 the account and thus render it unnecessary to prove the items in 
 the account should litigation arise. It has often been argued 
 that a note may be realized upon much more quickly than an 
 account, since notes are frequently discounted. It may be 
 remarked with equal truth and facility that accounts in some 
 parts of the United States are in effect discounted. While both 
 of these statements may be true, they are the exceptions to the 
 rule that an account will ordinarily precede. a note; however, it 
 seems only logical to give preference, in the order of arrangement, 
 to the accounts as representing the bulk of the credit. 
 
 Similar discussion may also be had with regard to current 
 liabilities. As to the items of taxes and wages, there need be 
 little argument, since the law makes both preferred claims, taxes 
 and all claims to the government taking preference over wages. 
 The same argument which was used in the case of accounts 
 receivable and notes receivable may be used in the case of accounts 
 payable and notes payable. Notes are not preferred over 
 accounts, but rate with them in liquidation. They have no 
 stronger claim on the business than have the accounts and, in 
 view of the fact that in the history of the business transactions 
 the accounts usually precede the notes, it is thought consistent to 
 follow this arrangement in the balance sheet. 
 
 Good-will frequently comes up for discussion and the question 
 which presents itself is whether it shall be included among the 
 capital assets or as a miscellaneous asset. Its allocation depends 
 entirely upon the circumstances surrounding its creation. If it 
 is purchased in exchange for assets of the concern, it should be 
 included as a capital asset. If it is raised by the concern without 
 having been acquired in exchange for value which can be 
 measured, it should be shown as a miscellaneous asset. 
 
 Another point worthy of discussion is the treatment of re- 
 serves. Many accountants follow the practice of deducting the 
 
 292 
 
The Preparation of Financial Statements 
 
 reserves from the respective assets, while others show them 
 broad. The reason for deducting them is that it is argued that 
 reserves are merely bookkeeping expedients for reducing the 
 values of certain assets ; that what an observer is interested in 
 when he looks at the balance sheet is the net value of the asset; 
 that it is a waste of time and source of annoyance for him to be 
 obliged to find the reserve on the liabilities side and make the 
 necessary deduction from the asset. This is, of course, a prac- 
 tical reason for the treatment just suggested. The adherents of 
 the other theory, which holds that the reserve should be set up 
 broad, seem to have more or less philosophy on which to base the 
 practice. Their reasoning is as follows : Proprietorship is the 
 excess of assets over liabilities. It is an equity in all the 
 assets taken collectively. The proprietor shares with creditors 
 the ownership of the assets. It would not be correct to assign 
 certain of the assets to creditors and to say that the equity of the 
 proprietor was vested in the remainder. A reserve is a portion 
 of proprietorship set aside for a particular purpose. Proprietor- 
 ship being an equity and reserves being a part of proprietorship 
 they may not be deducted from any specific assets any more than 
 proprietorship. The Interstate Commerce Commission makes a 
 distinction between reserves for depreciation and reserves for 
 other purposes, deducting the depreciation reserves from the assets 
 and setting the others up broad. This would appear to be a good 
 distinction. There is nothing in the idea that to deduct, or not 
 to deduct, reserves has any bearing on the relations of the organ- 
 ization to fire insurance companies in the case of a fire loss. 
 
 Another interesting point presents itself in connection with 
 sinking funds. As is well known, sinking fund cash may be used 
 for the purpose of buying up bonds of the company before they 
 mature, usually at a slight increase over par. The treatment of 
 such purchases and the manner in which they are shown in the 
 balance sheet takes one of two forms. One way is to show them 
 broad. The other is to deduct them from the liability in a manner 
 similar although on the opposite side to that in which reserves 
 are deducted from assets. If such bonds when purchased are 
 actually canceled then there would seem to be no question about 
 the treatment to be accorded them. That is, they should be 
 charged against the liability for bonds outstanding, thereby 
 reducing it. In this way the reduced liability would appear in 
 
 293 
 
Principles of Accounting 
 
 the balance sheet without any question concerning it. If, how- 
 ever, the bonds were not actually canceled, as sometimes happens, 
 they may either be carried on the balance sheet on the asset side 
 as an investment, whereas the liability in full is shown on the 
 opposite side; or they may be deducted from the liability side 
 and the net account extended. The latter method would seem 
 to be preferable, since the bonds at time of purchase are in the 
 possession of the company or its agent and there can be no 
 further liability to the public. 
 
 Whether investments or securities owned shall be classed as 
 fixed or capital assets or as current assets is also a debatable 
 point and will depend upon the purpose for which they are held. 
 It is not probable that any one would think of considering shares 
 of stock of a subsidiary concern held for purposes of control, or 
 desirable affiliation, as a current asset. On the other hand, 
 scarcely anything is more marketable, nor can anything be more 
 readily converted into cash as a rule than securities. Since we 
 look upon current assets as those which may be realized upon for 
 the purpose of liquidating current liabilities it would not seem 
 amiss to class securities as current assets. If the stocks were 
 pledged as security for some capital liability it would seem further 
 to complicate the situation. We might sum the matter up by 
 concluding that when securities are held for purpose of control, 
 affiliation, permanent investments of excess capital, or when 
 pledged for capital liabilities, they are to be considered as fixed 
 or capital assets, but when held as temporary investments of excess 
 capital, until the time when the usual current assets will not be 
 realized upon fast enough, or when pledged as security for current 
 liabilities, they should be considered as current assets. As to ad- 
 vances to subsidiaries, if they are to be repaid in cash they are 
 usually considered as current, whereas if they are to be repaid in 
 securities they are considered as investments under fixed or capital 
 assets, since the securities when received will constitute control or 
 affiliation. 
 
 There very often arises in connection with the preparation of 
 balance sheets the question as to whether or not consignments 
 received and shipped shall be shown on the balance sheet and if 
 so how. The best practice probably dictates the use of a memor- 
 andum or foot-note showing to what extent consigned goods are 
 on hand. If consignments received are to be carried on the 
 
 294 
 
The Preparation of Financial Statements 
 
 balance sheet at all they should, it seems, be shown on the asset 
 side as the very last item, whereas the corresponding account- 
 ability should appear in the same relative position on the liabilities 
 side. It is not desirable that consignments should be shown as 
 a part of the working and trading assets of the concern in order 
 that the accounts payable on the other side include as a liability 
 the corresponding amount. With regard to consignments shipped 
 many accountants favor ignoring any reference to them in the 
 balance sheet. It would seem that they might with propriety be 
 shown therein as deferred credits to income, provided, however, 
 that the corresponding amount which has been charged to ac- 
 counts receivable is set forth separately so that there can be no 
 question as to the value of the accounts receivable in so far as 
 the consignments are concerned. 
 
 Notes receivable discounted are frequently the subject of 
 heated discussion. One person may prefer to show them merely 
 as a foot-note with the statement that a contingent liability exists 
 in connection therewith in whatever the amount may be. Another 
 practice consists in placing the contingent liability among the 
 current liabilities on the theory that the notes are included in the 
 current assets. Still another practice excludes the notes from the 
 current assets and places them below among the miscellaneous 
 assets, while the contingent liability offsetting them is shown 
 among the miscellaneous liabilities. It is important that this 
 matter should not be overlooked, since notes receivable discounted 
 play an important part many times in the financial condition of a 
 concern. It is probable, however, that the preferable practice is 
 to make mention of them through the medium of a foot-note on 
 the balance sheet. 
 
 Where the details of certain items appearing on the balance 
 sheet are numerous and the detailed information is necessary to a 
 comprehensive statement, it is customary to supply them in the 
 form of supporting schedules. Such schedules appear most 
 frequently as those which show the details of plant and equip- 
 ment, securities owned, accounts receivable, notes receivable, 
 capital stock outstanding, accounts payable, notes payable, etc. 
 Schedules are also used in the case of co-partnership to show the 
 adjustment of proprietorship as affected by additions and with- 
 drawals of capital, interest, salary and division of profits, etc. 
 The following illustration of this use may be of interest : 
 
 295 
 
Principles of Accounting 
 HEMMINGWAY & BLAUVELT 
 
 SCHEDULE SHOWING ADJUSTMENT OF PROPRIETORSHIP AS 
 AFFECTED BY ENTRIES DURING THE SIX MONTHS ENDED 
 DECEMBER 3!, I9II 
 
 Total 
 
 Proprietorship — July i, 191 1.. $53,900.00 
 
 Add: 
 
 Interest on capital $1,617.00 
 
 Salary of manager 2,500.00 
 
 Total $4,117.00 
 
 Total $58,017.00 
 
 Deduct — drawings 16,000.00 
 
 Proprietorship, as adjusted.... $42,017.00 
 Add profits — six months ended 
 
 Dec. 31, 191 1.. 26,280.00 
 
 M. Hem- I M. Blau- 
 mingway vielt 
 
 Proprietorship — Dec. 31, 191 1. $68,297.00 
 
 $26,950.00 
 
 $808.50 
 2,500.00 
 
 $3,308.50 
 
 $30,258.50 
 6,000.00 
 
 $24,258.50 
 17,520.00 
 
 $41,778.50 
 
 $26,950.00 
 
 $808.50 
 
 $808.50 
 
 $27,758.50 
 10,000.00 
 
 $17,758.50 
 8,760.00 
 
 $26,518.50 
 
 Consolidated balance sheets and income statements are used 
 to show the combined financial condition and results of operations 
 of two or more controlled or affiliated companies. They are 
 usually prepared in cases of holding companies where it is desir- 
 able to consolidate the showing of the subsidiaries with those of 
 the parent company, or when it is desired to know the combined 
 financial condition and operations of a group of companies about 
 to be consolidated. 
 
 The holding company maintains its control over subsidiaries 
 through stock-ownership. The profits from the subsidiaries are 
 taken up by the holding company through dividends on the capital 
 stock. The stock is supplemented at times by bonds so that in 
 such cases the income of the holding company is made up of 
 both dividends on stocks owned and interest on bonds owned. As 
 a rule the holding company has little other income. 
 
 296 
 
The Preparation of Financial Statements 
 
 There may be financial transactions between the holding com- 
 pany and its subsidiaries, such as advances and loans. The same 
 transactions may also take place among subsidiaries as well as 
 inter-company sales of materials and supplies, parts to complete 
 and finished goods. The mere fact of the existence of such 
 transactions is sufficient in itself to raise a considerable problem 
 in preparing consolidated statements, but the problem is usually 
 complicated by the further fact that such inter-company sales 
 have been booked as sales so as to show a profit instead of being 
 mere transfers at cost. It is much the same practice as that 
 wherein one department of an organization turns over partly 
 finished product to that which performs the next operation at the 
 market price, allowing departments to show profits. 
 
 From the above it will be seen that before consolidated state- 
 ments may be prepared considerable work must be done in recon- 
 ciling the various accounts pro and con to the end that they will 
 agree and offset one another when they are put together for 
 elimination. The most common accounts which require such 
 treatment are capital stock, bonds, advances, accounts, notes, in- 
 terest, sales and consignments. 
 
 Let it be assumed that the New York Mfg. Company is a 
 holding company owning the capital stock of the Bronx Mfg. 
 Company in the amount of $100,000 and the capital stock of the 
 Manhattan Mfg. Company in the amount of $500,000. The two 
 latter companies as subsidiaries own and operate plants in the 
 respective boroughs. Let it be further assumed that the cost to 
 the holding company of the Bronx Mfg. Company stock was 
 $95,000, and if the cost of the Manhattan Mfg. Company stock 
 was $525,000, the stocks of the respective operating or subsidiary 
 companies will be carried on the books of the holding company 
 at $95,000 and $525,000, respectively. The earnings of the hold- 
 ing company will with respect to these investments appear in the 
 form of dividends on the stocks. If the Bronx Mfg. Company 
 pays an annual dividend of 10 per cent, and the Manhattan Mfg. 
 Company an annual dividend of 12 per cent., the earnings will 
 appear as dividends in the amounts of $10,000 and $60,000, 
 respectively, except in the case of a consolidated balance sheet 
 or consolidated statement of income and profit and loss. These 
 will be the only transactions and entries appearing on the books 
 of the holding company. If, however, the holding company has 
 
 297 
 
Principles of Accounting 
 
 other assets and liabilities and other income and expense, and it is 
 desired to show the combined financial condition of the holding 
 company as well as the subsidiaries and corresponding statements 
 of income and profit and loss, then it will be necessary in prepar- 
 ing the statements to resort to certain eliminations. It will be a 
 matter of combining the assets, liabilities, income and expense of 
 all the companies. Since the investments in the subsidiary com- 
 panies have been shown as capital stock and the specific assets and 
 liabilities of the subsidiary companies are to be brought into play 
 so as to show their true financial condition in place of the invest- 
 ments, it will be necessary to offset the capital stock shown as the 
 asset on the books of the holding company against the account- 
 ability for said capital stock shown on the books of the subsidiary 
 companies, and if perchance, as is the case here, the stocks have 
 not been carried by the holding company at par, an adjustment of 
 the combined surplus of the three companies will be necessary. In 
 the case of the Bronx Mfg. Company, from the point of view of 
 the consolidated balance sheet, the capital stock carried at $95,000 
 will have to be brought up to par and the consolidated surplus 
 correspondingly increased in the amount of $5,000. The stock 
 of the Bronx Mfg. Company carried as an asset by the New York 
 Mfg. Company may then be offset against the accountability for 
 capital stock outstanding shown by the Bronx Mfg. Company in 
 the amount of $100,000. In a similar manner in preparing the 
 consolidated balance sheet the stock of the Manhattan Mfg. 
 Company carried as an asset by the New York Mfg. Company in 
 the amount of $525,000 will have to be adjusted by charging the 
 combined surplus with $25,000, so that the capital stock as an 
 asset may be offset against the accountability for same on the 
 books of the Manhattan Mfg. Company. The dividends shown 
 as earnings by the holding company will have to be offset against 
 the charges for dividends on the part of the subsidiary companies. 
 It seems scarcely necessary to go through the details incident 
 to elimination in the case of the other items mentioned, since in 
 each case the procedure consists in first bringing the items into 
 agreement with respect to each of the two companies involved 
 and then offsetting one against the other. It should be noted, of 
 course, that eliminations may have to do not only with the ac- 
 counts between one subsidiary and the holding company but that 
 similar relations may exist among tht various subsidiary com- 
 
 298 
 
The Preparation of Financial Statements 
 
 parries. Such items as bonds and advances will usually be found 
 in cases where the holding company is involved in these par- 
 ticulars with one or more of the subsidiary companies. In the 
 cases of accounts, notes, interest, sales and consignments, the 
 necessity for elimination occurs probably with greater frequency. 
 Inter-company sales where same have been recorded at the prices 
 at which goods are sold to outsiders will have the effect not only 
 of fictitiously increasing the volume of sales, but in cases where 
 certain of such goods remain on hand at the time of taking inven- 
 tories such goods will, unless the condition is corrected, appear 
 in the consolidated balance sheet at an inflated value. It is 
 customary to correct this erroneous statement of assets by making 
 a deduction from the inventories. In cases where the profits are 
 not entirely vested in the inventories the correction is made 
 through the medium of a reserve. There is presented below a 
 specimen consolidated balance sheet and a statement of income 
 and profit and loss accompanied by working sheets showing the 
 procedure incident to their preparation. It is not intended to 
 make these statements exhaustive or even complete but rather to 
 bring out the principles underlying their preparation : 
 
 2QHJ, 
 
Principles of Accounting 
 
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 300 
 
The Preparation of Financial Statements 
 
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Principles of Accounting 
 
 NEW YORK MANUFACTURING COMPANY 
 
 CONSOLIDATED BALANCE SHEET — DECEMBER 31, IO,I2 
 
 Liabilities and capital 
 
 Assets 
 Plant and equip- 
 ment 
 
 Securities owned.. 
 
 Inventories 
 
 Current assets : 
 
 Cash 
 
 Accounts receiv- 
 able 
 
 Notes receivable 
 
 Total current 
 assets 
 
 Deferred charges 
 to expense 
 
 $545,000 
 212,750 
 
 134,000 
 
 $144,825 
 
 99,000 
 33>75o 
 
 $277,575 
 $11,075 
 
 
 $500,000 
 
 Bond and mort- 
 
 
 gage payable. . . 
 
 $250,000 
 
 Current liabilities: 
 
 
 Taxes accrued.. 
 
 $1,085 
 
 Salaries and 
 
 
 wages accrued 
 
 6,500 
 
 Accounts pay- 
 
 
 able 
 
 51,575 
 
 Notes payable. . 
 
 265,000 
 
 Total current 
 
 
 liabilities . . 
 
 $324,160 
 
 Reserve for inter- 
 
 
 company profits. 
 
 . $22,285 
 
 Surplus 
 
 $83,955 
 
 Total liabilities and 
 
 capital 
 
 $1,180,400 
 
 Total assets. . $1,180,400 
 NEW YORK MANUFACTURING COMPANY 
 
 CONSOLIDATED STATEMENT OF INCOME AND PROFIT AND LOSS 
 FOR THE YEAR ENDED DECEMBER 31, 1912 
 
 Sales ,. $485,875 
 
 Cost of sales 185,000 
 
 Gross profit on sales $300,875 
 
 Selling and administrative expense 153,500 
 
 Income from operations $147,375 
 
 Other income 2 3,940 
 
 Total income $171,315 
 
 Deductions from income I 5>075 
 
 Net income — -profit and loss $156,240 
 
 Dividends 30,000 
 
 Profit and loss surplus $126,240 
 
 Provision for inter-company profits and adjust- 
 ments of surplus 42,285 
 
 Surplus — December 31, 1912 $83,955 
 
 302 
 
The Preparation of Financial Statements 
 
 The statement of income and profit and loss appears to be the 
 work of evolution. Statements of this character apparently be- 
 gan with a simple profit and loss statement in account form in 
 which the nominal accounts were classified with respect to debit 
 and credit. This statement had the effect of connecting the bal- 
 ance sheet at the beginning of the period with that at the end, 
 but it was far from comprehensive. It showed that a collection 
 of credit items exceeded a similar collection of debit items and 
 that the excess of credits over debits was equal to the difference 
 between the proprietorship as shown by the first balance sheet and 
 that of the second. 
 
 A demand apparently on the part of the proprietor for infor- 
 mation which would be of more use to him brought out the trad- 
 ing and profit and loss account. This was, of course, used only 
 in cases of concerns engaged in trading. For manufacturing 
 and trading concerns there was a similar statement which 
 included an added section for manufacturing preceding the trad- 
 ing section. Doubtless a remark to the effect that the trading 
 and profit and loss account is now somewhat passe will be chal- 
 lenged with a great deal of vehemence. There are many who 
 have used it for several years and have become so accustomed to 
 its use that they blindly refuse to recognize any other form of 
 statement. An unbiassed investigation of the relative merits of 
 the trading and profit and loss account and the statement of in- 
 come and profit and loss must, it would seem, find in favor of 
 the latter. It would almost appear to be so far in advance of the 
 trading and profit and loss account as not to permit of comparison. 
 
 The purpose of the statement of income and profit and loss is 
 not merely to connect the proprietorship at two dates. While 
 this is, of course, essential, its prime purpose is to group trans- 
 actions of the period around the three main functional divisions 
 of organization, so that such information will be of administrative 
 value. It also aims to separate from the above mentioned trans- 
 actions those incident to the acquisition, use and protection of 
 capital and to classify the profit resulting not only with regard to 
 its origin, but to show the income from operations separate and 
 distinct from income from other sources. The statement takes 
 the report form rather than the account form. It is thought that 
 this makes it more easily understood by the business man, who 
 often lacks a technical knowledge of bookkeeping and accounting. 
 
 3°3 
 
Principles of Accounting 
 
 If the layman were attempting to ascertain profits he would set 
 down first, probably, his sales. From these he would deduct the 
 cost of his sales. With just this same thing in mind the statement 
 under consideration is begun by showing the gross sales. Real- 
 izing that returns decrease the gross sales they are, therefore, 
 deducted. This deduction then shows the net sales. Sales 
 returns are quite distinct from sales allowances. The latter may 
 take the form of trade discount, rebates, allowances for breakage, 
 damage, loss in transit, etc. These allowances may be supple- 
 mented by outward freight and cartage and together will con- 
 stitute the deductions from sales, so designated because of the fact 
 that there will in reality be, to the extent of the deductions, less 
 income produced by the sales. A trading concern derives its in- 
 come usually from two sources. The principal or primary source 
 is sales. The secondary source is usually interest on surplus 
 capital. It is, therefore, thought that the expression income from 
 sales may be appropriately used to describe that earning which 
 results after deductions from the net sales have been made. The 
 first section in the statement may be said to constitute the sales. 
 Following this there comes the cost of the goods sold, and it 
 should be borne in mind that the construction of this group will 
 depend upon whether the concern is engaged solely in trading or 
 in manufacturing and trading. If engaged in trading solely, the 
 problem is a very simple one and the section may show first the 
 inventory at the beginning of the period, plus the purchases, less 
 the inventory at the end of the period, with the cost of goods 
 sold resulting; or it may show simply as one item the cost of the 
 goods sold without showing how the amount is arrived at. If, 
 however, the concern is engaged in manufacturing its own goods 
 the situation changes considerably. Here it may be necessary to 
 show the inventory of materials and supplies at the beginning of 
 the period, the purchases, including inward freight, inward cartage 
 and, in some cases, duty ; the returns and allowances in connection 
 with purchases, the inventory of materials and supplies at the end 
 of the period, with the materials and supplies applicable to cost 
 resulting. In addition to this there will be the manufacturing 
 expenses, such as superintendence, heat, light and power, manu- 
 facturing supplies, factory office salaries and expenses, repairs 
 and renewals, depreciation of machinery and tools, etc. The 
 total at this point will of necessity be treated with the differences 
 
 304 
 
The Preparation of Financial Statements 
 
 of inventories of goods in process and finished goods respectively, 
 in order to arrive at the cost of the goods sold. The total cost of 
 sales resulting from the second section will be deducted from the 
 income from sales, as shown in the first section, and the gross 
 profit of sales resulting will be brought down. From this figure 
 will be deducted that resulting from the third section, or selling 
 expense, and the excess brought down will be selling profit. 
 Selling profit is a somewhat new term and will not be as generally 
 understood as gross profit. In fact; it is a sub-division of gross 
 profit as found in the trading and profit and loss account. This 
 latter account combined the selling expenses with the cost of 
 goods sold and opposed the combined result against sales, showing 
 the balance as gross profit on sales. It would appear that this 
 gross profit might, with consistency, be further divided, and that, 
 in short, is what has been attempted in the statement of income 
 and profit and loss. It is thought that this further classification of 
 profit has distinct advantages over the former classification, since 
 it may be very important to know to what extent the gross profit 
 on sales is reduced by selling expenses. Administrative expenses 
 comprise the next section and are deducted in turn from the 
 selling profit in order to ascertain the net profit on sales. This 
 profit is, in fact, the income from operations, or the primary in- 
 come, since it is the prime object of the concern to engage in the 
 manufacture and sale of goods for the purpose of profit. With 
 respect to the various classes of profit above described, it will add 
 to the value of the statement if there is shown, with regard to 
 gross profit, selling profit and net profit respectively, the percent- 
 age of cost. 
 
 The secondary income is usually added to the income from 
 operations, in order to determine the gross income. From this 
 figure there is then deducted the items which offset the other in- 
 come and which are commonly known as deductions from income. 
 The figure resulting then becomes net income, or profit and loss. 
 With regard to these two sections, the statement will vary at 
 times. The principal variation consists in combining other income 
 and deductions from income into one section and either adding 
 or deducting the net figure, as the case may be, to or from the 
 income fron. operations. The result produced will, however, in 
 each case be the same, the form of setting up the information 
 varying. 
 
 305 
 
Principles of Accounting 
 
 At this point a question sometimes arises concerning certain 
 items as to whether they shall be considered as income or de- 
 ductions therefrom, or profit and loss debits and credits in accord- 
 ance with their character. It is sometimes fairly difficult to decide 
 whether a certain item is a profit and loss charge or a deduction 
 from income. The controlling factor in deciding this point is 
 whether or not the charge recurs with regularity and consistency 
 and is connected with the income. It will usually be found upon 
 investigation that most of these questionable items should be 
 included as profit and loss charges and credits rather than items 
 of income or deductions therefrom. To the "net income — profit 
 and loss," there should be added any profit and loss credits applic- 
 able to the period. From the total of these there should then be 
 deducted the profit and loss charges for the period. The balance 
 will be the profit and loss for the period. It may be found 
 necessary to adjust this figure on account of debits and credits 
 occurring during the present period but affecting previous 
 periods. Such adjustments are in truth adjustments of surplus, 
 or proprietorship of a previous period, and will be added to or 
 deducted from the profit and loss for the period after it has been 
 combined with the previous surplus or proprietorship. The final 
 result will be the proprietorship or surplus at the end of the period 
 and should agree with the corresponding items on the balance 
 sheet. In the case of corporations dividends will be shown in the 
 last section and as a distribution of surplus. 
 
 The question has frequently arisen as to whether the profits 
 for the period should be connected with the previous proprietor- 
 ship on the statement of income or on the balance sheet. The 
 answer to this is that it is very largely a matter of personal choice 
 and there does not appear to be very much reason why one method 
 is not as good as another. Tying the figures up on the balance 
 sheet reveals the profits for the period without being obliged to 
 refer to the statement of income in case one does not care to see 
 how the figures are arrived at. On the other hand, tying them up 
 on the income statement relieves the balance sheet of some detailed 
 information which sometimes has the effect of making it appear 
 complicated. The latter method is preferred by the writer, for 
 the reason that it permits of as much adjustment as is desired 
 without detracting at all from the appearance of the balance sheet, 
 A specimen statement of income and profit and loss follows : 
 
 306 
 
The Preparation of Financial Statements 
 THE HARFORD COMPANY 
 
 STATEMENT OF INCOME AND PROFIT AND LOSS FOR THE MONTH 
 ENDED JULY 3 1, I912 
 
 Gross sales $78,852.33 
 
 Less — Returns 65.97 
 
 Net sales $78,786.36 
 
 Deductions from sales: 
 
 Allowances $83.68 
 
 Outward freight and cartage 328.28 
 
 Provision for reserve for containers 1,098.09 
 
 Total deductions from sales $1,510.05 
 
 Income from sales $77,276.31 
 
 Cost of goods sold — (Factory cost, manufac- 
 turing cost) : 
 Purchases — materials less transfers, returns 
 
 and allowances $28,686.39 
 
 Purchases — containers 894.78 
 
 Inward freight and cartage 989.36 
 
 Duty 1,882.34 
 
 Proportion stable and garage expense 53- 21 
 
 Labor expense in stores 122.65 
 
 Total $32,628.73 
 
 Deduct — Increase in inventory 1,743.00 
 
 Purchases applicable to cost $30,885.73 
 
 Direct labor 20,650.07 
 
 Superintendence 45°- 00 
 
 Factory office salaries 400.48 
 
 Heat, light and power 320.69 
 
 Factory supplies 10.50 
 
 307 
 
Principles of Accounting 
 
 Factory expense 12-75 
 
 Alterations, repairs and renewals 22.75 
 
 Provision for depreciation of buildings and 
 
 equipment 7°-83 
 
 Factory office expense T 8-75 
 
 $52,842.55 
 Add — Decrease in inventory — goods in 
 
 process 15,571.06 
 
 Total manufacturing cost $68,413.61 
 
 Subdividing department (expense) 6,703.64 
 
 Box-making department (expense) 279.40 
 
 Total factory cost $75,396.65 
 
 Deduct increase in finished goods inven- 
 tory 8,407.37 
 
 Total cost of goods sold $66,989.28 
 
 Gross profit on, manufactured goods sold $10,287.03 
 
 Gross profit on trading goods sold 747-54 
 
 Total gross profit on sales $11,034.57 
 
 Selling expenses — Salaries : 
 
 Sales manager and clerks $484.00 
 
 Salesmen 750.00 
 
 Commission 897.23 
 
 $2,131.23 
 
 Traveling expense 500.00 
 
 Advertising 832.00 
 
 Total selling expense $3,463.23 
 
 Selling profit $7,571-34 
 
 Administrative expense : 
 
 Salaries of officers $1,300.00 
 
 Salaries of general office clerks 306.67 
 
 308 
 
The Preparation of Financial Statements 
 
 Stationery and printing expense 8.50 
 
 Postage expense 16.38 
 
 Telephone and telegraph 18.7 5 
 
 General office expense 10.80 
 
 Legal expense 125.00 
 
 General expense T 33-Q7 
 
 Total administrative expense $1,919.17 
 
 Net profit on sales — income from operations.. $5,652.17 
 
 Other income: 
 
 Income from retail department $1,250.00 
 
 Income from securities 515.75 
 
 Commissions earned 3.37 
 
 Interest on bank balances T 35-62 
 
 Interest on notes receivable I Z-^>9 
 
 Cash discount on purchases 2.33 
 
 Total other income $1,920.76 
 
 Total income $7>57 2 -93 
 
 Deductions from income: 
 
 Interest on first mortgage bonds payable. . $800.00 
 
 Interest on bond and mortgage payable. . . 156.16 
 
 Interest on notes payable 30.77 
 
 Interest on loans payable 633.09 
 
 Cash discount on sales 500.08 
 
 Rent 40.00 
 
 Insurance 93-00 
 
 Taxes 6.35 
 
 Royalty expense 76.30 
 
 Total deductions from income $ 2 >335-75 
 
 Net income — profit and loss ,. . . . $5,237.18 
 
 Profit and loss credits: 
 
 Profit on sale of Michigan Central bonds. . $200.00 
 
 Forfeited subscription — L. Wimbleton .... 250.00 
 
 3°9 
 
Principles of Accounting 
 
 Profit on exchange 41-34 
 
 Profit from purchase of Minturn Co. stock. 764.00 
 
 Total profit and loss credits $1,255.34 
 
 Total $6,492.52 
 
 Profit and loss charges: 
 
 Provision for depreciation — 'buildings and 
 
 equipment $358-33 
 
 Provision for doubtful accounts 775-34 
 
 Provision for depreciation — furniture and 
 
 fixtures 6.24 
 
 Good-will — written off 1,010.03 
 
 Organization expense — written off 16.91 
 
 Discount on bonds — written off 41.66 
 
 Patents — written off 83.33 
 
 Expense — traveling salesmen — underesti- 
 mate by Austin, Bennett & Carlton 64.18 
 
 Error — interest on J. T. Lawson's note. . . . 5.76 
 
 Total profit and loss charges $2,361.78 
 
 Profit and loss — surplus for the period 4,130.74 
 
 Dividend declared $1,297.50 
 
 Profit and loss surplus — July 31, 1912.. ..... $2,833.24 
 
 Exhibit "B" 
 
 The statement of affairs may be called an estimated balance 
 sheet, and it should be noted that the books are not adjusted 
 thereto. Just as the balance sheet in the condition of solvency 
 shows the financial condition, so the statement of affairs in the 
 case of insolvency shows the estimated financial condition based 
 on the assumption of enforced realization and liquidation. As the 
 statement of income and profit and loss shows, in the case of sol- 
 vency, how the profit or loss occurred, so the deficiency account, 
 in the case of insolvency, explains how the estimated deficit is 
 arrived at. The statement of affairs may be said to parallel the 
 balance sheet. The deficiency account may be said to parallel the 
 statement of income and profit and loss. 
 
 310 
 
The Preparation of Financial Statements 
 
 In preparing a statement of affairs it should be borne in 
 mind that there are three parties interested in the preparation of 
 the statement: first, those who have preferred or secured claims; 
 second, those creditors who are unsecured; and, third, the pro- 
 prietor. Preferred and secured creditors may be the least in- 
 terested; the unsecured creditors probably the most interested. 
 Another important matter in connection with the preparation of 
 this statement is the point of view to be maintained. The state- 
 ment is not made by the creditors, or from the point of view of the 
 creditors, but by, or in behalf of, the proprietor, in order to show 
 his relation to the creditors. It is, therefore, important that the 
 point of view should be precisely the same as that which is taken 
 in the preparation of the balance sheet. No authoritative form for 
 this statement exists. The one most commonly used is probably the 
 one which has been inherited from the English and Scotch ac- 
 countants. This form, like the English balance sheet, shows the 
 two sides in the transposed order from that used by Americans. 
 It has been suggested that the reason for this transposed order in 
 the case of the statement of affairs was that the statement repre- 
 sented or purported to show the relation of creditors to the pro- 
 prietor rather than the opposite of this. This is not thought to be 
 so, and the reason for the transposition is that it follows the Eng- 
 lish form of balance sheet. Showing it thus is not thought by 
 Americans to be any more desirable than transposing the assets 
 and liabilities on the balance sheet, and to do so only results in 
 great confusion in view of the fact that there are numerous con- 
 tras of equities, etc., to be deducted. By the time the American 
 student has transposed the two sides of the balance sheet and 
 carried equities back and forth once or twice he is so completely 
 confused that it becomes almost impossible for him to prepare a 
 correct statement. The writer favors placing the assets on the 
 left and the liabilities on the right, arranging them respectively 
 in the order in which it is estimated that they will be realized and 
 liquidated. It should be kept in mind that in the case of sole 
 proprietors and co-partners their personal estates become liable 
 for business debts and such assets and liabilities should therefore 
 be included in the statement of affairs, since business and personal 
 creditors rate, under sole proprietorship, equally in the distribution 
 of the assets. There is presented below a statement of affairs 
 and a deficiency account : 
 
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 312 
 
The Preparation of Financial Statements 
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 $50,000.00 
 27,796.96 
 
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 $70,433-89 
 7,363-07 
 
 
 $77,796.96 
 
 $77,796.96 
 
 
 $7,363-07 
 
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 3,160.73 
 
 30,624.23 
 
 $41,468.40 
 
 
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 26,468.40 
 
 
 $41,468.40 
 
 The statement of realization and liquidation purports to show 
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 which is made up to show the accounting of the receiver or 
 trustee. Like the statement of affairs, there is no prescribed form. 
 There has been in use for some time a realization and liquidation 
 account, for which, however, it is difficult to find any authority. 
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 country, and has been recognized to some extent by the various 
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 and credits which will eventually balance one another and it does 
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 liabilities not shown on the books. These, added to those shown 
 by the books, will give the total with which to begin. In subse- 
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 313 
 
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 The statement of cash receipts and disbursements needs little 
 description or explanation. It should preferably be in report 
 form, in order to facilitate comparison. It should begin with the 
 balance on hand at the beginning of the period, show in classified 
 form the receipts, the total accountability, classified disbursements 
 and balance on hand at the end of the period, as follows : 
 
 THE STANDARD TRADING COMPANY 
 
 STATEMENT OF RECEIPTS AND DISBURSEMENTS FOR THE MONTH 
 ENDED DECEMBER 31, I9I2 
 
 Balance November 30, 1912 $32,962.58 
 
 Receipts : 
 
 Accounts receivable $58,236.85 
 
 Cash sales 2,327.49 
 
 Notes receivable and interest .10,097.58 
 
 Sale of land 5,350.00 
 
 Rent of loft 250.00 
 
 Sales of scrap 25.00 
 
 Miscellaneous 12-37 
 
 Total receipts $76,299.29 
 
 Total accountability $109,261.87 
 
 Disbursements : 
 
 Accounts payable $39,472.13 
 
 Notes payable and interest 25,536.25 
 
 Rent 2,000.00 
 
 Salaries 2,538.50 
 
 Office expenses 1,547.32 
 
 Legal expenses 500.00 
 
 Miscellaneous 27.83 
 
 Total disbursements $71,622.03 
 
 Balance — December 31, 1912 $37,639.84 
 
 For the sake of completeness a realization and liquidation ac- 
 count is presented herewith : 
 
 316 
 
The Preparation of Financial Statements 
 
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 B«FKRENCES FOR COLLATERAL READING: 
 
 Accountine. Theory and Procedure. Dickinson, Chapter VIII. 
 31? 
 
CHAPTER XLVII 
 
 PUBLIC SERVICE ACCOUNTING 
 
 In 1907 the Legislature of the State of New York passed — "An 
 act to establish the public service commissions and prescribing 
 their powers and duties and to provide for the regulation and con- 
 trol of certain public service corporations and making an appro- 
 priation therefor." This law took effect July 1, 1907. 
 
 The State, for the purpose of administration of this law, was 
 divided into two public service districts. The first district in- 
 cluded the counties of New York, Kings, Queens and Richmond. 
 The second district included all other counties in the state. 
 
 Under the provisions of this law the commission acquired 
 jurisdiction over steam railroads, street railroads and gas and 
 electrical companies. There was embraced in the jurisdiction the 
 laying out of rapid transit routes, the preparation and supervision 
 of contracts for construction and operation of such routes, and in 
 certain cases the granting of franchises. 
 
 The act also empowered the commission to prescribe systems 
 of accounts to be used by railroad corporations, street railroad 
 corporations, and all other common carriers subject to its juris- 
 diction, gas corporations and electrical corporations. The term 
 "common carrier" includes not only railroad and street railroad 
 corporations, but also express, car, sleeping car, freight and 
 freight line companies and all other such agencies for public use 
 in the conveyance of persons or property within the State of New 
 York. 
 
 Stock and Bond Applications. The act provides that stocks or 
 bonds or other certificates of indebtedness may not be issued for 
 periods longer than 12 months without the approval of the Com- 
 mission and then for four purposes only, vis : — 
 
 1. Acquisition of property. 
 
 2. Construction, completion, extension or improvement of 
 
 facilities. 
 
 3. Improvement or maintenance of service. 
 
 4. Discharge or lawful refund of obligations. 
 
 The following matter is quoted from the Annual Report of the 
 
 318 
 
Public Service Accounting 
 
 Public Service Commission for the First District for the year 
 ending December 31, 1908: 
 
 In the case of common carriers, the statute provides that the 
 systems of accounts and records established by the Public Service 
 Commission shall conform, as near as may be, to those prescribed 
 by the Interstate Commerce Commission. The apparent reason 
 for this proviso is that, as the Interstate Commerce Commission 
 has jurisdiction over interstate business, and as many corporations 
 do both a local and interstate business, it would cause unnecessary 
 inconvenience to require a corporation to keep its accounts in two 
 ways, one according to the orders of the Interstate Commerce 
 Commission and the other according to the requirements of the 
 Public Service Commission. 
 
 The power to establish uniform systems naturally includes not 
 merely the enumeration of the titles of the accounts, but also 
 specific provision as to the method of keeping these accounts, the 
 definition of terms used and a statement of how various items shall 
 be debited and credited. 
 
 The law also provides that when the Commission has pre- 
 scribed the forms of accounts, records and memoranda, it shall be 
 unlawful for a corporation to keep accounts, records or mem- 
 oranda other than those prescribed. This provision was probably 
 taken from the Interstate Commerce Law and has been interpreted 
 by the Federal Commission, not as an absolute prohibition upon 
 keeping any accounts, records or memoranda explanatory and 
 supplementary to those prescribed by the Commission, but merely 
 as prohibiting the keeping of any records which do not conform to 
 the orders of the Commission or which might conflict with them in 
 any way. This seems to be a natural interpretation of the clause, 
 and the system prescribed allows sub-accounts, departmental ac- 
 counts and other accounts of a temporary or experimental nature 
 to be instituted upon filing with this Commission a notice of such 
 intention ten days in advance. 
 
 The Commission may likewise prescribe uniform records to be 
 kept by municipalities supplying gas or electricity. 
 
 Status when Commission was Created. When the Commission 
 came into existence, the Interstate Commerce Commission had pre- 
 scribed certain accounting forms and methods for steam railroads 
 doing an interstate business. After careful examination, that 
 system was adopted by this Commission and became effective upon 
 
 319 
 
Principles of Accounting 
 
 January ist of this year. A few changes have since been found 
 necessary, but, in the main, the system is quite satisfactory. 
 
 Up to July i, 1907, no system of accounts for electric roads, 
 street railways or other common carriers had been adopted by the 
 Interstate Commerce Commission and the Railroad Commission 
 of this State had not prescribed a system. The Commission of 
 Gas and Electricity had considered forms for gas and electrical 
 companies, but had reached no definite conclusion before it went 
 out of office. In other States little had been done, and the net 
 result was that a great deal of pioneer work had to be done by the 
 Commission. Conferences were held in Washington and New 
 York with the representatives of the Interstate Commerce 
 Commission, the Public Service Commission for the Second 
 District, similar commissions in other States, and the associations 
 representing the various classes of corporations. Public hearings 
 were also held in this city at which the representatives of the 
 corporations appeared and also persons from various parts of the 
 United States. Tentative classifications of accounts were sub- 
 mitted to the various corporations, commissions and associations 
 interested for criticism. These were again and again revised, 
 until at last systems have been reached that are believed to be 
 quite satisfactory. The systems for gas and electrical' company 
 operations will go into effect January I, 1909. 
 
 Principal Purposes of the Systems. In the three systems of 
 accounts adopted, the fundamental purposes are : 
 
 (1.) To establish uniformity between all corporations of the 
 same class, such as street railways, electric railroads, gas under- 
 takings and electricity supply undertakings. Street railways are 
 operated mostly by electricity, and it was found practicable to in- 
 clude all, whether operated by animal power or electricity, in one 
 group, and also to cover by the same classification all railroads 
 running over a private right of way principally and operated by 
 electric current. A separate classification was prepared for gas 
 corporations and a third for corporations supplying electricity for 
 light, heat and power, but not operating street railways or rail- 
 roads. 
 
 Each of these classes was subdivided so as not to require the 
 small company with limited means and few employees performing 
 different functions to keep the same accounts that are required of 
 a big corporation with large expenditures under each heading and 
 
 320 
 
Public Service Accounting 
 
 with an organization permitting a minute differentiation of func- 
 tions. The corporrations are grouped into classes according to 
 the size of their operations. The division points have been fixed 
 at $500,000 and $100,000. Thus, the corporations having a gross 
 revenue in excess of $500,000 are in Class A ; those having a rev- 
 enue between $500,000 and $100,000 are in Class B ; and less than 
 $100,000 in Class C. The gas corporations and the electrical 
 corporations have been divided into but two classes ; there are 
 three or four companies with receipts of less than $100,000, but 
 they are not independent companies, and it would be very incon- 
 venient to place them in a separate class. 
 
 Practically the only difference between the accounting form to 
 be used by the corporations in Classes A, B and C is one of extent. 
 The fundamental principles are the same for every class and for 
 every group. The principal accounts are to be kept by every cor- 
 poration, no matter what its size, but there are several sub-accounts 
 of less importance which must be kept by the corporations in Class 
 A which are not required of Class B, and those in Class B are 
 required to keep certain sub-accounts which are not of sufficient 
 magnitude to be required of Class C. The accounts of each class, 
 however, dovetail with the accounts of the other classes, so that 
 it will be a simple matter for a corporation to pass from one class 
 to another ; and, if a corporation desires, it may keep the system of 
 accounts required of a higher class than that in which it is auto- 
 matically placed according to the amount of revenue. 
 
 (2.) To establish systems of accounts which will show 
 clearly and accurately the specific source of all income and the 
 purpose of every expenditure. The results of the creation of such 
 a system will be beneficial to the public, to the corporation man- 
 ager, to the prospective investor and to the present holder of stocks 
 and bonds. There is the consumer who is anxious to know 
 whether he is being charged more or less than a reasonable price 
 for the service rendered and whether charges ought to be reduced 
 in view of the actual cost of operation. It may be that he prefers 
 improved service. The facts must be had in order to determine 
 whether it is reasonable for him to demand it at existing rates, or 
 whether an increased charge will be necessary. The taxpayer 
 desires to know whether the corporations are bearing their proper 
 share of the burdens of government and whether the taxes paid 
 may reasonably be increased or should be decreased. 
 
 321 
 
Principles of Accounting 
 
 The prospective investor is interested because he may be able 
 to determine whether he may wisely invest. He is entitled to know 
 the facts and without a proper system of accounts he can only 
 surmise or guess what is the actual situation. If he does not have 
 the facts, his surmise may or may not prove correct, and the un- 
 certainty thereby introduced not only tends to prevent the genuine 
 investor from putting money into the securities of public service 
 corporations, but makes it difficult for those corporations to secure 
 the funds with which to develop their undertakings. Further, the 
 efficient and progressive corporation is apt to be classed with the 
 non-efficient and badly managed corporation. The former suffers 
 because of the misdeeds of the latter, and the latter tries to rise 
 upon the record of the former — a condition which is as unfair as it 
 is injurious to the public. 
 
 It goes without saying that the present bond and stock holders, 
 having put their money into the enterprise, are entitled to know 
 the results of operation and the actual status of the company, in all 
 details. It is hardly conceivable that any one would dispute this 
 assertion, but it is a fact that not infrequently the holders of se- 
 curities have been kept in the dark and ignorant of important 
 matters of their own company. If there is mismanagement or im- 
 proper use of corporate funds, how can stockholders punish the 
 guilty unless they know of it? How can they reward efficiency 
 unless there are accurate reports to reveal the facts ? 
 
 In order to show accurately the actual conditions, so far as they 
 can be represented through accounting systems, receipts and par- 
 ticularly expenditures should be subdivided so as to show each 
 source of revenue and the amounts received from such source, and 
 also the purpose of each expenditure and the amount spent. Of 
 course, this does not mean that a system of accounts should show 
 every voucher that is drawn, but there should be such a classifica- 
 tion of vouchers as to separate each expenditure from the others 
 that are not of the same character. This has been accomplished 
 by the systems adopted and it will be possible in the future to an- 
 alyze expenditures and to show the cost of performing each separ- 
 ate and distinct function. It is only through such a system of 
 accounts that the operating man, particularly, is able to discern 
 whether there is unnecessary waste or whether greater economy 
 can be secured by more attention to special features. t Uniform 
 accounting would not reach the desired result if it were not pos- 
 
 322 
 
Public Service Accounting 
 
 sible to carry comparisons beyond the chief items and into an an- 
 alysis of the details which go to make up the main rubrics. Under 
 the proposed systems it will be possible not only to compare re- 
 sults obtained by the various companies in New York City but 
 also throughout the State, and perhaps in other States, thereby 
 stimulating efficient and economical operation. 
 
 (3.) To state the fundamental principles according to which 
 accounts shall be kept, so as to prevent the charging of items to 
 wrong accounts. The problem would be relatively simple if all 
 moneys expended within a fiscal year were for labor or for materi- 
 als which were fully utilized or consumed during that year and 
 which were not carried over in any degree for use in a following 
 year. But, in practically every case, there is some "plant" that 
 lasts more than one year, the cost of which must not be wholly 
 charged, therefore, against the service rendered in a single year. 
 From this fact arises the difficult problem of framing a system 
 which shall secure in each year's accounts the inclusion of the 
 proper portion of the fixed capital consumed in that year. 
 
 The danger upon the one hand is that a sufficient amount will 
 not be expended or set aside to keep the property of the company 
 up to the proper standard. Sometimes rates are too low, but more 
 often the straining for big dividends leads to the setting up of a 
 large book profit by neglecting repairs, renewals or provisions for 
 depreciation. The virtual effect of such a policy is to hand each 
 stockholder year by year a small portion of the plant dividends. 
 Even the common method of including the cost of repairs and 
 upkeep of the productive plant in operating expenses for the year 
 in which the money was actually spent is objectionable, for it 
 allows the managers of the enterprise to put either more or less 
 money into maintenance and thus overstate or understate true 
 costs at will. Under conscientious management, operating costs 
 would vary from year to year according to the amount of recon- 
 struction necessary. 
 
 The other danger, with which there has been less experience 
 so far, is that an undue amount will be taken out of earnings and 
 spent upon the plant, usually in the form of extensions. In this 
 case, provided the capital receives a fair return, it is the user who 
 suffers, for he has been taxed without his leave to provide capital 
 for the undertaking and without receiving in return stock or 
 bonds. To guard against this possible overstatement of the oper- 
 
 323 
 
Principles of Accounting 
 
 ating costs, it is necessary to provide that extensions and improve- 
 ments of property shall be charged to capital and not to operating 
 expenses. Unless such additions to capital assets are shown in 
 the capital accounts, they may be carried as a secret reserve until 
 the opportune moment arrives for their distribution in the form of 
 stock dividends, or in the form of extra cash dividends, the funds 
 for which have been secured from the sale of stock or bonds to 
 offset the cost of the additions. Even if neither of these methods 
 is allowed, the charging of additions to earnings or even to income 
 is improper because thereby costs are abnormally inflated or the 
 public led to believe that profits are not sufficient to warrant 
 better service or a reduction in rates. The existence of this 
 secret reserve is an inducement for the manipulator to come in ; it 
 is an attractive prize if he can only reach it without running foul 
 of the law in so doing. 
 
 (4.) The primary purpose of the three systems of accounts 
 is to ensure the integrity of "capital" and the correctness of the 
 charges to "cost of operation." The corporations are required to 
 ascertain the life or term of service of their fixed capital, and to 
 include in each year's operating costs a sufficient allowance to 
 cover that part of the life of the productive plant which has 
 expired within the year. The deterioration that has taken place 
 during the year may at times be no greater than the expenditures 
 for repairs (and included in operating expenses) ; in which event, 
 the operating expenses afford a true statement of the real cost of 
 the service rendered. But cars and machinery cannot be made 
 to last forever by repairing; some allowance must be made each 
 year for the expense of eventual replacement. The consumption 
 of capital invested in a machine that gives ten years service is just 
 as much a part of the expense of operation as is the cost of 
 materials consumed in a single day, and it would be just as false 
 accounting to reckon profits before paying for materials consumed 
 as to do so before meeting the cost of expired outlay on machinery 
 and other productive plant. 
 
 In order that "capital" may not be impaired, a corporation 
 must provide not only for repairs and eventual replacement but 
 also for depreciation due to obsolescence and inadequacy. New 
 processes are being discovered and new machinery invented. 
 Plants must be placed upon the scrap heap before they are com- 
 pletely worn out because it has been superseded by more efficient 
 
 324 
 
Public Service Accounting 
 
 machinery. Cities are expanding and conditions are changing, 
 so that occasionally certain portions of the physical property have 
 to be reconstructed because the original plans have been outgrown 
 or rendered useless thereby. Street railway tracks, for example, 
 sometimes have to be moved to new streets because the direction 
 of traffic has changed. Central stations or works are removed 
 to new locations because urban growth has made their first 
 locations undesirable or uneconomical. 
 
 Amortisation Scheme. The accounting systems specifically 
 prescribe how these factors shall be dealt with. In the first place, 
 in connection with all entries in capital accounts, there shall be 
 furnished facts to identify every particular item, and the actual 
 money cost shall be given. The next important step to be taken 
 by the corporation is to determine what amount should be set 
 aside month by month to cover wear and tear, obsolescence and 
 inadequacy — repairs, renewals, replacements and other depreci- 
 ation. Each corporation is required to file with the Commission 
 a copy of the rules according to which this amount is computed, 
 and a sworn statement of the facts, expert opinions and estimates 
 upon which such rules are based. This requirement applies to 
 intangible as well as tangible capital. The corporation must also 
 determine amount estimated to be necessary to provide a reserve 
 to cover cost of property destroyed by extraordinary casualties. 
 
 Suspense Accounts for Discounts. The corollary of the prin- 
 ciple that capital accounts shall be charged only with actual 
 money cost is that discounts and commissions upon securities 
 and other commercial paper issued in payment for capital shall 
 not be charged to capital, but shall be charged to a suspense ac- 
 count. The debit item shall be the difference between the par 
 value of the securities and the cash value of the consideration 
 received. To this account there is also to be charged all expense 
 connected with the issue and sale of evidences of debt, such as 
 fees for drafting mortgages and trust deeds, fees and taxes for 
 recording mortgages and trust deeds, cost of engraving and 
 printing bonds, certificates of indebtedness, and other commercial 
 paper having a life of more than one year, fees paid trustees pro- 
 vided for in mortgages and trust deeds, fees and commissions 
 paid underwriters and brokers for marketing such evidence of 
 debt, and other like expense. At or before the close of each fiscal 
 period thereafter, a proportion of such discount and expense 
 
 325 
 
Principles of Accounting 
 
 based upon the life of the security to maturity shall be credited 
 to this account, and charged to an amortization account. The 
 amounts thus periodically set aside must be sufficient to amortize 
 completely these expenses by the time the debt matures. 
 
 Capitalisation of Franchises. Another important requirement, 
 which carries out statutory provisions, is that the account, "Fran- 
 chises," shall be charged only with the amount actually paid to 
 the State or to a political subdivision in return for the granting 
 of franchises or rights, exclusive of taxes or other annual charges. 
 As the preceding paragraphs apply to intangible property as well 
 as to tangible property, these amounts must be amortized during 
 the life of the grant. The accounts also draw a clear distinction 
 between taxes, license fees and other obligatory payments to the 
 public exchequer upon the one hand and compensation for the 
 right to use the streets and public places upon the other hand. 
 The former are levied through the power to tax and may be 
 altered without the consent of the grantee from time to time. The 
 latter partake of the nature of rentals and are fixed before the 
 franchise or right is granted. They are the result of a bargain 
 to which each party agrees. 
 
 Effects of Requirements. These requirements mean that every 
 charge to capital account shall represent ioo cents on the dollar 
 in money actually spent in creating the property of the corpor- 
 ation. When $100 par value of stocks or bonds are exchanged 
 for $75 worth of materials or machinery, there is obviously no 
 propriety in charging capital account with $100 to be carried as a 
 permanent asset. The same holds true when the corporation 
 sells securities at a discount or pays a commission to bankers for 
 floating a loan — the asset to be capitalized is not the $100 par 
 value of the paper, but the $95 or $97 received in actual cash. 
 
 The far-reaching effect of the establishment of such principles 
 can hardly be overestimated. The investor will be given a guar- 
 antee that he has never had before, for one of the things which 
 have worried him most has been the fear that the capital of the 
 company would be impaired and his investment rendered of little 
 value. Any system of accounts that can be devised will not pre- 
 vent impairment absolutely, but it may go a great way in that 
 direction. The removal of such risk not only will attract capital, 
 but will lead to the obtaining of capital at a lower rate. When 
 the investor himself must provide against depreciation out of the 
 
 326 
 
Public Service Accounting 
 
 interest or dividends he receives, he naturally demands a higher 
 rate of return than if he knows of a certainty that the corporation 
 itself has already made ample provision. This inures to the 
 benefit of the public as well as to the company. 
 
 Treatment of Appreciation. In conclusion, it should be 
 noted that the systems of accounts do not recognize appreciation 
 in the value of property as an offset for depreciation. The policy 
 adopted by many public service corporations of depending upon 
 the increase in the value of their assets consequent upon com- 
 munity growth or changes in market values is not recognized as 
 proper. Of course, ultimately the accounts will reflect these 
 facts, but the fundamental principle, however, is that any appre- 
 ciation shall not appear in the accounts until it is an actuality and 
 until the amount of such appreciation has been determined by an 
 actual sale. What shall be done when such a case arises is natur- 
 ally a matter to come before the Commission. It is not necessary 
 in the systems of accounts to lay down a hard and fast rule. 
 
 The following specimens of balance sheet and income state- 
 ments rendered to the Public Service Commission are taken from 
 the "Annual Report of the Public Service Commission for the 
 First District" for the year ended December 31, 1908: 
 
 STATEN ISLAND MIDLAND RAILWAY COMPANY 
 
 BALANCE SHEET STATEMENT 
 
 Assets Side Increase 
 June 30, June 30, or (D) 
 1907 1908 decrease 
 $628.26 Track and roadway con- 
 struction $1,758.43 $1,130.17 
 
 6.60 Electric line construction 6.60 
 
 2,000,000.00 To equal capital stock 
 and bonds outstanding 
 on the reorganization 
 
 of the company 2,000,000.00 
 
 2,257.06 Materials and supplies. . 2,944.02 686.96 
 
 12,489.24 Cash assets 41,410.01 28,920.77 
 
 1,106.04 Accounts receivable.... 1,522.49 416.45 
 
 Prepayments 806.27 806.27 
 
 20,921.58 Corporate deficit 32,083.91 11,162.33 
 
 $2,037,408.78 Grand total $2,080,531.73 $43,122.95 
 
 327 
 
Principles of Accounting 
 
 Liabilities Side 
 
 $1,000,000.00 Capital stock $1,000,000.00 
 
 1,000,000.00 Funded debt 1,000,000.00 
 
 37,408.78 Current liabilities ma- 
 tured and unpaid 80,531.73 43,122.95 
 
 $2,037,408.78 Grand total $2,080,531.73 $43,122.95 
 
 Current Liabilities. — Taxes matured, $5,384.86; interest on 
 funded debt matured, $62,500; accounts payable matured, 
 $12,646.87. 
 
 Funded Debt. — Staten Island Midland Railroad Company's 
 thirty-year first mortgage gold bonds of January 2, 1896; 5 
 per cent, payable January and July; authorized and issued, 
 $1,000,000; cash realized, not reported; net amount outstanding, 
 $1,000,000; interest accrued, $50,000; paid $12,500. 
 
 Stocks. — Authorized 10,000 shares of $100 par value each; 
 amount issued, 10,000 shares of a par value of $1,000,000; cash 
 realized, $1,600; net amount outstanding June 30, 1908, $1,000,- 
 000; none held by or on behalf of respondent; no dividends 
 declared or paid during the year. 
 
 Income Account 
 Operating revenues: 
 
 Passenger , $230,807.90 
 
 Mail earnings 761.68 
 
 Express earnings 721.00 
 
 Advertising 510.00 
 
 Rents 31742 
 
 Street sprinkling 821.85 
 
 Miscellaneous 9.73 
 
 $233,949-5 8 
 
 Operating expenses: 
 
 Maintenance of way and structures.. . $36,009.76 
 
 Maintenance of equipment 30,271.55 
 
 Operation of power plant 25,323. 1 1 
 
 Operation of cars 80,966.42 
 
 Damages (including attendant legal 
 
 expenses) 5,527.64 
 
 General expenses 11,013.43 
 
 $189,11191 
 
 328 
 
Public Service Accounting 
 
 Net operating expenses $44,837.67 
 
 Taxes accrued (estimated) 5,000.00 
 
 Operating income (operating revenue over expenses 
 
 and taxes) $39,837.67 
 
 Deductions from income: Interest on funded debt. . 50,000.00 
 
 Net corporate loss. $1,162.33 
 
 Previous deficit 20,921.58 
 
 Debit to P. & L., old claim on property sold for 
 
 taxes 1,000.00 
 
 Total deficit, June 30, 1908 $32,083.91 
 
 Taxes. — Assessed for year, $6,162.72 (real estate, $298.07; 
 personal property, $1,274.17; special franchise, $2,510.14; State 
 tax on gross earnings, $2,080.34); accrued as shown in income 
 account above, $5,000 (actually accrued $6,162.72) (a); paid, 
 $2,115.14; due and unpaid June 30, 1908, about $4,601.75 (in 
 dispute). 
 
 KINGS COUNTY LIGHTING COMPANY 
 
 BALANCE SHEET STATEMENT 
 
 Assets Side 
 
 June 30, 
 1907 
 
 Dec. 31, 
 1907 
 
 Increase 
 
 or(D) 
 
 decrease 
 
 $4,687,905.00 
 
 and 
 
 op- 
 
 Organization 
 
 franchises .... 
 Land devoted to 
 
 j erations 
 
 I Other fixed capital. . . 
 26,341.55 Materials and supplies.. 
 
 16,582.17 Cash 
 
 422,747.48 Accounts receivable 
 
 40,325.00 Special deposits 
 
 Bills receivable 
 
 Treasury bonds 
 
 Prepayments 
 
 Suspense 
 
 $4,730,073.59 $42,168.41 
 
 37,489.71 11,148.16 
 
 44,920.20 28,338.03 
 
 I03.937-79 318,809.69 
 
 47,300.00 6,975.00 
 
 1,000.00 1,000.00 
 
 274,000.00 274,000.00 
 
 142.40 142.40 
 
 6,389.50 6,389.50 
 
 $5,193,901.38 Total $5,245,253.19 $51,351.81 
 
 329 
 
Principles of Accounting 
 
 KINGS COUNTY LIGHTING COMPANY 
 Liabilities Side 
 June 30, Dec. 31, Increase or 
 
 1907 1907 decrease 
 
 $2,333,000.00 Funded debt $2,603,000.00 $270,000.00 
 
 40,325.00 Current liabilities ma- 
 tured and unpaid 115,089.52 74,764.52 
 
 336,031.96 Current liabilities unma- 
 tured 25,065.19 310,966.77 
 
 2,000,000.00 Capital stock 2,000,000.00 
 
 484,544.42 Corporate surplus 502,098.48 17,554.06 
 
 $5,193,901.38 Total $5,245,253.19 $51,351.81 
 
 Franchises, Real Estate and Other Fixed Capital 
 
 ■•-> - 
 
 mo 
 
 OM 
 O 
 O 
 
 cd 3° 
 "o , ~ 3 '- , 
 
 M bO 
 
 * 1 
 
 o| 
 
 tn p. 
 w as 
 
 ca 
 
 5 
 
 M 
 
 a 
 'E 1 
 
 bo 
 
 a 
 
 Si 
 
 -O CO 
 
 1.3 8 
 
 
 
 O 
 
 en 
 
 <— 1 
 E-i 
 
 
 'B uildings," 
 
 
 1 
 
 
 
 machinery 
 and appa- 
 
 432,331.41 
 
 $12,291.01 
 
 
 $4,680,61349- 
 
 ratus 
 
 Street mains 
 
 8,921.04 
 
 2,922.30 
 
 ,.$4,724,615.04 
 
 
 Services .... 
 
 11,450.70 
 
 2,129.27 
 
 
 
 Meters, land 
 
 J 
 
 
 
 
 etc 
 
 9,125.68 
 
 484.70 
 
 
 2,725.00 
 
 Stable equip 
 
 
 
 
 
 
 
 500.00 
 
 2,225.00 
 
 2,649.00 
 
 Office furni 
 t u re a n c 
 
 1 
 
 
 
 
 fixtures .. 
 
 584-55 
 
 
 3.233-55 
 
 $4,685,987.49 
 
 Total .. .$62,413.38 $18,327.28 $4.730,073-59 
 
 Details of Liabilities and Credit Balances 
 Current Liabilities. — Taxes unmatured, $6,183.95; interest on 
 funded debt matured, $47,300; unmatured, $9,375; customers' 
 
 330 
 
Public Service Accounting 
 
 deposits matured, $62,023.95; other accounts payable unmatured, 
 $15,271.81. 
 
 Funded Debt. — Kings County Gas and Illuminating Co.'s 
 5 per cent. 10-year debenture bonds, Jan. 1, 1900, authorized and 
 issued, $250,000 (assumed). 
 
 Kings County Gas and Illuminating Co.'s 50-year mortgage 
 bonds, Oct. 1, 1890, 5 per cent., payable April 1 and Oct. 1; 
 authorized and issued, $750,000 (assumed). 
 
 Kings County Lighting Co.'s 50-year mortgage bonds, July 
 1, 1904, 5 per cent., payable Jan. 1 and July 1; authorized, 
 $5,000,000; issued, $1,603,000, of which $274,000 held in the 
 treasury (reacquired); $1,1 12,000 were issued in part payment for 
 $1,000,000 of stock of the Kings County Gas and Illuminating 
 Co. and $217,000 were issued to provide funds for meeting cur- 
 rent liabilities of the former company assumed by the respondent; 
 $274,000 held in the treasury on Dec. 31, 1907, were sold in 1908 
 at 90 per cent. 
 
 Stocks. — Authorized and issued, 20,000 shares of $100 par 
 value each, in part payment for $1,000,000 of stock of the Kings 
 County Gas and Illuminating Co. 
 
 KINGS COUNTY LIGHTING COMPANY 
 
 Income Account Amount 
 
 July 1 -Dec. 
 31, 1907 
 
 Operating revenues $236,869.05 
 
 Operating expenses 117,850.74 
 
 Net operating revenues $1 19,018.31 
 
 Uncollectible bills 2,562.36 
 
 Taxes accrued 13,933.82 
 
 Operating income $102,522.13 
 
 Non-operating income: 
 
 Miscellaneous rents $120.00 
 
 Interest accrued on bonds owned. . . 6,950.00 
 Interest on other securities, loans 
 
 and accounts 16,021.98 
 
 23,091.98 
 
 Total clear income $125,614.1 1 
 
 331 
 
Principles of Accounting 
 
 Deductions from income: Interest accrued on 
 
 funded debt 65,075.00 
 
 Net corporate income $60,539.1 1 
 
 Previous surplus 484,544.42 
 
 Total surplus $545.°83-53 
 
 Debit profit and loss: 
 
 Dividends $40,000.00 
 
 Bad debts written off.. . 1,709.06 
 Taxes for 1906, in dis- 
 pute 1,226.31 
 
 Abandoned mains 980.13 
 
 Credit profit and loss: 
 
 Taxes accrued in excess when books 
 opened 
 
 $43,915.50 
 
 930-45 
 
 42,985.05 
 
 Total surplus, December 31, 1907 $502,098.48 
 
 OPERATING REVENUES 
 
 Class of 
 operating 
 revenues 
 
 Number of 
 eu. ft. sold 
 in half-year 
 ended, Dec. 
 31, 1907 
 
 O ^ 
 
 M 0,3 
 o> « 
 
 s "s 
 
 >. P.r-< 
 < 
 
 a 
 a 
 
 0) 
 
 ™ Ul 
 
 in W> 
 
 °.2 
 a" 
 
 •a i 
 "I 
 
 sts 
 
 5 " o 
 
 ■ofl 
 O 
 
 'a 
 a, to 
 
 a =» 
 
 •a a 
 
 ^ > 
 
 u 
 
 is 
 
 ■< 
 
 Commerc'l lighting, or- 
 Com. lighting, private 
 
 171,825,400 
 
 64,621 
 
 36,753,398 
 
 2,239,400 
 
 $1.00 
 
 1-73 
 
 1-75 
 1. 00 
 
 $171,825.40 
 
 112.00 
 
 64,233.46 
 
 2,239.40 
 
 $118.90 
 1,521-45 
 
 $171,706.50 
 
 112.00 
 
 62,712.01 
 
 2,239.40 
 
 Munic. street lighting. . 
 Municipal buildings. . . . 
 
 Total sale of gas. . . . 
 
 210,882,819 
 
 $1-13 
 
 $238,410.26 
 
 $1,640.35 
 
 $236,769.91 
 
 Rent of gas lamps 
 
 
 
 
 
 $99-14 
 
 Total gas revenues . . 
 
 $236,869.05 
 
 KINGS COUNTY LIGHTING COMPANY 
 Interest. — Interest on bonds (accrued) July 1 to December 31, 
 1907, $6,850; interest on bank balances, $1,144.72; interest on 
 
 332 
 
Public Service Accounting 
 
 four bonds received July i, 1907, not accrued, $100; interest or 
 old city bills, $14,877.26. 
 
 OPERATING EXPENSES, JULY I TO DECEMBER 31, I907 
 
 1. Production: Water gas 
 
 Salaries — manufacture $1,750.00 
 
 Labor — manufacture 7,214.67 
 
 Labor — purification 4 2 9-97 
 
 Generator fuel (water gas) 18,113.79 
 
 Oil (water gas) 35-435-17 
 
 Boiler fuel 3,843.08 
 
 Water 239.29 
 
 Purification materials 621.58 
 
 Works expense 3,01 1 .97 
 
 Repairs — works 3,047.66 
 
 Total — production $73,707.18 
 
 2. Distribution: 
 
 Complaints and gratuitous work 1,059.22 
 
 Setting and removing meters 3,745-95 
 
 Operating and repairing street lamps. . 13,402.35 
 
 Gas stoves and appliances 751.52 
 
 Repairs, mains 2,404.40 
 
 Repairs, services 566.96 
 
 Repairs, meters 2,390.77 
 
 Total — distribution $24,321.17 
 
 3. General expense: 
 
 Office salaries $7,019.24 
 
 Office expense 3.595-9Q 
 
 Registering 850.64 
 
 Advertising and canvassing new busi- 
 ness 36432 
 
 Damages (including legal expenses) . . . 750.00 
 
 General legal expense 3,580.53 
 
 Insurance .40 
 
 General expense 2 ,57 I -53 
 
 Miscellaneous general expense 1,089.83 
 
 Total — general expenses $19,822.39 
 
 Total operating expenses $117,850.74 
 
 333 
 
Principles of Accounting 
 
 Taxes. — Assessed for half-year ended Dec. 31, 1907, $13,- 
 933.82 (real estate, $3,727.48; special franchise, $7,948.87; State 
 tax on gross earnings, $2,257.47); accrued, $13,933.82 (paid); in 
 dispute, $2,508.43; due and unpaid, $5,765.57. 
 
 EDISON ELECTRIC ILLUMINATING COMPANY OF 
 
 BROOKLYN 
 
 BALANCE SHEET STATEMENT 
 
 Assets Side 
 
 Increase or 
 decrease 
 
 June 30, Dec. 31, during half 
 
 1907 1907 year 
 
 $13,944,632.60 Fixed capital $14,555,315.22 $610,632.62 
 
 805,473.25 Work in progress... . 555,820.86 249,652.39 
 
 275,000.00 Discount on bonds.. . 225,000.00 50,000.00 
 
 945,000.00 License rights 945,000.00 
 
 395,214.88 Materials and supplies 457,547.38 62,332.50 
 
 239.985-3I Cash 134,509.61 105,475.70 
 
 4,796.28 Bills receivable 10,132.88 5,336.60 
 
 1,490,345.66 Accounts receivable.. 1,144,059.15 346,286.51 
 
 Other current assets. . 7,500.00 7,500.00 
 416,692.00 Securities of other 
 
 corporations 416,920.00 
 
 169,926.97 Advances to subsid- 
 iary and affiliated 
 
 companies 21,495.52 148,431.45 
 
 112,415.49 Insurance investment 112,415.49 
 
 4,900.00 Special deposits 99,156.75 94,256.75 
 
 14,891.29 Prepayments 10,253.10 4,638.19 
 
 45,280.09 Suspense 7.545-Q2 37.735-Q7 
 
 $18,864,831.82 Grand total $18,702,670.98 $162,160.84 
 
 Liabilities Side 
 
 $4,275,000.00 Funded debt $4,275,000.00 
 
 382,969.72 Current liabilities ma- 
 tured and unpaid. . 788,268.82 $405,299.10 
 636,724.84 Current liabilities un- 
 matured I99.738-98 436,985.86 
 
 334 
 
Public Service Accounting 
 
 8,097,336.73 Due controlling and 
 affiliated companies 
 
 for advances 8,032,487.87 64,848.86 
 
 360,385.04 Reserve for replace- 
 ments and renewals 294,759.82 65,625.22 
 112,415.49 Other reserve — insur- 
 ance 112,415.49 
 
 5,000,000.00 Stocks 5,000,000.00 
 
 $18,864,831.82 $18,702,670.98 $162,160.84 
 
 INCOME ACCOUNT 
 
 Amount 
 
 July 1 -Dec. 
 
 31, 1907 
 
 Operating revenues $1,745,316.23 
 
 Operating expenses 811,330.83 
 
 Net operating revenue $9,933,985.40 
 
 Taxes 106,614.83 
 
 Total operating income (revenues over ex- 
 penses and taxes) $827,370.57 
 
 Non-operating income: 
 
 Rents 3,443-9^ 
 
 Dividends on stock owned 209.00 
 
 Interest accrued on bonds owned 350.00 
 
 Miscellaneous income 26,275.38 
 
 Total clear income $857,648.93 
 
 Deduction from income 679,774.00 
 
 Rents accrued for lease of other 
 
 electric plant and equipment. . . $376,494.00 
 Interest accrued on funded debt. . 85,500.00 
 Other contractual deductions. . . . 217,780.00 
 
 Net corporate income $177,874.93 
 
 Credit adjustments of accounts of previous 
 months $8,680.13 
 
 $186,555.06 
 
 335 
 
Principles of Accounting 
 
 Debits to profit and loss : , 
 
 Appropriations to reserves $128,419.25 
 
 Bad debts written off 8,135.81 
 
 Discount of bonds written off 50,000.00 
 
 186,555.06 
 
 OPERATING REVENUE JULY I-DECEMBER 31, I907 
 
 Amount 
 Class of operating revenues credited to 
 
 revenue 
 
 Commercial incandescent lights — by meter $1,452,47047 
 
 Municipal street lighting — incandescent 224,603.48 
 
 Municipal buildings — arc and incandescent 63,002.59 
 
 Railroad and street railway companies 880.78 
 
 Other electric companies 4,358.91 
 
 Total $1,745,316.23 
 
 OPERATING EXPENSES JULY I- DECEMBER 31, I907 
 
 Production : 
 
 Labor — production $73,179.44 
 
 Salaries — production 12,570.15 
 
 Fuel 141,095.40 
 
 Oil, waste and sundries 8,137.67 
 
 Water 17,063.81 
 
 Repairs of building construction. . 3,044.32 
 
 Repairs of motive power 22,562.59 
 
 Repairs of electric apparatus 1,350.17 
 
 Station expense 2,271.24 
 
 Purchased power I S.953-6o 
 
 Total — production $297,228.39 
 
 Distribution : 
 
 Salaries — distribution $3,336.63 
 
 Sub-station labor and expense. . . 37,066.44 
 
 Distribution expense 57,218.83 
 
 Incandescent lamp renewals 59,716.66 
 
 Repairs of sub-station buildings 
 
 and apparatus 21,816.35 
 
 336 
 
Public Service Accounting 
 
 Repairs of poles and lines 15,538.66 
 
 Repairs of subways and cables.. . 15,311.85 
 
 Repairs of meters 2,646.06 
 
 Repairs of transformers 1 18.65 
 
 Repairs and expense commercial 
 
 arc lamps 27,928.86 
 
 Total — distribution $240,698.99 
 
 General expense: 
 
 Salaries of officers $10,850.00 
 
 Office expense 45,219.48 
 
 Collecting and reading meters... 11,062.01 
 
 Legal expenses 10,600.00 
 
 General expense 42,382.29 
 
 Advertising 39,318.29 
 
 Canvassing new business 45,165.36 
 
 Insurance 24,374.10 
 
 Miscellaneous 35>75°-79 
 
 Leaseholds, rentals, etc 8,681.13 
 
 Total general expense $273,403.45 
 
 Grand total $811,330.83 
 
 337 
 
CHAPTER XLVIII 
 
 TAXATION OF CORPORATIONS AND REPORTS TO STATE COMPTROLLER 
 
 "There is, first, an organization tax, payable to the State, 
 which is imposed but once and is exacted for the privilege of 
 becoming a corporation. Next, there is a tax upon the real estate 
 owned by the corporation in this State, which is assessed the 
 same as if it were owned by an individual. The personal property 
 of the corporation is not directly taxed, but its capital stock and 
 surplus, after deducting the assessed value of its real estate and 
 making some other deduction, is assessed at its actual value. 
 Finally, there is a franchise tax on corporations which is payable 
 annually to the State, 'computed from the basis of the amount of 
 its capital stock employed within this State.' This is not a tax 
 upon property, although it is measured by the value of property, 
 but upon the right of a corporation to exist and exercise the 
 powers granted by its charter. These forms of taxation do not 
 all rest upon the same principle. The organization tax is in the 
 nature of a license fee for the right to become a corporation. 
 The tax upon real estate is a direct tax upon real property, and 
 the tax upon capital stock is an indirect tax upon personal prop- 
 erty, while the franchise tax is not laid upon property at all, but 
 is imposed upon the corporation for the privilege of carrying on 
 business in this State and exercising the corporate franchises 
 granted by the State." (Vann J., in People ex rel. United States 
 Aluminum Printing Plate Co. v. Knight, 174 N. Y., 475,477.) 
 
 "Every corporation, association or joint stock company liable 
 to pay a tax under section one hundred and eighty-two of this 
 chaptei shall, on or before November 15th in each year, make a 
 written report to the comptroller of its condition at the close of its 
 business on October 31st preceding, stating the amount of its 
 authorized capital stock, the amount of stock paid in, the date and 
 rate per centum of each dividend declared by it during the year 
 ending with such day, the entire amount of capital of such cor- 
 poration and the capital employed by it in this State during such 
 year." (Tax L., paragraph 189.) 
 
 "Every report required by this article shall have annexed 
 thereto the affidavit of the president, vice-president, secretary or 
 
 338 
 
Taxation of Corporations and Reports to State Comptroller 
 
 treasurer of the corporation, association or joint stock company, 
 or of the person or one of the persons, or the members of the 
 partnership making the same, to the effect that the statements 
 contained therein are true. Such reports shall contain any other 
 data, information or matter which the comptroller may require 
 to be included therein, and he may prescribe the form in which 
 such reports shall be made and the form of oath thereto. When 
 so prescribed such form shall be used in making the report. The 
 comptroller may require at any time a further or supplemental 
 report under this article, which shall contain information and 
 data upon such matters as the comptroller may specify." (Tax L., 
 paragraph 191.) 
 
 FORM OF REPORT TO STATE COMPTROLLER 
 Each statement must be full and explicit 
 To the Comptroller of the State of New York : 
 
 As of the Company, I 
 
 make the following report of such Company for the year ending- 
 October 31, 190 , pursuant to the provisions of Section 182, 
 Chapter 908, Laws of 1896, and acts amendatory thereof: 
 
 (1) The last preceding report made by this Company to the 
 
 Comptroller of the State of New York under the pro- 
 visions of the above acts was for the year ending October 
 31, 190 . 
 
 (2) Organized 190 , under the laws of 
 
 (3) This Company began business in the State of New York 
 
 on 190 . 
 
 (4) Authorized capital stock of Company $ 
 
 (5) Number of shares of stock authorized: 
 
 Commoni 
 
 Preferred 
 
 (6) Number of shares of stock issued: 
 
 Common 
 
 Preferred 
 
 (7) Par value of each share: 
 
 Common $ 
 
 Preferred $ 
 
 (8) Amount paid into treasury of Company on 
 
 each share: 
 
 Common $ 
 
 Preferred $ 
 
 339 
 
Principles of Accounting 
 
 (9) Amount of capital stock issued for cash or 
 property $. 
 
 (10) Amount of capital stock issued for good- 
 
 will, copyrights, brands, patents, trade- 
 marks, formulae, services, etc., other than 
 cash or property $ . 
 
 (11) Amount of common stock on which divi- 
 
 dends were declared $. 
 
 (12) Amount and date of each dividend on com- 
 
 mon stock 
 
 (13) Rate per cent, per annum of dividends on 
 
 common stock 
 
 (14) Amount of preferred stock on which divi- 
 
 dends were declared $. 
 
 (15) Amount and date of each dividend on pre- 
 
 ferred stock 
 
 (16) Rate per cent, per annum of dividends on 
 
 preferred stock 
 
 (17) Nature of business in State of New York 
 
 and how transacted 
 
 (18) Place, street and number where such busi- 
 
 ness was conducted 
 
 (19) Average value of stock in trade carried in 
 
 the State of New York during the year 
 ending October 31, 190 $. 
 
 (20) Average monthly bank balance employed 
 
 in the State of New York during the 
 year ending October 31, 190 $. 
 
 (21) Average value of bills and accounts receiv- 
 
 able in State of New York during the 
 year ending October 31, 190 $. 
 
 (22) Average value of shares of stock of other 
 
 corporations doing business in the State 
 of New York and owned by this Com- 
 pany during the year ending October 31, 
 190 $. 
 
 340 
 
Taxation of Corporations and Reports to State Comptroller 
 
 (23) Average value of personal property, includ- 
 
 ing bonds, loans on call and other finan- 
 cial securities employed in the State of 
 New York, other than heretofore men- 
 tioned, during the year ending October 
 
 31, 190 $ 
 
 (24) Capital invested in real estate located in the 
 
 State of New York during the year end- 
 ing October 31, 190 , and where situated „ 
 
 (25) Total of assets above enumerated located in 
 
 the State of New York during the year 
 
 ending October 31, 190 $ 
 
 (26) Average value of stock in trade carried 
 
 outside the State of New York during 
 
 the year ending October 31, 190 $ 
 
 (27) Average monthly bank balance employed 
 
 outside the State of New York during 
 
 the year ending October 31, 190 $ 
 
 (28) Average value of bills and accounts receiv- 
 
 able outside the State of New York dur- 
 ing the year ending October 31, 190. . . .$ 
 
 (29) Average value of shares of stocks of other 
 
 corporations owned by this corporation, 
 where such corporations are doing busi- 
 ness wholly without the State of New 
 York $ 
 
 (30) Average value of personal property, includ- 
 
 ing bonds, loans on call and other finan- 
 cial securities employed outside the State 
 of New York, other than heretofore men- 
 tioned, during the year ending October 
 31. 190 $••• 
 
 (31) Capital invested in real estate located out- 
 
 side the State of New York during the 
 year ending October 31, 190 , and where 
 situated $ 
 
 341 
 
Principles of Accounting 
 
 (32) Total assets located outside the State of 
 New York during the year ending Octo- 
 ber 31, 190 $ 
 
 Preferred $. 
 
 Common . . . . $ . 
 
 Liabilities 
 
 Bonds $ 
 
 Mortgages not secured by bonds $ 
 
 Bills payable $ 
 
 Accounts payable. $ 
 
 Other liabilities, excluding capital stock.. $ 
 Total liabilities $ 
 
 (33) Highest bona fide price at 
 
 which stock sold during 
 the year ending October 
 
 31. 190 
 
 (34) Lowest bona fide price at 
 
 which stock sold during 
 the year ending October 
 
 31, 190 
 
 (35) Percentage of capital stock of the Com- 
 
 pany employed in the State of New York 
 during the year ending October 31, 
 190 , in manufacturing and in the sale of 
 the product of such manufacture 
 
 Preferred $. 
 
 Common.... $. 
 
 (36) Are your goods manufactured for you by others?. 
 
 (37) Do you operate a factory? 
 
 Remarks 
 
 Note.- — Corporations paying 6 or more than 6 per centum on 
 their entire issued capital stock need not appraise their capital 
 
 stock. 
 
 The UNDERSIGNED, being the of the above 
 
 Company, estimates and appraises the capital stock of said Com- 
 pany as follows: 
 shares at dollars 
 
 342 
 
Taxation of Corporations and Reports to State Comptroller 
 
 • • • cents per share, amounting in the whole to 
 
 dollars 
 
 IN WITNESS WHEREOF, I have set my hand this!. . .day 
 of 190 . 
 
 (Official Title). 
 State of New York , 
 
 County of 
 
 ss 
 
 On this day of A.D. 190 , personally 
 
 appeared before me, a Notary Public in and for the County 
 
 of , of the above named Company, who, 
 
 being duly sworn according to law, did depose and say that the 
 foregoing report is just, true and correct, and that it includes all 
 dividends of any description declared by said Company during 
 the year ending October 31, 190 , and that he has, according to 
 his best knowledge and belief, appraised the capital stock of the 
 Company as provided by statute, at not less than the average 
 price at which it sold and not less than the difference between its 
 assets and liabilities, exclusive of capital stock. 
 Sworn to before me the day and year aforesaid. 
 
 Notary Public. 
 
 If the dividend or dividends amount to less than 6 per centum 
 on the par value of the capital stock, or no dividend is declared, 
 the president, treasurer or secretary of the company liable to pay 
 a tax under the provisions of Section one hundred and eighty- 
 two of this chapter, shall, under oath, between the first and 
 fifteenth day of November in each year, estimate and appraise the 
 capital stock of such company, at its actual value, and shall for- 
 ward the same to the comptroller with the report provided for in 
 the last section. If the comptroller is not satisfied with the valua- 
 tion so made and returned, he is authorized and empowered to 
 make a valuation thereof, and settle an account upon the valua- 
 tion so made by him, and the taxes, penalties and interest to be 
 paid the State (Tax L., paragraph 190; L. 1907, c. 734). 
 
 343 
 
Principles of Accounting 
 
 In case any report required by any of the preceding sections 
 of this article shall be unsatisfactory to the comptroller, or if any 
 such report is not made as herein required, the comptroller is 
 authorized to make an estimate of the dividends paid by such 
 corporation and the value of the capital stock employed by it, 
 from any such report or from any other data, and to order and 
 state an account according to the estimate and value so made by 
 him for the taxes, percentage and interest due the State from 
 such corporation, association, joint stock company, person or 
 partnership. The comptroller shall also have power to examine 
 or cause to be examined, in case of a failure to report, or in case 
 the report is unsatisfactory to him, the books and records of any 
 such corporation, joint stock association, company, foreign 
 banker, person, or partnership, and may hear testimony and take 
 proofs material for his information either personally, or he may 
 appoint a commissioner by a written appointment under his hand 
 and official seal for that purpose. 
 
 REFERENCES FOR COLLATERAL READING: 
 
 State of New York, Tax Law Para 189 et seq. 
 Journal of Accountancy, Young, November, 1913. 
 
 344 
 
CHAPTER XLIX 
 
 INTERSTATE COMMERCE COMMISSION ACCOUNTING 
 
 The following extract taken from Section 20 of "An Act to 
 Regulate Commerce," as amended June 29, 1906, contains in 
 substance the provisions relating to the accounting: 
 
 "That the commission is hereby authorized to require annual 
 reports from all common carriers subject to the provisions of this 
 act, to prescribe the manner in which such reports shall be made, 
 and to require from such carriers specific answers to all questions 
 upon which the commission may need information. 
 
 "Such annual report shall show in detail the amount of capital 
 stock issued, the amounts paid therefor, and the manner of pay- 
 ment for same; the dividends paid, the surplus fund, if any, and 
 the number of stockholders; the funded and floating debts and 
 the interest thereon; the cost and value of the carrier's 
 property, franchises and equipments; the number of employees 
 and the salaries paid each class; the amounts expended for im- 
 provements each year, how expended, and the character of such 
 improvements; the earnings and receipts from each branch of 
 business and from all sources; the operating and other expenses; 
 the balance of profit and loss; and a complete exhibit of the 
 financial operations of the carrier each year, including an annual 
 balance sheet. * * * The commission may, for the purpose 
 of enabling it the better to carry out the purposes of this Act, 
 prescribe a period of time within which all common carriers sub- 
 ject to the provisions of this Act shall have, as near as may be, a 
 uniform system of accounts, and the manner in which such 
 accounts shall be kept. * * * 
 
 "The commission may, in its discretion, prescribe the forms 
 of any and all accounts, records and memoranda to be kept by 
 carriers, subject to the provision of this Act, including the ac- 
 counts, records and memoranda of the movement of traffic, as 
 well as the receipts and expenditures of money. The commission 
 shall at all times have access to all accounts, records and memo- 
 randa kept by carriers subject to this Act, and it shall be unlawful 
 for such carriers to keep any other accounts, records or memo- 
 randa than those prescribed or approved by the commis- 
 
 345 
 
Principles of Accounting 
 
 sion." * * * The penalty for failure to keep and show such 
 accounts is a fine of $500; also $1,000 to $5,000 and one to three 
 years' imprisonment or both for making false entries. 
 
 Pamphlets containing detailed information concerning the 
 various balance sheet and income and expense accounts may be ob- 
 tained from the Superintendent of Public Documents, Washing- 
 ton, D.C. They are styled, respectively, "Form of General Bal- 
 ance Sheet Statement as prescribed by the Interstate Commerce 
 Commission for Steam Roads" and "Form of Income and Profit 
 and Loss Statement for Steam Roads," etc. 
 
 The following specimen statements give a fairly comprehen- 
 sive idea of the classification and form: 
 
 INTERSTATE RAILROAD COMPANY 
 
 GENERAL BALANCE SHEET, JUNE 30, I<)12 
 
 Assets Items Amount 
 
 Property investment: 
 
 I. Road and equipment — 
 
 B i-a. Investment to June 30, 1907 — 
 
 (a) Road — page 37 $4,000,000.00 
 
 (b) Equipment — page 37.... 1,000,000.00 
 
 $5,000,000.00 
 
 B i-b. Invesmt. since June 30, 1907 — 
 
 (a) Road — page 35 $2,000,000.00 
 
 (b) Equipment — page 37.... 1,000,000.00 
 
 (c) Gen. expend.— page 37.. 3,000,000.00 
 
 $8,000,000.00 
 B i-c. Res. for accr'd deprec'n — Cr. 1,260,000.00 
 
 Total $6,740,000.00 
 
 II. Securities : 
 
 B 2. Securities of proprietary, af- 
 filiated and controlled 
 companies — pledged $450,000.00 
 
 (a) Stocks — page 48 
 
 (b) Funded debt — page 50. . 
 
 (c) Miscellaneous — page 52. 
 
 346 
 
 $450,000.00 
 
interstate Commerce Commission Accounting 
 
 II. Securities (continued) : Items Amount 
 
 B 3. Securities issued or assumed 
 — pledged — 
 
 (a) Stocks — page 21 
 
 (b) Funded debt — page 27.. 
 
 (c) Miscellaneous — page 52. 
 
 B 4. Securities of proprietary, af- 
 filiated and controlled 
 companies — unpledged . . $100,000.00 
 
 (a) Stocks — page 48 
 
 (b) Funded debt — page 50. . 
 
 (c) Miscellaneous — page 52. 
 
 100,000.00 
 
 Total $550,000.00 
 
 (II. Other investments : 
 
 B 5. Advances to proprietary, af- 
 filiated and controlled 
 companies for construc- 
 tion, equipment and bet- 
 terments — page 61 
 
 B 6. Miscellaneous investments — 
 
 (a) Physical prop'y — page 17 $600,000.00 
 
 (b) Secur. pledged — pages 49, 
 
 51 and 52 
 
 (c) Secur. unpledged — pages 
 
 49, 51 and 52 100,000.00 
 
 $700,000.00 
 
 Total $700,000.00 
 
 Total property invesmt. $7,990,000.00 
 
 Working assets : 
 
 B 7. Cash $273,900.00 $273,900.00 
 
 B 8. Securities issued or assumed, held 
 in treasury — 
 
 (a) Stocks— page 21 
 
 (b) Funded debt— page 27 
 
 (c) Miscellaneous — page 52 
 
 B 9. Marketable securities — 
 
 (a) Stocks— page 53 $200,000.00 
 
 1,000,000.00 
 
 (b) Funded debt— page 54 500,000.00 
 
 (c) Miscellaneous — page 52 500,000.00 
 
 2,200,000.00 
 
 347 
 
Principles of Accounting 
 
 Working assets (continued) : Items 
 
 B io. Loans and bills receivable 
 
 B ii. Traffic and car service balances due 
 
 from other companies 
 
 B 12. Net balance due from agents and 
 
 conductors 
 
 B 13. Miscellaneous accounts receivable. 
 
 B 14. Materials and supplies 
 
 B 15. Other working assets 
 
 Accrued income not due: 
 
 B 16. Unmatured interest, dividends and 
 
 rents receivable $2,000.00 
 
 38,500.00 
 
 Deferred debit items : 
 B 17. Advances — 
 
 (a) Temporary advances to pro- 
 
 prietary, affiliated and con- 
 trolled companies — page 61. $168,000.00 
 
 (b) Working funds 115,000.00 
 
 (c) Other advances 
 
 B 18. Rents and insurance paid in advance 
 
 B 19. Taxes paid in advance 
 
 B 20. Unexting'd discount on securities^ 
 
 (a) Unextinguished discount on 
 
 capital stock — page 29 
 
 (b) Unextinguished discount on 
 
 funded debt — page 29 
 
 B 21. Property abandoned, chargeable 
 
 to operating exp. — page 65 . . 
 
 B 22. Special deposits — page 61 
 
 B 23. Cash and securities in sinking and 
 
 redemption funds — page 57. . . 
 B 24. Cash and securities in insurance and 
 
 other reserve funds — page 57. 
 B 25. Cash and securities in provident 
 
 funds — page 57 
 
 B 26. Other deferred debit items 
 
 Total 
 
 Profit and loss : 
 
 B 27. Balance— page 43 
 
 Grand total 
 
 Amount 
 50,000.00 
 
 63,000.00 
 
 16,000.00 
 
 415,000.00 
 
 $3,017,900.00 
 
 $40,500.00 
 
 $283,000.00 
 4,000.00 
 4,600.00 
 
 51,500.00 
 
 69,000.00 
 60,000.00 
 
 380,000.00 
 
 82,000.00 
 
 250,000.00 
 
 $1,184,100.00 
 
 $12,232,500.00 
 
 348 
 
Interstate Commerce Commission Accounting 
 
 Liabilities Items Amount 
 
 Stocks : 
 
 B 28. Capital stock — page 21 — 
 
 (a) Common stock — 
 
 Held by Co $1,000,000.00 
 
 Not held by Co. 1,000,000.00 
 
 $2,000,000.00 
 
 (b) Preferred stock — 
 
 Held by Co.... 
 
 Not held by Co. $1,000,000.00 
 
 1,000,000.00 
 
 (c) Debenture stock — 
 
 Held by Co. . . . 
 Not held by Co. 
 
 (d) Receipts outstand- 
 
 ing for install- 
 ments paid 
 
 $3,000,000.00 
 
 B 29. Stock liability for conversion of 
 
 outstanding securities of constit- 
 uent companies 
 
 B 30. Premiums realized on capital stock 
 
 —page 29 $40,000.00 
 
 40,000.00 
 
 Total $3,040,000.00 
 
 Mortgage, bonded and secured debt: 
 B 31. Funded debt— p. 27— 
 
 (a) Mortgage bonds — 
 
 Held by Co $500,000.00 
 
 Not held by Co. 3,500,000.00 
 
 $4,000,000.00 
 
 (b) Col. trust bonds — 
 
 Held by Co.... 
 Not held by Co. 
 
 (c) Plain bonds, de- 
 
 bentures & notes 
 Held by Co. . . . 
 Not held by Co. 
 
 (d) Income bonds — 
 
 Held by Co.... 
 Not held by Co. 
 
 (e) Equip, tr. oblig'ns 
 
 Held by Co $500,000.00 
 
 Not held by Co. 2,500,000.00 
 
 ^ 3,000,000.00 
 
 349 
 
Principles of Accounting 
 
 Mortgage, bonded and secured debt (cont'd) : Items Amount 
 
 (f) Miscel. fund obli- 
 gations — 
 Held by Co.... 
 Not held by Co. 
 
 $7,000,000.00 
 
 (g) Receipts outstan'g 
 for f'ded debt — 
 
 ^ 32. Receivers' certificates — page 31.... 
 B 33. Obligations for advances 
 
 Received for construction.- 
 
 Equipment and betterment — page 61 
 
 Total $7,000,000.00 
 
 Working liabilities : 
 
 B 34 Loans and bills payable $390,000.00 
 
 B 35. Traffic and car service balances due 
 
 to other companies 75,000.00 
 
 B 36. Audited vouchers and wages unpaid 90,000.00 
 
 B 37. Miscellaneous accounts payable... 6,500.00 
 
 B 38. Matured interest, dividends and 
 
 rents unpaid 80,000.00 
 
 B 39. Matured mortgages, bonded and 
 
 secured debt unpaid 
 
 B 40. Working advances due to other 
 
 companies — page 61 
 
 B 41. Other working liabilities 
 
 Total $641,500.00 
 
 Accrued liabilities not due: 
 
 B 42. Unmatured Interest, dividends and 
 
 rents payable $18,000.00 
 
 80,000.00 
 
 $98,000.00 
 
 B 43. Taxes accrued 
 
 Total $98,000.00 
 
 Deferred credit items: 
 
 B 44. Unextinguished premiums on out- 
 standing funded debt — page 29. . 
 
 B 45. Operating reserves — page 59. 
 
 B 46. Liability on acct. of provident funds $250,000.00 
 
 B 47. Other deferred credit items 
 
 ISO 
 
 $250,000.00 
 
Interstate Commerce Commission Accounting 
 
 Liabilities (continued) Items Amount 
 
 Appropriated surplus: 
 
 B 48. Additions to property since June 
 
 30, 1907, through income 
 
 B 49. Reserves from income or surplus — 
 page 59 
 
 (a) Invested in sinking and re- 
 
 demption funds $380,000.00 
 
 (b) Invested in other res. funds.. 82,000.00 
 
 (c) Not specifically invested (claims 
 
 and injuries) 100,000.00 
 
 Total... $562,000.00 
 
 Profit and loss : 
 
 B 50. Balance — page 43 $641,000.00 
 
 Grand total $12,232,500.00 
 
 INTERSTATE RAILROAD COMPANY 
 
 INCOME ACCOUNT FOR THE YEAR ENDED JUNE 30, I912 
 
 Operating revenues: 
 
 Coai freight revenue $17,155,534-15 
 
 Merchandise freight revenue 14,687,291.27 
 
 Passenger revenue 4.568,029.75 
 
 Mail revenue 190,760.08 
 
 Express revenue 453,819.83 
 
 Other transportation revenue 360,717.36 
 
 Miscellaneous revenue. 271,250.55 
 
 Total operating revenues $37,687,402.99 
 
 Operating expenses: 
 
 Maintenance of ways and structures $3,620,176.26 
 
 Maintenance of equipment 6,003,286.95 
 
 Traffic expenses , . , 1,010,675.41 
 
 Transportation expenses 11,979,278.24 
 
 General expenses 793,901.50 
 
 Total operating expenses $23,407,318:36 
 
 Ratio of operating expenses to operating revenues 62.11% 
 
 Net operating revenue $14,280,084.63 
 
 Outside operations, net *320,I70.33 
 
 Total net revenue $i3.959,9i4-30 
 
 351 
 
Principles of Accounting 
 
 Taxes accrued 
 
 Operating income 
 
 Other income : 
 
 Hire of equipment — balance., 
 
 Joint facilities rents — credits. 
 
 Dividends on stocks 
 
 Interest on bonds 
 
 Miscellaneous income 
 
 Total other income 
 
 Total income 
 
 Deductions from income : 
 
 Interest accrued on funded debt 
 
 Rentals of leased lines and guaranties. 
 
 Joint facilities rents — debits 
 
 Miscellaneous deductions. . , 
 
 Additions and betterments." 
 
 Total deductions from income 
 
 Net income 
 
 ♦Deficit. 
 
 1,145.476-fo 
 $i2,8i4.437-6i 
 
 $90,324.66 
 
 244,756.92 
 
 584,026.62 
 
 46,121.00 
 
 710,509.42 
 
 $1,675,738.62 
 
 $14,490,176.23 
 
 $3,306,268.20 
 
 3,286,103.07 
 
 228,803.19 
 
 168,993.88 
 
 5,980,54942 
 
 $11,970,718.66 
 
 $2,5 19,457.57 
 
 INTERSTATE RAILROAD COMPANY 
 
 PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED JUNE 30, 1912 
 
 
 Dr. 
 
 Cr. 
 
 
 $15,764.30 
 
 140,777.91 
 1,689,647.47 
 
 4,245,759.00 
 641,000.00 
 
 $3,219,779.64 
 
 Expenditures for additions and betterments de- 
 
 2,519,45757 
 
 967,829.00 
 25,882.47 
 
 
 
 Federal excise tax for calendar years 1909, 1910, 
 
 
 Reduction of book value of capital stock of sub- 
 
 
 Dividends : 
 
 Five per cent, on pref'd stock, 
 
 oaid Tulv 14. ion Ss.iis.oo 
 
 
 Three per cent, on common 
 
 stock, paid July 14, 1911 1,210,044.00 
 
 Five per cent, on pref'd stock 
 
 paid Jan. 14, 1912 5,315-°° 
 
 Five per cent, on common 
 
 stock, paid Jan. 14, 1912 3,025,085.00 
 
 
 
 
 
 
 
 $6,732,948.68 
 
 $6,732,948.68 
 
 
 
 $641,000.00 
 
 For References for Collateral Reading see page 353 
 352 
 
Principles of Accounting 
 
 References for Collateral Reading, Chapter XXI, page 125 
 Accounts, Their Interpretation and Construction, Cole, pages 
 91, 92, 270. 
 
 Auditing Theory and Practice, Montgomery, pages 84, 104, 
 
 107, no, in, 113, 246, 299, 311, 409, 413, 519. 
 
 Science of Accounts, Bentley, pages 83, 110-117, 210-212, 217, 
 218. 
 
 Accounts in Theory and Practice, Lisle, pages 52, 267. 
 Accounting Practice and Procedure, Dickinson, pages 96, 
 
 108, no, 112, 113, 188. 
 
 Journal of Accountancy, Vol. XVI, page 443. 
 Journal of Accountancy, Vol. IX, page 114. 
 
 References for Collateral Reading, Chapter XXII, page 133 
 
 Modern Accounting, Hatfield, pages 46, 98. 
 
 Accounting Practice and Procedure, Dickinson, pages 40, 93,, 
 
 126. 
 
 Science of Accounts, Bentley, pages 95-109. 
 
 Auditing, Theory and Practice, Montgomery, page 94. 
 
 Accounts, Their Construction and Interpretation, Cole, page 
 
 3I7- 
 
 Philosophy of Accounts, Sprague, Monograph "A." 
 
 References for Collateral Reading, Chapter XLIX, page 352 
 Interstate Commerce Commission, Uniform System of Ac- 
 counts for all carriers. 
 
 Handbook of Railroad Expenses, Eaton. 
 
 353 
 
INDEX 
 
 Account Form, 284 
 
 Accountant, Duties of, 4 
 
 Accounting, 
 
 Interstate Commerce Commis- 
 sion, 343; Old Methods of, 1; 
 Present Methods of, 3; Provi- 
 sions relating to, 343;' Public 
 Service Commission, 316; Uni- 
 form, 320 
 
 Accounts, 
 Accounts Receivable, 65, 128, 
 280, 290; Arrangement of, in 
 books, 66; Associations or So- 
 cieties, 19; Bad, 276; Capital, 
 50; Capital Stock, 19, 20; Classi- 
 fication of, 50, 128, 129; Con- 
 sumption, 118, 120; Contract, 
 86; Controlling, 63, 65; Cost of 
 Sales, 206; Deficiency, 284, 308, 
 311; Definition and Construc- 
 tion of, 46; Doubtful, 276; Elim- 
 ination of, 295, 296; Finished 
 Goods, 118, 123, 124, 125; Gen- 
 eral, 63, 64, 281; Goods in 
 Process, 118, 123, 124, 125; 
 Group, 63 ; Inventory, 122 ; Man- 
 ufacturing, 205, 206; Materials 
 and Supplies, 118, 119, 123, 124; 
 Merchandise, 48; Mixed, 48, 49, 
 118, 119; Nominal, 51; Purpose 
 of, 45; Classified, 58; Payable 
 290; Principles of Handling, 
 321 ; Property, 67 ; Proprietor's, 
 50; Purchase, 47; Real, 51; 
 Realization and Liquidation, 
 315; Simple, 48, 49; Statistical 
 or Administrative, 63, 64; Sum- 
 mary, 63, 64; of, 19, 20; Sus- 
 pense, 323; Systems of, 318-322; 
 Taxes accrued, 270, 271; Trad- 
 ing, 301 
 
 Accruals, 278-281 
 
 Administrative Expense, Classifi- 
 cation of, 218, 303 
 
 Advances, Elimination of, 295, 296 
 
 Advertising, 157, 216, 280, 281 
 
 Allowances, 190, 200, 205, 281 
 
 Amortization, 
 Meaning of Term, 227; Of 
 Patents, Trademarks or Good- 
 will, 276; Of Premiums, 111; 
 Scheme, 323 
 
 Applied Theory Test, 
 No. 1, 69; No. 2, 87; No. 3, 91; 
 No. 4, 99, 100, 101 
 
 Appreciation, Treatment of, 325 
 
 Architect, Duties of, 72 
 
 Assessment, Definition of, 268 
 
 Assets, 
 And Liabilities, 52, 53; Arrange- 
 ment of, 286, 290; illustration 
 of, 287; Current, 53, 126, 286; 
 Deferred Charges to Income, 
 53, 54; Fixed or Capital, 53; 
 Miscellaneous or Special, 53, 
 280; Note as, 129; Working and 
 Trading, 53, 118 
 
 Associations or Societies, 28; Ac- 
 counts of, 19 
 
 Bad Accounts, 276 
 
 Balance Sheet, 
 Arrangement of Assets on, 290; 
 Classified, 286 ; Consolidated, 
 294; Specimen of, 299; Defini- 
 tion of, 166, 284; Discussion of, 
 283; Form of, as prescribed by 
 Interstate Commerce Commis- 
 sion, 344; General, 287; Sched- 
 ules supporting, 288, 289; Of 
 To-day, Changes in, 4; Purpose 
 of, 5 ; Schedules supporting, 293, 
 294; Specimen of, 325 
 
 354 
 
Index 
 
 Bill, 130; Of Exchange, 130 
 
 Bonds, 110; 
 And Mortgages, 114, 115; Value 
 of, 115; And Stocks as Assets, 
 how carried, 116; Accounts and 
 instruments, chart of, 21 ; Defi- 
 nition of, 169, 170; Discounting 
 of, 171; Elimination of, 295, 296; 
 Holders of, Rights of, 320; In- 
 terest on, 113, 172; Purchased 
 below Par, Interest on, 226, 227; 
 Method of Keeping Record of, 
 112, 113; Sold at a Premium, 
 172 
 
 Bonuses, 221 
 
 Bookkeeping, 
 Double Entry, 45; Methods of, 
 43; Single Entry, 44; Tendency, 
 47 
 
 Books, 
 Cash, 40; Classification of, 36; 
 Evolution of, 35, 36; Form and 
 Ruling of, 38; Government su- 
 pervision of, 35; Journals, 37; 
 Ledgers, 36; Purchase Journal, 
 41 ; Sales Journal, 41 ; Value of, 
 35 
 
 Borrowed Capital, 20, 90 
 
 Buildings, 
 Alterations to, 95 Architect's 
 duties in connection with, 72; 
 Contracts for, 72, 73, 74; Con- 
 tractor's position in erection of, 
 74; Contractor's Reserve, 76, 
 77, 86; Convenience in construc- 
 tion of, 89; Depreciation of, 
 Method of Entering, 279; Dis- 
 position of, 97; Estimates for, 
 75, 76; Given as security, 90; 
 Improvements to, 93, 94; In- 
 surance of, 96; Methods of 
 handling contracts on books of 
 contractor, 78, 79, 80, 81, 82, 83, 
 84; Methods of handling con- 
 tracts for, on client's books, 73; 
 Renewals and replacements of, 
 94; Repairs to, 94; Ways of Ob- 
 taining, 71, 89; What may Hap- 
 pen to, 93, 96. 
 
 Capital, 6, 223; As Production of 
 Income, 6; Contributors of, 285; 
 Forms of, 7, 18; Liabilities 
 Form of, 169; Of Value to Ad- 
 ministrative Force, 257 
 
 Capital Stock, 116, 194; Accounts, 
 19, 20; Elimination of, 295; 
 Classification of, 195; Dividends 
 on, 196; Increase in Value of, 
 197 
 
 Cartage, Outward, 199, 202; In- 
 ward, 203, 204 
 
 Cash, Adjustment of, at Closing, 
 280; Book, 40, 127; Discounts 
 on Purchases, 225; on Sales, 
 229; In Hand, 126; Petty, 126; 
 Position of, on balance sheet, 
 290; Working Funds, 126, 127 
 
 Charges, Deferred, to Expense, 
 153 
 
 Classified Balance Sheet, 286 
 
 Closing Entries, 278, 281 
 
 Closing of a Title, 90, 91 
 
 Commissions, 215, 281 
 
 Comptroller, State, Reports to, 
 336, 337; Power of, 342 
 
 Consigned Sales, 167, 168 
 
 Consignments, Adjustment of, 
 281 ; Carried on Memorandum 
 Book, 165 ; Charging of, to 
 Agent, 168; Consignor's Ac- 
 count, Procedure to be followed 
 in, 163, 164; Disposition of, 
 when taken up at receipt of 
 goods, 160-163; Disposition of, 
 when taken up at time of sale, 
 165; Elimination of, 295, 296; 
 From viewpoint of Consignee, 
 159 ; Accounting, 161 ; Books to 
 be kept, 161 ; Invoice, 160 ; 
 Goods Shipped on, 167; In^ 
 voiced at specified prices, 167; 
 On Memorandum, 167 ; Goods 
 received on, 159; Manner of 
 handling, on balance sheets, 292; 
 Manner of showing account on 
 balance sheet, 166 
 
 Consolidated Balance Sheet, 29v, 
 Specimen of, 299 
 
 355 
 
Index 
 
 Consumption Account, 118, 120 
 
 Contracts for Buildings, 72 
 
 Contributors of Capital, Classifi- 
 cation of, 285 
 
 Copartnerships, Accounts of, 19; 
 Classification of, accounts of, 
 termination of, 25; Definition 
 of, 23; Insurance of employees 
 of, 260; Interest important fac- 
 tor in, 256, 257; Limited, 26 
 
 Copyrights, 134; Value of, 135, 
 137, 138 
 
 Corporations, Accounts of, 318, 
 319; Classification of, by Pub- 
 lic Service Commission, 318; 
 Classified, 19; Definition of, 29; 
 Dissolution and surrender of 
 franchise of, 33; Insurance of 
 employees of, 260; Liability of 
 Stockholders of, 32; Officers of, 
 15; Taxation of, 30, 336; Trans- 
 fer of Stock of, 32 
 
 Cost, Manufacturing, 203; Of 
 Sales, 203, 206, 207; Prime, 203 
 
 Creditors, 18, 285 
 
 Current Assets, 126; Accounts 
 Receivable, 126; Adjustment of, 
 at closing, 280; Cash, 126; 
 Notes Receivable, 126 
 
 Current Liabilities, 290 
 
 Debenture, 170 
 Debtors, 285 
 
 Deductions from Income, 229 
 Deficiency Account, 284, 308, 311 
 Deferred Charges to Expense, 
 Methods of Handling, 153, 154; 
 Nature of, 153 
 Depreciation, Definition of, 234; 
 Duration of asset important 
 factor in calculation of, 244; 
 Examples of, 235, 236, 237; 
 Methods of calculating, 240, 
 241 ; Chart showing, 243 ; Neces- 
 sity of providing for, 238; Of 
 Land, 239; Rates of, Variance 
 in, 238, 239; Relation of, to re- 
 pairs, 240; Treatment of, in 
 accounts, 245 
 
 Development Expense, 157, 158 
 
 Directors' Fees, 219 
 
 Discount, Cash, 225; Classification 
 
 of, 252; Distinction between 
 
 interest and, 253; Register, 255; 
 
 Suspense Account for, 323; 
 
 Treatment of, in accounts, 253, 
 
 254; Unearned, 254, Treatment 
 
 of, by banks, 255 
 Dividends, 63, 224, 225; Payable, 
 
 277 
 Donations, 221 
 Doubtful Accounts, 276 
 
 Economic Functions of Organi- 
 zation, 9 
 
 Elimination of Accounts, 295, 296 
 
 Employer as Economic Type of 
 Organization, 13 
 
 Employer's Liability Insurance, 
 267 
 
 Entrepreneur, 7 
 
 Equipment, 
 Accounts for, 107, 108; Build- 
 ing, 103; Cost of, 106; Disposi- 
 tion of, 106; How acquired, 106; 
 Machinery and tools, divisions 
 of, 106, 107; Meaning of term, 
 102; Technical, 103; Classifica- 
 tion of, 104; What may Hap- 
 pen to, 106 
 
 Expense, Administrative, 218; 
 Definition of, 59; General, 221; 
 Legal, 220; Miscellaneous, 218, 
 220, 221; Office, 214; Operating, 
 59, 60; Of Salesmen, 214; Sales 
 Department, 214; Traveling, 
 220 
 
 Financial Condition, 50 
 
 Financial Statements, Classifica- 
 tion of, 283, 284; Necessity of, 
 4; Preparation of, 283 
 
 Fire Insurance, 260; Treatment 
 of, 266 
 
 Franchise, Duration of, 141; Pur- 
 poses for which granted, 139; 
 Valuation of, 140 
 
 356 
 
Index 
 
 Freight, Inward, 203, 204; Out- 
 ward, 199, 201 
 
 Functions, Economic, of Organi- 
 zation, 9 
 
 Funds, As Assets, 147; Capitaliza- 
 tion of, 324; Classification of, 
 147; Creation of, 148; Deposit 
 of, 149, ISO; Interest on, 149, 
 151; Methods of Handling, 185, 
 186, 187, 188, 190, 191; Relation 
 of, to Reserves, 184; Sinking, 
 149; Object of, 185 
 
 General Balance Sheet, 287; 
 Schedules supporting, 288, 289 
 
 General Expenses, 221 
 
 Goods, Capital and consumers', 6; 
 Finished, 118, 123, 124, 125, 279; 
 In Process, 118, 123, 124, 125, 
 279, 280 
 
 Goodwill, Adjustment of, 280; Al- 
 location of, 290; Amortization 
 of, 276; Different kinds of, 146; 
 Disposition of, 146; Duration 
 of, 145; Meaning of word, 142; 
 Methods of Valuation of, 143, 
 144 
 
 Government, as Party at Interest 
 in an organization, 285; Finan- 
 cial statement demanded by; 
 286 
 
 Gratuities to Employees, 221 
 
 Gross Profit, Method of Obtain- 
 ing, 209; On Cost, 209, 210; On 
 Sales, 209, 210; Percentage of, 
 211 
 
 Health Insurance, 260 
 
 Holding Companies or Trusts, 
 33; Subsidiaries of, 294, 295; 
 Elimination of accounts of, 295, 
 296, 297 
 
 Improvements to Property, 94 
 
 Income, and Profit and Loss 
 Statement of, 3, 5, 202, 207, 217, 
 222, 228, 233, 283, 284, 301, 305, 
 325; Form of Statement pre- 
 scribed by Interstate Commerce 
 
 Commission, 344, 349; Consoli- 
 dated Statement, 294, 295, Spec- 
 imen sheet for, 299; Bonds, 
 170; Classified, 6; Deductions 
 from, 229, 303, 304; Distinction 
 between, and Profits, 274; Fac- 
 tors which Produce, 6; From 
 Operations, 58, 223, 229, 303; 
 From Sales, 199, 302; Gross, 
 303; Net, 303; Production of, 
 10; Secondary, or Primary, 223, 
 303; Sources of, 59 
 
 Insurance, Adjustment of, 280; 
 Classification of, 259; Com- 
 panies, Commissions paid by, 
 215; Credit, 266; Definition of, 
 259; Depreciation in relation to, 
 265; Employers' Liability, 267; 
 Expense, 229, 231; Fire, 260; 
 Health, 259; Life, 259; Politics, 
 Cancelation of, 155 ; Relations 
 of Parties to, 263-265 ; Premiums, 
 260, 261, 267; Register, 154, 262; 
 Unexpired, Computation of, 
 261-263; Valuation of, 155 
 
 Interest, Accrual of, 250, 251, 255; 
 As Item of Expense, 250; As 
 Item of Income, 250; Charac- 
 teristics of, 249; Definition of, 
 8, 249; Distinction between dis- 
 count and, 253; Elimination of, 
 295, 296; Entries in connection 
 with, 251, 252; Methods of 
 Computing, 249; Example of, 
 250; On Accounts Payable, 229; 
 On Bonds, 224, and Mortgages 
 Payable, 229; On Capital, 229; 
 On Notes and Loans Payable, 
 229; On Taxes, 271; When to 
 Charge and Credit, 257, 258 
 
 Interstate Commerce Commis- 
 sion, Accounts required by, 343, 
 344; Authorization of, 343; Re- 
 ports required by, 343 
 
 Inventory, Account, 122; Adjust- 
 ment of, 281; Method, 119, 123, 
 205; Of Materials and Supplies, 
 206 
 
 357 
 
Index 
 
 Investments, Bonds, 110; Bonds 
 and Mortgages, 114; Classifica- 
 tion of, 292; Fluctuation of, 
 Method of Entering, 279; Pur- 
 pose of, 109; Stocks, 113; 
 Treasury Stock, 116, 117 
 Inward Cartage, 203, 204, 206 
 Inward Freight 203, 204, 206 
 
 Joint Stock Associations, 26; Ac- 
 counts of, 19 
 
 Joint Ventures, 27; Accounts of, 
 19 
 
 Journal, 37, 38, 43; Sales, 41 
 
 Labor, as factor in Production of 
 Income, 6; Direct and Indirect, 
 203 
 
 Land, Account for, Acquisition of, 
 68; As factor in Production of 
 Income, 6, 7, 69; Disposition 
 of, 69; Increase in value of, 
 Method of Entering, 278; What 
 may Happen to, 69 
 
 Ledger, 36, 43 
 
 Legal Expenses, 218, 220 
 
 Liabilities, Adjustment of entries 
 on, 281 ; Arrangement of, 286, 
 Illustration of, 287; Capital, 54, 
 169; Current, 54, 55, 286, 290; 
 Deferred Credits to Income, 54, 
 55; Secured and unsecured, 170; 
 Special, 54, 55 
 
 Liability, 52 
 
 License, 139 
 
 Life Insurance, 259 
 
 Losses, 59; and Profit and Income, 
 Statement of, 202, 207, 217, 222, 
 228, 233, 283, 284, 301, 305, Con- 
 solidated Statement, 294, 295, 
 Specimen sheet for, 299 
 
 Losses, And Profits, 60; Miscel- 
 laneous, 275, 276, 277 
 
 Manufacturing, Cost, 203, 205; 
 
 Department, 103 ; Organization, 
 
 Division of, 17; Overhead, 203 
 
 Materials and Supplies, Account, 
 
 118, 119, 203, 279; Inventory of, 
 206 
 
 Members, as Contributors of Cap- 
 ital, 285 
 
 Merchandise Account, 48 
 
 Miscellaneous Expenses, 220, 221 
 
 Mixed Account, 48, 49, 118, 119 
 
 Money, 7 
 
 Mortgages, 90 
 
 Moving Expense, 158 
 
 Nominal Accounts, Adjustment 
 of, 281; Analysis of, 61, 62, 63; 
 Classified, 58, 60; Definition of, 
 51 ; Purpose of, 45 
 
 Note, As an Asset, 129; Consider- 
 ation for indorsing, 226; Effect 
 of a, 290; Elimination of, 295, 
 296; Interest on, 130; Payable, 
 290; Receivable, 131, Discount- 
 ing of, 132, 293; Interest on, 
 133, 280 
 
 Office Expense, 214 
 
 Organization, Business, as Chief 
 Factor in Production of In- 
 come, 10; Employer as Eco- 
 nomic Type of, 13; Expense, 
 157, 158; Functions to be per- 
 formed by, 10; Legal Forms of, 
 12 ; Legal Types of, 23 ; Manage- 
 ment of, 13, 14; Manufacturing 
 Divisions of, 17; Object of, 8; 
 Parties at Interest in an, 285 ; 
 Purchasing Officer or Depart- 
 ment of, 16; Types of, from 
 Economic Viewpoint, 10 
 
 Outward Cartage, 199, 202 
 
 Outward Freight, 199, 201 
 
 Owned Capital, 18 
 
 Ownership, 193 
 
 Paciolo, Luca, double entry book- 
 keeping, System of, 45 
 
 Parties at Interest in Organiza- 
 tion, 285 
 
 Partnership, 24 
 
 Patents, Amortization of, 276; 
 
 358 
 
Index 
 
 Definition of, 134; Value of, 
 135-137 
 
 Plant Equipment, Chart of Classi- 
 fication of, 105 
 
 Postage, 218, 219, 280 
 
 Premiums on Insurance Policies, 
 261, 262, 267 
 
 Primary, or Secondary, Income, 
 223 
 
 Prime Cost, 203 
 
 Principal, 249 
 
 Principles of Handling Accounts, 
 321 
 
 Printing, 218, 219, 280 
 
 Profit, and Loss, 58, 303 , 305, 
 Form of Account prescribed by 
 Interstate Commerce Commis- 
 sion, 350, and Income, State- 
 ment of, 202, 207, 217, 222, 228, 
 233, 283, 284, 301, 305, Consoli- 
 dated Statement, 294, 295, Spec- 
 imen sheet for, 299; Classifica- 
 tion of, 303; Gross, 209, 303; 
 Object of Business Organiza- 
 tion, 8; Selling, 303 
 
 Profits, and Losses, 60, 274, 
 Method of Accounting, 275, 304; 
 as Item of Income; 6, 7; Dis- 
 tinction between, and Income, 
 274; Meaning of word, 184; 
 Methods of Handling, 185, 191; 
 Miscellaneous, 274; Net, 144 
 
 Proprietor, 18; Account of, 193; 
 As Contributor of Capital, 285 ; 
 Sole, 23 
 
 Proprietorship, 18, 50, 55, 56, 193 
 
 Public Service Commissions, Dis- 
 tricts covered by, 316; Estab- 
 lishment of, 316; Jurisdiction 
 of, 316; Purposes of, 318; Sys- 
 tems of Accounting prescribed 
 by, 317, 318, 319 
 
 Purchase Account, 47 
 
 Purchase Journal, 41 
 
 Purchases, Adjustment of, 281 ; 
 Classes of, 205 
 
 Purchasing Department, 204 
 
 Real Accounts, 51 
 
 Rebates, 199, 201, 205 
 
 Register, Discount, 255; Insur- 
 ance, 262 
 
 Rent, 6, 90, 91, 115, 156, 224, 229, 
 230, 231 
 
 Report, Form of, 284, to State 
 Comptroller, 337 
 
 Requirements, Effect of, 324 
 
 Reserves, Considered as Capital, 
 19, 55, 182; Creation of, 179, for 
 depreciation, 247 ; Disposition 
 of, 180, 181; Duration of, 181; 
 Funding the, 246; Location of, 
 on balance sheet, 182; Methods 
 of Handling, 185-191; Purposes 
 of, 147, 174, 175, 179, 180; Rela- 
 tion of Funds to, 184; Treat- 
 ment of, 290, 291; Use of word, 
 176; Various kinds of, 177, 178 
 
 Ruling of Books, 39 
 
 Salaries of Officers and Clerks, 
 219 
 
 Sales, Adjustment of, at closing, 
 281; Cost of, 203, 205; Deduc- 
 tions, 202; Elimination of, 295, 
 296; Gross, 199; Gross Profit 
 on, 209; Income from, 199, 202; 
 Journal, 41; Return, 199; Turn- 
 over, 212 
 
 Salesmen, Adjustment of ac- 
 counts of, 280; Commissions of, 
 215; Expenses of, 214 
 
 Schedules supporting balance 
 sheet, 293, 294 
 
 Secondary Income, 223 
 
 Securities, Classification of, 292 
 
 Selling, Expense, 214; Account 
 217; Price, 200; Purpose of, 8 
 
 Simple Account, 48, 49 
 
 Sinking Funds, Adjustment of, 
 280; Creation of, 149; Treat- 
 ment of, 291 
 
 Societies or Associations, 26; 
 Accounts of, 19 
 
 State Comptroller, Reports to, 
 Form of, 337; Requirements of, 
 336 
 
 359 
 
Index 
 
 Statement, Of Affairs, Definition 
 of, 284, 308, Preparation of, 
 309, Specimen, 310; Of Cash 
 Receipts, Definition of, 284, 
 Preparation of, Specimen of, 
 314; Of Income and Profit and 
 Loss, 3, 5, 202, 207, 217, 222, 
 228, 283, 284, 301, 305, Consoli- 
 dated, 294, 295, Specimen sheet 
 for, 299, 300; Of Realization and 
 Liquidation, Definition of, 284, 
 Preparation of, 311, Specimen, 
 312, 313 
 
 Statements, Financial, Prepara- 
 tion of, 283; Necessity of, 4; 
 Statistical, 283 
 
 Stationery, 218, 219, 280 
 
 Stock, Certificates, Issuance of, 
 194, 195; Definition of word, 
 113, 114; Donated, Treatment 
 of, 197, 198; Holder of, Rights 
 of, 320; Issuance of, 195, Rec- 
 ords, 120 
 
 Stockholders, as Contributors of 
 Capital, 285 
 
 Subsidiaries, 294, 296; Elimination 
 of accounts of, 295, 296, 297 
 
 Suspense Accounts for Discounts, 
 323 
 
 Systems of Accounts established 
 by Public Service Commission,- 
 318 
 
 Taxation of Corporations, 268, 
 336 
 
 Taxes, 156, 229, 290; Accrual of, 
 270, 272; Bill, Treatment of, 
 271 ; Classification of, 268 ; In- 
 terest on, 270, 271; Method of 
 Computing, 268, 269; Prepaid, 
 Treatment of, 270 
 
 Taxpayers as Contributors of 
 Capital, 285 
 
 Taylor, Dr. F. W., Study of Man- 
 agement of Organization by, 14 
 
 Telegraph, 218, 219, 220 
 
 Telephone, 218, 219, 220 
 
 Time, as -characteristic of interest, 
 249 
 
 Title, Closing of a, 90, 91 
 
 Trade Discount, 199, 200, 205 
 
 Trademarks, 134; Amortization 
 of, 276; Value of, 135, 137, 138 
 
 Trading Account, 301 
 
 Traveling Expenses, 218, 220 
 
 Treasury Stock, 116, 117, 197 
 
 Trusts or Holding Companies, 33 
 
 Turnover, 212, 213 
 
 Types of Organization, Legal, 23 
 
 Ventures, Joint, Accounts of, 19 
 Voucher, Classification of, 320; 
 Register, 41 
 
 Wages, 6, 290 
 
 Working Fund, 126, 127 
 
 360